Bourgeois value theory after Ricardo

As I explained last month, the rising tide of struggle of the British working class obliged Ricardo’s bourgeois successors to abandon the concept of value based on the quantity of labor necessary on average to produce a commodity of a given use value and quality. They were forced to do this because any concept of labor value implies that profits and rents—surplus value—are produced by the unpaid labor performed by the working class. The challenge confronting Ricardo’s bourgeois successors was to come up with a coherent economic theory that was not based on labor value. Let’s look at some of the options open to them.

Malthus, borrowing from certain passages in Adam Smith, held that the capitalists simply added profit onto their wage costs. Like Smith and Ricardo, Malthus assumed that what Marx was to call constant capital could be reduced to wages if you went back far enough. Therefore, constant capital really consisted of wages with a prolonged turnover period—what the 20th-century “neo-Ricardian” Pierro Sraffa (1898-1983) was to call in his “Commodities Produced by Means of Commodities” “dated labor.”

Malthus held that since capitalists are in business to make a profit, they simply added the profit onto their costs—ultimately reducible to the price of “dated labor,” to use Sraffa’s terminology.

The idea that profits are simply added onto the cost price of a commodity is known as “profit upon alienation.” This notion was first put forward by the mercantilists in the earliest days of political economy. In this period, preceding the industrial revolution, merchant capital still dominated industrial capital. After all, don’t merchants make their profits by buying cheap and selling dear?

But what determined the magnitude of the charge above and beyond the cost of the commodity to the capitalist? And even more devastating for Malthus, since every capitalist was overcharging every other capitalist—as well as working-class consumers who bought the means of subsistence from the capitalists—how could the capitalists as a class make a profit? If Malthus was right, the average rate of profit would be zero!

But perhaps we don’t need the concept of “value” at all? Why not simply say that the natural prices of commodities are determined by the cost of production that includes a profit? But then what determines the prices of the commodities that entered into the production costs of a given commodity? Following this logic to its end, the natural prices of commodities are determined by the natural prices of commodities. This is called circular reasoning.

We haven’t moved an inch forward from our starting point. To avoid a circle, we have to determine the prices of commodities by something other than price. There is no escaping some concept of value after all.

The diamonds-versus-water paradox

Perhaps the value of a commodity is really determined by the commodity’s use value? If we can find a way of deriving price from use value, we don’t need labor value, with all its implications of profits arising from unpaid labor. The pure use value or utility theory of value, however, runs into what is known in economics as the diamonds-versus-water paradox.

Our need for water is far greater than our need for diamonds. We cannot live very long without water, but many of us go through life very well without ever owning a diamond. Indeed, our need for air is even more intense than our need for water. We die without breathable air within a few minutes.

If the value of a commodity is determined by the intensity of our need for its use value, the price of water should be far higher than the price of diamonds, and the price of air should be higher still. In reality, the price of water is far lower than the price of diamonds, and the price of air is normally zero. Clearly, the naive utility theory of value and price does not work.

The scarcity theory of value and the rise of marginal utility theory

But perhaps the value of commodities is determined not by their use values as such but by the scarcity of their use values? This can be formalized and expressed mathematically if we rephrase this question as the intensity of our need for an additional unit of a given type of commodity.

For example, if I am dying of thirst in a desert, my need for an additional glass of water might be greater than my need for an additional diamond. But under normal conditions, water is so abundant that I can easily obtain an additional glass of water at a very low price. If I am not thirsty, my need for an additional glass of water will be nonexistent, and therefore I will not pay a penny for it. As for air, I am surrounded by it. My need for an additional unit of air beyond what I already have is zero.

Diamonds, in contrast to air and water, are very scarce. If we had a choice of either having diamonds or water, we would choose water. But if we have a choice between an additional glass of water or an additional diamond, most people would choose the diamond.

As a result, the economists who developed the theory of marginal utility reasoned, it is not the intensity of the need for a given use value that determines its value. Rather, it is the intensity of the need for an additional unit of a given use value that determines its value. This idea at least had the merit of determining prices by something other than price.

While hints of the concept of marginal utility can be found earlier, from 1870 onward a whole series of economists, such as William Stanley Jevons (1835-1882) and Alfred Marshal (1842-1924) in Britain and Leon Walras (1834-1910) and Carl Menger (1840-1921) in Austria, proposed and developed the marginal utility theory of value. By the end of the 19th century, the marginal utility theory of value had become dominant among bourgeois economists. The turn of economics toward marginal utility theory and marginalist analysis in general is called the “marginalist revolution.”

It is tempting to see the publication of “Capital” Volume One in 1867 as the underlying reason for this “revolution” in bourgeois economic thought. In “Capital,” the workers’ movement had an economic theory far more powerful than the theory put forward by the Ricardian socialists or indeed by Ricardo himself. If the marginalist idea could lead to the development of a more logically and mathematically consistent theory than the one developed by Marx, it would demonstrate that capitalism is not based on the exploitation of the working class.

Comparing the two theories

These two theories of value, Marx’s perfected version of the labor theory of value and the marginalist theory of value based on the scarcity of use values, have been dueling it out ever since. Before I examine how the basic idea of marginal utility was extended to explain the operation of the economy as a whole, we should compare marginal utility theory to the concept of value based on the quantity of labor that it takes on average to produce a commodity of a given use value and quality.

The labor value approach of both the classical bourgeois economists and Marx begins with production of products by the labor of human beings and then studies how humans exchange the products of their labor. The marginal utility approach, in contrast, begins with the consumer. (1) Indeed, the marginalists apply their theory of value to all scarce products desired by humans, whether they are products of human labor or products of nature.

Labor value is objective while the marginalist approach to value is subjective. At any given movement under the prevailing conditions of production, a commodity represents a certain quantity of (abstract) labor. In contrast, the marginal utility approach has a consumer subjectively valuing an object, which may or may not be a product of human labor.

For example, to a smoker addicted to nicotine a cigarette will have a positive marginal utility unless there is no scarcity of cigarettes at all. But for a non-smoker, cigarettes have absolutely no use value and thus no marginal utility. This would be true even if the cigarette was the last cigarette in the entire world. Every individual, therefore, will subjectively value a commodity of a given use value and quality differently. However, under the prevailing conditions of production, a cigarette will always take on average at any point in time a certain definite quantity of human (abstract) labor to produce.

Marx explained that when producers exchange the products of their individual concrete labors they in effect abstract all the differences that distinguish these labors from one another, reducing them to labor as such, or abstract labor. As values—but not as use values—commodities are “made” of the same thing—value. This makes it possible for different commodities of quite different use values to be quantitatively compared to one another in the market place.

The end of marginal utility

The challenge to the subjective marginal utility economists was to reduce marginal utility to some homogeneous social substance like Marx had done with his concept of abstract labor. It was proposed that utility could be reduced to “utils”. But exactly what would be the unit of measure of a “util”? Are “utils” measured in terms of weight like gold or barrels like oil is? No. Can “utils” be measured by a unit of time like abstract human labor? Again no.

In the end, the problem could not be solved, and bourgeois economists were obliged to abandon marginal utility in their “advanced” writings, retaining it only in introductory college textbooks.

This was the first big setback for marginalism. Instead, the economists were obliged to settle for graphical representations of “consumer preferences,” which are mathematical models of how consumers with different subjective needs will choose among different scarce commodities. For example, will a given consumer in the supermarket spend her last dollar on an extra orange or an extra apple?

From the ‘trinity formula’ to the marginal product of the factors of production

Post-Ricardian economics made heavy use of what Marx in Volume III of “Capital” called the “trinity formula.” Adam Smith had divided all incomes into three categories coinciding with the three basic classes of capitalist society. The three forms of income are the rent of land, the wages of labor, and the profit of capital.

The trinity formula takes the commonsense approach that land produces rent, capital produces profit, and labor produces the value of its wages. The marginalist economists developed this most commonplace and naive of notions into the mathematical theory of marginal productivity that is taught in university economics departments today.

Suppose, the marginalist reason, we add an extra unit of land of a given type to an apple orchard owned by a capitalist farmer. How many extra apples will we get as a result? The extra apples are the marginal product of the land, and the value of these extra apples, the marginalists claim, determines the value the land contributes to the value of apples produced in the farmer’s orchard. The value produced by the land goes to the landowner—whether the farmer, if he or she owns the land, or a separate landowner, in the form of rent. What could be more fair?

Suppose instead we add an extra unit of capital. How many extra apples will we get? The extra apples will be the marginal product of capital, and their value will determine the value the farmer’s capital contributes to the apples. The farmer as an owner of capital gets this value in the form of interest on this capital. (2)

Or the capitalist orchard owner could hire an extra worker. How many extra apples will be produced in this case? The value of the extra apples is the marginal product of labor. The value of these extra apples, the marginalist hold, determines the value that the workers produce through their labor, which determines their wage. The marginalists then explain that they have proven through rigorous mathematical reasoning that the workers get paid exactly the value their labor contributes to the products. No unpaid labor by the workers is involved.

As long as free competition prevails, marginalist economists insist, none of the three “factors of production”—land, capital or labor—will exploit another, at least not for very long. Only if wages for some reason happen to be less than the value of the marginal product of labor, the marginalists hold, will labor be exploited.

But under these conditions the capitalists will eagerly hire additional workers in order to make an “economic profit” above the rate of interest on their capital. Demand for labor will rise and the price of labor—wages—will soon rise back to its marginal product. The free market itself will quickly end the exploitation of labor—and abolish the “economic profit” earned by the capitalists through their exploitation of labor—leaving only the interest on capital. No need for unions or a workers’ movement!

Suppose wages happen to be above the value of the marginal product of labor? In that case, the marginalists explain, labor will be exploiting capital! But again, free competition will come to the rescue of the exploited capitalists. The capitalists will incur losses if they pay more to labor than the value the labor is producing. The workers will either have to accept lower wages or will be laid off. Free competition will ensure that the landowners receive the full value produced by their land but not a penny more.

The marginalist economists reason that work is not always so pleasant. Who, for example, enjoys grading or lecturing to students on the glories of the free market? (3) So for workers, there is always a trade-off. They can either choose to supply an extra unit of labor to the capitalist and in return receive a wage exactly equal to the extra value they produce, or they can choose leisure and incur the opportunity cost of going without the extra wage. It is the workers’ choice.

How marginalists explain the huge incomes of the capitalists

How then do we explain the extremely high incomes of capitalists like John D. Rockefeller, Henry Ford, Bill Gates and Steve Jobs, to name a few? What choices are they making that entitles them to such tremendous incomes?

The marginalists reason that the entrepreneur is really a worker whose particular skills are in very short supply. Different types of labor have different marginal productivities and therefore earn different wages proportional to their relative scarcities. For example, the marginal product of a jeweler will be much higher than that of a ditch digger, since jewelers are “scarcer” than ditch diggers. After all, the marginalists reason, anybody can dig a ditch, but it takes years of training to master the jewelery trade and not everybody can do it.

And the marginal product of the labor of a Steve Jobs or even more of a Bill Gates is vastly higher than the marginal product of a jeweler. Rockefeller, Ford, Jobs and Gates were “geniuses,” and their particular type of labor is therefore far scarcer than mere jewelers. (4)

The marginal product of the labor of these billionaires—called “robber barons” in the 19th century—was not, the marginalist economists explain, simply a few extra ditches like is the case with the lowly ditch digger, a few more diamond rings like is the case with the skilled jeweler, but whole new industries. For example, oil in the case of Rockefeller, cheap mass-produced cars in the case of Ford, and modern computer “devices” and associated software like the Windows operating system from Microsoft or iThings from Apple.

But what about the money capitalists who perform no labor at all? If you have enough capital—and the richest money capitalists do—you can earn hundreds of millions of dollars a year without inventing whole new industries or engaging in labor of any kind. What entitles these money capitalists who perform no work to their considerable interest incomes? Borrowing from the pre-marginalist British economist Nassu Senior (1790-1864), the marginalists hold that it is the “abstinence” or “waiting” by the capitalists that produces interest.

The marginalists explain that every person has a choice of either consuming their income immediately or saving it. Whether we are conscious of it or not, we are engaging in a process of subjectively valuing, for example, the difference between the value of a cup of coffee today or two cups of coffee 20 years from now. Everything remaining equal, I’d rather have a cup of coffee this morning. But if I was told that if I am willing to wait 20 years I will get an extra cup of coffee, I have a choice to make. Is a cup of coffee today really worth two cups of coffee 20 years from now? I am free to choose.

While most people choose a cup of coffee today, a thrifty few instead choose to have two cups of coffee 20 years from now. The people who make the latter choice, the economists explain, are capitalists. The capitalists deposit their coffee money in a savings account at a bank.

When, the marginalists explain, I a capitalist decide to deposit my coffee money in the bank instead of buying a cup of coffee today, I am discounting the value of the two cups of coffee that I plan to consume 20 years from now to the value of a single cup I could drink today. The difference, the marginalist economists reason, between the subjective valuation I put on the cup of coffee I can consume today and the lower value of a cup of coffee that I will have to wait 20 years to consume is the interest on my capital.

Human capital

According to Marx, the labor power of the workers becomes (variable) capital once it is purchased by the industrial capitalist. It is in a sense “human capital.” However, the marginalist economists do not use the term in this sense. Instead, they argue that it is the worker who “invests” in learning skills that is a capitalist. And like all capitalists, the workers earn interest on their human capital that takes the form of the extra wage above what an unskilled worker would earn.

According to marginalist reasoning, skilled workers by choosing to learn skills instead of earning the regular wages they could earn today are like all capitalists choosing to consume more in the future by consuming less today. These thrifty workers are by abstaining from current consumption “producing interest” and are true capitalists. Therefore, the marginalists explain, everybody except the most unskilled workers are actually capitalists!

From rate of profit to rate of interest

Our modern economists, unlike the classical economists or Marx, do not in their theoretical writings use the term rate of profit but rather rate of interest. Economic profit above and beyond the rate of interest, modern bourgeois marginalist economists explain, simply reflects momentary disequilibriums in the market. If you take a university-level economics course, you will be told that when the economy is in equilibrium there are no profits. That’s right, no profits!

The rest of the very high incomes of the capitalists that cannot be explained away as interest is explained as we saw above as the wages of the labor of the capitalists that they earn due to the very high value of the marginal product of their labor.

The landlord and inheritance

The marginalists argue that it is the willingness of the capitalists to sacrifice consumption today so they can consume more in the future that has made our present-day society much wealthier than any earlier society. But what about the final member of the trinity, the landlord? After all, land in no way is the product of anything the landlord does since (unimproved) land is by definition the product of nature. Neither human labor nor human “waiting” or “abstinence” plays any role here. Some marginalists like Leon Walras actually opposed private ownership of the land. But most marginalists assume that landlords somehow deserve to enjoy the value of the marginal product of their land in the form of ground rent. (5)

Money and marginalist theory

The marginalists took over the classic quantity theory of money already found within classical political economy. In Ricardo’s time, money was defined as circulating gold (or silver) coins plus banknotes and small coins made of base metals—token money. Ricardo assumed that the general price level reflected the ratio between money and (non-money) commodities. If the quantity of commodities is fixed, a doubling of the quantity of money would double the price of commodities, while cutting in half the quantity of money would reduce the general price level to half the previous level. Ricardo assumed that price changes caused by changes in the quantity of money relative to the quantity of commodities would occur rapidly without friction.

Because of this relationship, Ricardo did not see how a “general glut” of commodities could possibly occur. If capitalists cannot invest money in their businesses directly, they will lend it to fellow capitalists in order to receive interest on their capital—for example, by depositing the money in a bank. Certainly, Ricardo argued, the capitalists would not hoard money, because it is only by throwing money into circulation that they can get richer.

Ricardo assumed that the value of gold and silver—money commodities—was determined like the value of all commodities by the labor on average necessary to produce them. If the general price level in terms of market prices were to exceed the general price level in terms of natural prices—prices of production—gold (money material) would be exchanging with commodities below its value. The general rate of profit would therefore be above the average rate of profit in gold mining and refining. Capital would therefore flow out of gold mining and refining into more profitable branches of production.

Over time, this would mean the production of gold would decline, and the quantity of money would grow more slowly than commodity production as a whole. As a result, the ratio of money to commodities would decline and the general price level would fall. The converse would occur if the general price level in terms of market prices were to fall below natural prices.

So on the scale of the world market, the general price level would be regulated by the relative labor values of gold or silver, on one hand, and all other commodities, on the other. But Ricardo believed such ups and downs of prices only affected the nominal wealth and not the real wealth of capitalist society. Real wealth consists of commodities whose use values serve as other than the means of circulation of commodities—in Ricardian theory, provided by money.

The marginalists took over the quantity theory of money used by Ricardo and as well Ricardo’s theory of international trade (today known as the theory of comparative advantage, which heavily depends on the quantity theory of money) while rejecting Ricardo’s theory of value based on human labor.

To the marginalists, money consists of tokens of value. The value of the monetary tokens, the marginalists hold, reflects the value of the scarce commodities they

help circulate. According to the marginalists, the scarcity of the monetary tokens relative to the value of commodities they circulate determines the general price level. The less scarce the monetary tokens are relative to the value of the total mass of commodities the higher the general price level will be. But, the marginalists explain, this affects only the nominal wealth of society, since monetary tokens have no value in themselves. What would be the value of a hundred-dollar bill if there was nothing to buy with it?

Marginalism versus the gold standard

Under the classical gold standard, the main job of the central bank, or other monetary authority, was to make sure the currency price of gold never changed. To accomplish this, the monetary authority maintained a reserve of gold and stood ready at all times to buy and sell gold at the official currency price of gold. All other considerations, such as preventing general price inflations or deflations or combating recessions with their associated mass layoffs, were either ignored or subordinated to the necessity to maintain the fixed currency price of gold.

Marginalist theory implies that the policy of stabilizing gold is a mistake. Gold, according to marginalist theory, is after all just another commodity, which has very limited uses other than serving as raw material for the production of monetary tokens (gold coins). But, according to marginalism, there is no need to make monetary tokens out of gold. Monetary tokens can just as well be made of paper and ink, which will work just as well as long as the tokens are sufficiently scarce.

True, if monetary tokens are made of gold, this will guarantee that the monetary tokens themselves will remain scarce. In this way, the marginalists agree, a gold standard will tie the hands of an irresponsible government or monetary authority that might otherwise follow a reckless policy of inflating the quantity of monetary tokens in order to get out of financial difficulties. But marginalism implies that as long as the monetary authority is responsible, there are no advantages to the gold standard. Indeed, marginalist logic leads to the conclusion that the ideal monetary system is not a gold standard but a well-managed system of paper money.

Marginalism leads to inflation targeting

The marginalists couldn’t help but notice that the swings of the industrial cycle—though marginalism couldn’t really explain why there was an industrial cycle in the first place—were accompanied by swings in the general price level. The marginalists tended to believe that the industrial cycle was therefore primarily a phenomena of changes in the general price level—as opposed to the prices of particular commodities. This was exactly the view developed by early U.S. marginalist economist Irving Fisher (1867-1947), who can be considered Milton Friedman’s immediate predecessor.

By stabilizing the price of one particular commodity, gold, Fisher explained, the economy was condemned to deflation whenever the supply of gold declined relative to other commodities, and inflation whenever the supply of gold increased relative to other commodities. Such swings in prices, in turn, disrupted the credit system—bankrupting many debtors when prices fell or hurting creditors when they rose. But these evils, Fisher reasoned, could easily be avoided if the monetary authority instead of stabilizing the price of gold stabilized the general price level.

Fisher argued that if prices are rising, thereby hurting creditors, the monetary authority should reduce the rate of growth of the monetary tokens it issues until prices stop rising. And if prices are falling, it should increase the rate of growth of the monetary tokens until prices stop falling. In this way, marginalists like Fisher reasoned, the general price level can be stabilized preventing inflation and deflationary depression, while the prices of particular commodities would be left free to rise and fall relative to the general price level. (6)

Today’s “gold bugs” often blame Keynes for laying the theoretical foundations for the abandonment of the gold standard. In reality, it was marginalism that did this.

The “monetarism” of the Nobel Prize-winning marginalist “fundamentalist” (7) Milton Friedman that became popular during the inflation of the 1970s was simply a variant of Fisher’s ideas. Friedman agreed with Fisher that the monetary authority should not target the “price of gold,” which after 1933 no longer circulated in the United States as currency. Since Friedman saw money as basically a means of circulation, he believed that once gold stopped being used to make monetary tokens in the form of legal tender gold coins—in Europe starting in 1914 and in the U.S. from 1933 onward—it ceased being money.

The U.S. Treasury, Friedman claimed, by selling and buying gold at the fixed price of $35 an ounce to foreign monetary authorities—as it was obliged to do under the post-World War II Bretton Woods system—was guilty of supporting the “price of gold” at an artificially high level. If the Treasury stopped doing this, as Friedman believed it should, the dollar price of gold would fall well below its artificially high level of $35 an ounce.

Instead of supporting the price of gold, Friedman argued, the monetary authority should set the annual rate of growth of the money supply—defined as legal tender tokens plus checkable bank deposits—at some stable relationship to the potential rate of growth of commodity production as a whole. Friedman defined the potential growth of commodity production as the rate of growth of the population—the number of potential additional workers—plus the rate of growth of labor productivity.

For example, if the population grew at the 2 percent rate and the productivity of labor increased at 1.5 percent a year, the monetary authority should increase the “money supply” at a rate of 3.5 percent if it desired a stable general price level. If the monetary authority decided on a rate of inflation of 2 percent, generally the goal today, it would simply add 2 percent to the rate of growth of the quantity of monetary tokens it is creating. This policy of targeting the general price level instead of the currency price of gold, as was the case under the gold standard, is called “inflation targeting.”

Inflation targeting

From a technical point of view, inflation targeting fails because the monetary authority would have to control the four variables needed to achieve the inflation target when it in reality controls only one. First, it would have to control the rate of growth of the quantity of commodities, which is completely beyond the control of the monetary authority.

Second, it would have to control the rate of growth of monetary tokens, the only variable of the four that it does control. Third, the monetary authority would have to control the ratio of credit money created by the commercial banking system to the monetary tokens it creates, called the monetary base, or “high powered money.” And fourth, it would have to control the velocity of circulation of both the monetary tokens it creates and the credit money created by the commercial banking system.

How can the monetary authority achieve “the inflation target” when it controls only one—the quantity of monetary tokens—of the four variables it would have to control to achieve the inflation target? Friedman’s answer to this objection was that marginalist theory had “proved” that a capitalist economy is extremely stable both in its potential to grow from year to year and in all other ways as well.

Because Friedman explained that this “profound stability” of capitalism had been proven by marginalist theory, the other three variables—the potential rate of growth of production, the ratio of the monetary tokens issued by the monetary authority to the quantity of credit created by the commercial banks, and the velocity of turnover of money in circulation, are also “profoundly” stable. The achievement of an inflation target is therefore quite easy. All the monetary authority has to do is keep the rate of growth of the monetary tokens it issues at a constant level.

Friedman held that virtually all real-world episodes of instability in the history of the capitalist economy—booms, inflations and recessions—could be traced to changes in the rate of growth of monetary tokens—the one variable that happens to be controlled by the monetary authority. Under the gold standard, since gold production was prone to considerable instability due to the finding of new mines, the depletion of old mines, changing technology an so on, significant economic swings between inflationary booms and deflationary recessions could not in fact be avoided.

But in a system of “paper money,” Friedman claimed, where monetary tokens are made of paper and ink, coins made up of cheap metals, or simple bookkeeping entries, the rate of growth of the quantity of the monetary tokens could be stabilized. If this were done, Friedman predicted, the “business cycle” would all but disappear.

The current dilemma in monetary policy and inflation targeting

Inflation targeting inspired by marginalist economic theory is now confronted with a great dilemma. Since the crisis of 2008—which defied marginalist theory by occurring in the first place—the U.S. Federal Reserve system, which acts as the central bank of the entire world under the dollar system—has increased the rate of growth of the dollar-denominated monetary tokens it creates to approximately 30 percent a year. According to marginalist theory, since rises in productivity and the rate of growth of the population are nowhere near this level but closer to 3 percent, such a rate of growth should soon result in global U.S. dollar inflation of around 27 percent, give or take a few percentage points. Such an inflation rate, if it should come to pass, would make make the Great Inflation of the 1970s look positively tame.

The problem is that despite the very rapid increases in the growth of monetary tokens—the monetary base—dollar inflation has remained well below the Fed’s inflation target of around 2 percent. Looking at the low rate of inflation or even slight deflation, the Federal Reserve System should, according to prevailing marginalist theory, move to accelerate the rate of growth of its monetary tokens until inflation reaches 2 percent.

But if the Fed looks at the rate of growth of its monetary tokens since the 2008 crisis, it seems that inflation is about to accelerate well into double-digit territory. The Fed fears, not without reason, that if it keeps the rate of growth of its monetary tokens at anywhere near the rate that it has been since 2008, when inflation does pick up it will shoot right past the 2 percent annual rate on its way to double digits. If this actually happens, the experience of the 1970s indicates that it will be costly to bring the inflation rate back down to the 2 percent target, threatening the very existence of the dollar-centered international monetary system that forms the foundation of the global U.S. empire.

As I write this, the stock market is bouncing around from day to day as the Wall Street speculators try to figure out exactly how the Fed will deal with this dilemma. What’s important to us here is to realize that the very existence of this dilemma shows that there is something very wrong not only with the monetary theories of Fisher and Friedman but with the marginalist economic theory their monetary theories are built on.

The Cambridge Capital Controversy disproves marginalism theoretically

In the early 1960s, the “Cambridge Capital Controversy” on the nature of capital occurred. Economists at Cambridge University in England (8) led by Piero Saffra were pitted against economists at the Massachusetts Institute of Technology in Cambridge, Massachusetts, led by Paul Samuelson (1915-2009). Samuelson was considered one of the most mathematically astute marginalist economists of his time.

Below when I talk about labor, rent and interest, unless I indicate otherwise, I am using these terms in the sense that modern (bourgeois) economists use them, not in the sense Marx used them.

The economists who participated in the Cambridge Capital Controversy ignored land, reducing the three “factors of production” to only two, labor and capital. As I explained above, according to marginalist economic theory, our two remaining factors of production have prices. The price of labor is the wage, and the price of capital is the rate of interest.

What, according to marginalist theory, determines the prices of capital and labor? The marginalist answer is the scarcity of labor and capital relative to one another. The scarcer capital is relative to labor the higher the rate of interest. Conversely, the more plentiful capital is relative to labor, the lower the rate of interest. Therefore, as wages rise interest rates fall and vice versa.

Pricing a unit of labor involves no great difficulties. First you reduce skilled labor to unskilled labor. You then measure the use value of labor by its appropriate unit of measurement. In the case of labor, the appropriate unit of measure is time. You then calculate exactly what a capitalist has to pay in wages in order to hire a given quantity of labor, let’s say an hour of labor. For example, an hour of labor might cost its capitalist buyer $10 in wages. We can use the same procedure to specify the price of any commodity.

Take the example of sweet oil. Oil is measured in terms of barrels just like labor is measured in terms of hours. On March 6, 2015, the price of sweet oil was quoted at $49.78 a barrel. We take a specific quantity of the use value of sweet oil—measured in terms of its appropriate unit—and compare it with a specific sum of money—$49.78—at a particular point in time—March 6, 2015.

Now how do we apply this procedure to a unit of capital?

First, what unit of measure should we use for capital? Oops! The problem is that, unlike unskilled labor or sweet oil, capital consists of many different use values that have the most diverse units of measure. Samuelson proposed that we can assume that all “capital” consists of one type of commodity—perhaps barrels of oil. But that is what Marx called a “violent abstraction.” Samuelson was forced to concede on this point and gave up on his “one commodity” model.

How do we compare in terms of utilities—use values—a barrel of oil, a lathe, a Phillips-head screwdriver, and a magnetic drill press, to name just a tiny percentage of the huge number of types of commodities that make up capital. Indeed, how can we quantify capital? To calculate the quantity of capital, we would have to add lathes, Phillips-head screwdrivers, and magnetic drill presses to one another. Economists even came up with a term for this problem. They called it the “aggregation problem.” (9)

But can’t we solve this problem like the capitalists solve it in the real world by using money? We simply add up the prices of a Phillips-head screwdriver, a magnetic drill press, and so on. But remember, according to marginalist theory money is simply a heap of tokens that are without value in themselves. (10) Instead, the monetary tokens reflect the value of the commodities that the tokens circulate. And as we saw above, all attempts to create a common substance of value on marginalist assumptions have failed. But let’s try to use money to define the “price of capital” anyway.

Interest is always measured in terms of percent. Let’s assume that the rate of interest is 3 percent a year. Now we can capitalize an annual interest income, $1,000, for example, by dividing it by the price of capital—rate of interest—(1,000/.03), which equals $33,333.33. Should we say that the price of $33,333.33 of capital equals $1,000? That is, should we say that the number 33,333.33 equals the number 1,000? No, that doesn’t work.

Perhaps we should say that $33,333.33 in capital rents for $1,000 a year. That’s better. But it still doesn’t solve the problem. If we are dealing with ground rent, we would at least be comparing a quantity of land—an acre, for example—with a sum of money. That’s better. But in the case of the “renting” of capital measured in terms of money, we are still comparing one sum of money to another sum of money. A price, in contrast, has to equate some object of utility other than money with a given quantity of money. And for the marginalists it’s all downhill from here.

How do we calculate the annual rate of interest on capital? First, we have to divide the quantity of interest in some unit of something—we don’t know what—by a quantity of capital defined as a quantity of the same something. And our difficulties do not stop here!

Since the marginalists are applying the laws of fictitious capital to real capital, it turns out that the quantity of capital in terms of something cannot be determined independently of the interest rate itself! Indeed, the prices of individual capital “goods” turn out to be simply a form of interest, just like the price of land is another form of the rent of land. Without some concept of labor value, there is simply no way to measure the quantity of capital independently of the rate of interest. We are stuck in a perfect circle of determining the rate of interest by the rate of interest.

Marx solved all these problems—both the aggregation problem and the problem of determining the quantity of capital independently of the rate of profit (what modern economists incorrectly call the rate of interest) through his concept of abstract human labor as the social substance of value. Capital, Marx explained, is not a physical substance like oil, lathes, factory buildings, and so on but rather a social relationship of production. The social substance that capital is “made” of is value—abstract human labor measured in some unit of time.

When we aggregate lathes, drill presses, assembly lines, and factory buildings as capital, we are not adding a lathe to a drill press to an industrial robot and so on. Indeed, we are not allowed to do this because the laws of arithmetic require that only qualitatively identical objects can be added to one another. Instead, we are adding definite quantities of qualitatively identical quantities of abstract human labor measured in terms of time to one another. This is a perfectly proper arithmetic procedure.

Similarly, when we calculate the rate of profit, we divide the total profit—surplus value measured in terms of a specific quantity of abstract human labor—by the total quantity of capital, also measured in terms of a specific quantity of abstract human labor.

But isn’t it awkward to use units of time? Isn’t it more convenient to use units of money like dollars, pounds, euros and so on. As we know, dollars, pounds and euros at any given time will represent a given quantity of gold measured in terms of weight. The gold fixing price in London provides a daily measure of this quantity for dollars. (Simply divide 1 by the fixing price to calculate the amount of gold in fractions of an ounce one dollar represents on a given day.)

We can take the shortcut of using units of money—and Marx often did in “Capital.” But if we want mathematically exact results using prices rather than values—that is, remove all influence of the rate of profit on the quantity of capital—we can only use direct prices. Otherwise, we cannot fully escape the circle, because if we use any type of price other than direct price, the value of capital cannot be determined independently of the rate of profit.

Marginalism disproved mathematically

The Italian-British economist Pierro Sraffa developed a mathematical disproof of marginalist theory in his book “The Production of Commodities by Means of Commodities,” published in 1960, which kicked off the Cambridge Capital Controversy.

Sraffa’s refutation of marginalism involved the “double re-switching of techniques.” Remember, marginalists assume that as capital grows scarcer relative to labor, the rate of interest rises, and conversely, if capital grows more plentiful relative to labor, interest rates fall. In the world of marginalist theory, wages and interest move inversely. The higher the level of wages the lower the rate of interest, and the lower wages are the higher the rate of interest. (11)

According to marginalist theory, as capital grows scarcer relative to labor the prices of capital goods rise. At some point, industrial capitalists will shift to a more labor-intensive technique because it is cheaper. Similarly, as capital goods become more plentiful relative to labor, they become cheaper and there is a shift from labor to more “capital-intensive” techniques of production. This is crucial to marginal productivity theory.

But Sraffa showed that under certain conditions—remember we are using assumptions that the marginalists themselves accept—as wages rise and interest rates fall, there can be a switch from capital back to labor. This is called double re-switching of techniques.

Double re-switching effectively disproves mathematically the whole theory of value and distribution among the capitalists and workers according to the marginal products of labor and capital. Sraffa arrived at this mathematical disproof of marginalist theory using arithmetic commonly used in commercial transactions and simple algebra. In doing this, he brought the entire pseudo-science of marginalist economics with all its buttressing of higher mathematics crashing to the ground! (12)

Some marginalists have pointed out, correctly, that the “neo-Ricardians,” as Sraffa suppporters are often called, have not been able to put anything in place of marginalism beyond commercial arithmetic. This is quite correct. Essentially, the neo-Ricardians propose to replace economics with commercial arithmetic. After all, commercial arithmetic serves the everyday businessmen quite well! But this argument, correct in itself, in no sense saves marginalism.

Of the two great schools of economics that grew out of what Marx called in “Theories of Surplus Value” the “disintegration of the Ricardian school,” only one, the Marxist school, is still standing. The other one, marginalism, has been reduced to a mass of logical and mathematical ruins.

Scientific versus vulgar economics

Here we see the difference between what Marx called “vulgar economics”—which includes both the marginalist and its “neo-Ricardian” critiques—versus scientific economics. Scientific economics began with the classical economists and continued with Marx’s critique of bourgeois political economy. In contrast to the classics and Marx, the vulgar economists think just like practical business people. Vulgar economists deal with prices, wages, rates of interest and the capitalization of income flows at the rate of interest. What vulgar economics is not interested in is what underlies these surface phenomena—the real social relations of production—and at its worst does everything to cover them up—for example, by denying the

exploitation of workers by the capitalists.

Developments in marginalism since the 1930s

The Great Depression of the 1930s turned marginalist assumptions about the working of the capitalist economy on its head. The impact was even greater in Britain, where the Depression effectively began in 1920, than it was in the U.S., where the Depression didn’t begin until 1929.

The more sensitive economics students were shocked when their professors droned on about how “full employment” was the only possible equilibrium in a capitalist economy while the Depression was unfolding just outside the classroom windows. Many young economics students began to turn to Marx for answers. This spurred John Maynard Keynes to produce a modified marginalism with the aim of turning radicalizing economics students back to bourgeois economics.

Keynes claimed that marginalism was basically sound but that the founders of marginalism had made one major mistake. They had analyzed only one case of economic equilibrium—equilibrium at “full employment.” In reality, Keynes claimed, equilibriums were possible at any level of employment, ranging all the way from zero employment to 100 percent employment. Keynes believed that left to its own devices, because of declining scarcity of capital, the capitalist economy was increasingly tending toward equilibriums with considerable unemployment.

But Keynes insisted that if the government and central bank followed the correct fiscal and monetary policies it would always be possible to nudge the capitalist economy back to an equilibrium of “approximately fully employment.” Exactly how the government should achieve this under the given concrete economic conditions became the subject of the new “macroeconomics.”

Keynes, however, never challenged the view that free competition is an approximation of capitalist reality. During the 1930s, young economists such as Paul Sweezy, who was then in transition from the conservative student of marginalist economics he had been to the founder of what was to become the Monthly Review interpretation of Marxism—began to modify marginalist price theory to take account of monopoly.

Under free competition, the marginalists assume that the individual firm controls such a tiny percent of the total output of the commodities of a given use value and quality they produce that if they went out of business there would be virtually no effect on prices.

These firms are thus obliged by the pressure of competition to choose levels of production where their marginal costs equal the prevailing price. According to the marginalists, with a given level of technique, in equilibrium marginal costs equal average costs equal the lowest possible costs. As a result, the marginalists claimed to demonstrate, “free competition”—unbridled capitalism—not only ensures “full employment” and no exploitation of one “factor of production” by “another factor of production”—it ensures that only the most efficient methods of production are employed. Therefore, everybody, especially the “consumer,” is the winner.

During the Depression, it was obvious to economic students like the young Paul Sweezy that the marginalist picture of free competition was far from the prevailing capitalist reality. By the 1930s, many sectors of industry were dominated by a handful of firms, each of which individually controlled a significant quantity of total production. If any of these firms chose to increase or reduce production, the effect on prices would be considerable. The greater the influence on price of the individual firm the higher the “degree of monopoly” was.

Therefore, the “monopoly price school” argued, in making decisions on production levels, firms operating in industries with any significant degree of monopoly would choose levels of production where their selling prices would equal their marginal revenues, not their marginal costs. The result would be a considerable amount of chronic unemployment, excess capacity and inefficient levels of production.

It was in the high degree of monopoly that had been reached by the 1930s that these younger economists trained in marginalism found the underlying cause of the Depression. Unlike the “orthodox” marginalists, these “unorthodox” marginalists believed that the role of government in the economy would have to continue to expand if economic and social disaster was to be avoided.

In contrast, the more traditional marginalists—such as Milton Friedman, nowadays called “neoliberals”—claim that the role of monopoly in modern capitalism is greatly exaggerated and the model of perfect competition is still a reasonably close approximation of today’s capitalist reality. They therefore have little use for the amendments that the “monopoly price school” made to marginalist price theory starting in the 1930s. Like the liberal political economists of old, the neoliberals insist that the government should keep its hands off the economy.

Today’s more “progressive” bourgeois economists such as Paul Krugman are influenced both by Keynes and the monopoly pricing school. They borrow, often on the sly, from the Monthly Review school, which has most consistently developed both Keynes and the monopoly price school to its logical conclusion. Unlike Monthly Review, however, the progressive bourgeois economists claim that capitalism can be made to operate in the interest of all the people if only the right mix of government intervention and the “free market” can be found.

Next month, we will examine the role that marginalist economics played in the socialist countries and Che Guevara’s criticism of the growing influence of marginalist ideas in both the economic professions and ruling parties of the socialist countries.

___________

1 The Russian Marxist economist and later Soviet leader N.I. Bukharin (1888-1938) explained in his “Theory of the Leisure Class”—not to be confused with the book of the same title by the U.S. economist Thorstein Veblen—the rise of marginal utility theory by the growing importance of a layer of the capitalist class completely removed from the sphere of production. (back)

2 Marx showed that interest is merely a fraction of the profit, which in turn is a sub-fraction of total surplus value. Profit is divided into two sub-fractions: the profit of enterprise and interest.

The marginalist do their best to explain away the profit of enterprise as either produced by the labor of the active capitalists or the “reward” for the extra risk capitalists incur when they choose to invest their capital in their own enterprises rather than lend it to another capitalist or the government. Indeed, the “pure” rate of interest is considered to be the rate on government bonds, which are considered to involve no risk because they are payable in the currency that the government or its monetary authority issues itself.

The biggest problem for marginalist theory, however, is explaining away that portion of the surplus value that cannot by any stretch of the imagination be justified in terms of the “labor of the entrepreneur” or by “risk.” (back)

3 Many marginalists are university professors, and this is the type of work they would be familiar with. (back)

4 The marginalists also claim that the very high incomes earned by entrepreneurs is a “reward” for risking their money on their own enterprises, which might not succeed, and could well lead to the loss of all their money. It is certainly true that would-be tycoons risk and lose their money every day. Is risk therefore supposed to be a fourth factor of production alongside the trinity of land, labor and capital, or is it supposed to contribute to the value of the marginal product of the entrepreneurs’ labor by making this type of labor scarce due to the relatively few people who are willing to take such risks? Presumably, the latter, since the textbooks speak of the three factors of production—the holy trinity—and not four factors of production. (back)

5 In ancient times, when animals were sacrificed to the gods, it was priests who represented the gods. They had to consume the meat of the sacrificed animals since the gods themselves were not able to carry out the act of consumption themselves. Perhaps the marginalists reason that since nature, which produced the land, cannot actually consume the ground rent, the duty of consuming the rent naturally falls to the landlords and their families. (back)

6 Like all other schools of economics, the marginalists realize that it is only fluctuating prices that enable commodities to be produced in the proper proportions in a market economy. (back)

7 I say “fundamentalist” because—unlike more pragmatic economists willing to concede that in the real world the economy with its monopolies and other “imperfections” will not really work the way the marginalist models based on “free competition” predict, at least not without considerable help from the government—Friedman stubbornly insisted that marginalist models would closely correspond to reality if the rate of growth of monetary tokens were kept stable and the government otherwise kept its hands off the economy. (back)

8 Politically, the economists of Cambridge, England, tended to be reformist socialists close to either the left wing of the Labor and Social Democratic parties or the right wing of the Communist Parties, later dubbed “euro-communists.” The economists of Cambridge, Massachusetts, in contrast, supported the liberal wing of the U.S. Democratic Party, which rejected even reformist socialism. The economists of Cambridge, England, disliked marginalism, though they were unwilling to embrace the Marxist alternative, while Cambridge, Massachusetts, economists as supporters of capitalism were strongly committed to marginalism and did everything within their considerable mathematical powers to salvage it. (back)

9 Marx solved the aggregation problem at the very beginning of “Capital,” even before he introduced the concept of “capital” proper, by asking what commodities of different use values that exchange with one another have in common. He found the answer in abstract human labor measured in some unit of time. In contrast, all attempts to solve the aggregation problem on the basis of marginalism have failed. (back)

10 As we have seen, many of today’s Marxists stubbornly insist on defending this viewpoint in direct opposition to Marx. This is what keeps the transformation and aggregation problems alive. A correct theory of money—the form of value—is therefore a necessary, not an optional, part of Marxist theory. (back)

11 Remember, I am using “interest” here in the marginalist sense that I explain in this post and not in the Marxist sense, which I explain elsewhere in this blog. (back)

12 How do the university economics departments explain to their unwary students that the marginalist theory they teach their students has been disproved both

logically and mathematically, not only by Marx but by the economists themselves in

the Cambridge Capital Controversy? Well, they follow the only possible course. They hush it up!

“In the United States, on the other hand, mainstream economics goes on as if the controversy had never occurred. Macroeconomics textbooks discuss ‘capital’ as if it were a well-defined concept—which it is not, except in a very special one-capital-good world (or under other unrealistically restrictive conditions). The problems of heterogeneous capital goods have also been ignored in the ‘rational expectations revolution’ and in virtually all econometric work.” (Burmeister 2000, quoted in Wikipedia’s article on the Cambridge Capital Controversy) (back)