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Economics

Limitations and understanding: Economic theories du jour

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It’s very easy to concentrate power and inequality. In fact, there’s not much to it. So when trying to understand economic theories, one needs to approach it from the angle of whether the economic policy will help or hurt the masses, whether there are specific groups affected, and what the effects are in the short-term, and in the long-term, even though in the long-run, we will all be dead.

Economics cannot be done in a vacuum, after all, economic theories aren’t universal laws, just an explanation or understanding of the economy in a social and historical context. The historical and social context gives the underlying assumptions and if they do not apply anymore, we cannot blindly use the rules derived from these assumptions. The world changed vastly from Adam Smith to Malthus and Ricardo to Keynes to the present day. And even when these so-called “laws”[i] are applicable, they also have limits which must be understood.

So, first, what has changed over the past several hundred years?

Movement of capital: In the 1800’s, capital was in the form of gold and land. Labor could move faster than capital, if capital could move at all. Now capital in the form of fiat money can move across the world and back in a matter of seconds. No need to send a ship full of gold across the ocean.

Transportation: Transportation has become much cheaper and faster. We can move goods across the world in a matter of days instead of months. In fact, this has accelerated in the past 5 years, with the death of the brick and mortar store in North America. It is more convenient to order items online and have them shipped. Having stock is almost an unnecessary overhead.

Automation, specialization, and manufacturing: The advances in technology allow cheap, untrained labor to produce goods. The mobility of the manufacturing plants gives international competition for labor.

Size of capital: Historically, corporations were granted a charter by the government to exist and generally worked for the “public good”. At any point in time, the charter could be revoked and the corporation dissolved. Many states in the US still hold these rights, but they are seldom, if ever have been enforced. It is a relatively new phenomenon that corporations can exist with the same effective rights as humans, live forever, and not be beholden to anyone.

Adam Smith and the invisible hand

The “invisible hand” is often referenced, and it certainly does have it’s applications, but the assertion that selfish individuals are always led by an invisible hand to produce what is the greatest good for society is an exaggeration at best. Partially quoted for reference:

“By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain; and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” (Adam Smith)

The invisible hand applies in “many cases”, though certainly not all cases. In Smith’s historical context, he’s referring to small entrepreneurs whose productivity was directly related to their revenue. If an individual entrepreneur produced an item, he derived value from any market transaction. The free market and invisible hand certainly applies here because there are many small independent players. But in present day, there are many subsidies, tax breaks, and different laws which corrupt the free market and give advantage to a few large corporations. Coupled with the interconnectedness of our economy[ii], the rampant unfreeness of our economy with large players/monopolies, and the joining of the state and market forces[iii] , the invisible hand no longer applies. There’s a very good reason that monopolies need to have regulation, since without competition, there is no free market capitalism of which to speak.

On the record, I’m in agreement with the laissez-faire capitalists in principle, however, it does not apply to our present economic environment. A market system cannot function for the benefit of the masses with a concentration of power in either wealth or state, but currently, we have both.

Ricardo and the law of comparative advantage

Ricardo outlined this law as follows:

“It can be of no consequence to America, whether the commodities she obtains in return for her own, cost Europeans much, or little labour, all she is interested in, is that they shall cost her less labour by purchasing than by manufacturing them herself.” (Ricardo, WC, II, p. 383)

This certainly applies in the short-term view, however, some assumptions do not apply. One of the prime assumptions would be that the employment levels would be equal and that each country has its own advantages that cannot be changed. This is no longer the case as technology, knowledge, and capital move faster than labor. Consequently, if a country has cheaper labor, it is relatively trivial for a company to move there to benefit from the cost reduction of the labor. Local workers, however, suffer.

What would happen if everything was produced in a remote country? How would the locals be able to purchase anything? At the most basic level, consumers are also workers. If they cannot work, they cannot consume. This has given rise to the proliferation of debt based purchasing and consumption in the US. And, to add to the irony, if the US did not do this, production and jobs in foreign countries would decline.

The law of comparative advantage has been espoused to promote free trade, which is actually more on the lines of free movement of everything but labor. Essentially, at the moment, this creates competition for labor, country vs country, but not for any other element of production. This destroys local jobs, but in theory allows a developing country to develop, given the willingness to subject their land to corporations. But make no mistake, this is only partially true. On the one hand, in the short-term, developing countries will benefit from the influx of capital and the usage of the cheap labor. This, in theory, should drive the wages up, etc. but in reality, there is too much excess labor since the productivity of the factories is very high. Secondly, there is rarely actually transfer of technology or knowledge to the country, they are beholden to the originator of the technology for maintenance and new purchases or replacements. And finally, a historical example of development should compare China and Russia with African nations. China and Russia developed in isolation with closed and protected markets and now have industrialized economies. African nations, under the guise of free trade, either trade agricultural products for trinkets under the guise of advantage or have their overflowing labor market accessed without the corresponding transfer of knowledge or ability to maintain the infrastructure and now have continual economic problems. Even free trade of goods is a double-edged sword, an example on the disruption of local markets will be given later. The common man does not win in the long-term.

Trickle down theory

The theory states that tax breaks, or other economic benefits, to those with capital or businesses, will overall benefit the economy by, for example, an increase in jobs, which will then benefit the rest of society.

The primary assumption here is that those with capital will use it to create jobs. Empirically, this is not the case since the movement of capital and existence of tax shelters doesn’t mean that the capital will be used locally, if at all. A recent study showed 21 trillion being stored off-shore by various companies and individuals in tax havens.[iv]. By definition, the fact that money is in tax-havens means it’s not being used locally, second and third tier effects not-withstanding.

As a counter-point, in a different economic era, I can see how the excessive taxation would be very detrimental to overall economic development with respect to lack of savings and investment for new businesses in the free market. For instance, currently, I can see some validity in the trickle down effect in 3rd world countries, where due to the lack of capital and infrastructure, there are many opportunities for businesses to grow and develop. However, if taxes were excessive, those business opportunities might disappear. This is not the case in first world countries, where it is difficult to see what new business would be worth investing in, and among other causes, certainly helps explain the capital flight demonstrated by the link given above. In our present economic situation, taxation helps the redistribution of wealth. If the lowering of taxes for the wealthy continue, eventually the poor will have nothing to eat but the rich, and a zombie apocalypse will begin.

Every economic theory or law has express assumptions and limitations. Examining and understanding the short and long term effects, as well as the groups which they effect, is important when considering economic policy.

tl;dr – Examine the assumptions of economic laws and theories, most of them don’t apply now.

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  1. As Captain Barbosa said: the code is more what you’d call guidelines []
  2. http://www.newscientist.com/article/mg21228354.500-revealed–the-capitalist-network-that-runs-the-world.html []
  3. http://endthelie.com/2012/04/18/18-venn-diagrams-showing-how-corrupted-american-democracy-really-is/ []
  4. http://www.guardian.co.uk/business/2012/jul/21/offshore-wealth-global-economy-tax-havens []
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