Adam Smith

Reality has a very nasty way of intruding into the fancies of life. Economics is no exception. There is a growing realization amongst the ‘experts’ that the hoopla being accorded our imminent exit from recession is actually no big deal to a huge swathe of America. It won’t matter. As a result we are being treated to all sorts of articles and essays about the ‘two economies’ – or, in the case of the Wall Street Journal, the many economies. It’s as if, all of a sudden, that economists and those who work in investing are shocked when they perceive their magical ‘market’ as the amalgam of individuals that it truly is. And always has been.

I find all this both laughable and distresssing.

Of course there are a multitude of economies. Each of us has an entirely unique trajectory through the ‘space’ that encloses all economic activity. We experience it individually. There may be common features to those individual experiences such that economists can legitimately speak of ‘global properties’ of an economy, and can consequently talk abstractly about what a ‘market’ does, but we should never forget that those properties are never precisely played out at an individual level. Instead they are approximations.

Think of it this way: when we speak of a group of people having an average height of 5 feet 4 inches, we do not actually mean that any single person in that group is that height. The average is simply a useful way of describing an aggregate phenomenon.

Likewise with an ‘economy’ or a ‘market’.

When free market advocates speak about a market correcting itself, what they mean is that, eventually, enough people change their behavior that the average shifts direction. The word’ market’ is just a proxy for that average behavior.

Economists and market analysts are so inculcated with their ‘market speak’ that they tend to forget this simple truth. Thus when the economy turns a corner and moves from recession into recovery, they are surprised, apparently, to learn that the entire thing didn’t move. Only enough moved to alter the average.

The rest may still be mired in decline. For that group of people the ‘recovery’ may seem a distant mirage.

This inability to understand the economy as an aggregation of individual experiences is odd given the relentless ‘methodological individualism’ that underlies economic theory. Modern economics rejected the old analytical method of the ‘Classical’ era of economics – Adam Smith, David Ricardo, and Karl Marx being the standard bearers of that era – exactly because the Classicists tended to focus on groups within the population. The Classical analysis tried to explain the relationship between those groups – capitalists, landowners, landlords, and workers – and was thus concerned with a different sort of aggregate relationship. Obviously Marx is the most recognizable of this group, but his analysis of value and price structure is purely classical in its origins and is closely related to both Smith and Ricardo.

The roots of modern ‘market mythology’ can be found in the political ferment of the early industrial revolution, and the need for economics to present a counterpoint to the Marxist critique of capitalism. The problem was that his critique was accurate within the theoretical framework that then existed. So, in order to defend capitalism, a new framework was necessary.

This new framework was built around the individual, not ‘classes’ or ‘groups’, and sought to demonstrate that Smith’s metaphor of the ‘invisible hand’ was an accurate description of the power of the market. In the modern view, value and price flowed not from the costs associated with production, as the Classicists theorized, but from the ‘utility’ a product represented to a consumer. This is the way we envisage value today: something is ‘worth’ whatever someone will pay for it, no matter how much it cost to make. So modern economics blended Benthamite Utilitarianism – almost word for word – with engineering like concepts like ‘equilibrium’ and ‘efficiency’ to create model of a market faithful to Smith’s vision, yet capable of defending capitalism from Marx.

The problem is that in so doing economics sacrificed any analytical content attributable to ‘classes’ or ‘groups’.

So, returning to the two economies discussion: the modern view is that the economy is recovering. The measure we use is GDP, which itself is an accounting identity contrived to keep score of how much wealth we create each year. GDP does not speak to any of the questions that a Classicist like Smith or Ricardo would have been interested in. It tells us nothing about the welfare of workers or capitalists. It simply is an aggregate score card of wealth creation. And a flawed one at that – it excludes all sorts of things that are obviously sources of wealth [housework], and includes perverse things such as disaster relief as being a contribution to wealth [Katrina wiped out New Orleans, but added to GDP when the rebuilding started – did we accrete new wealth or simply replace old wealth?].

So as GDP starts to grow, our definition of a recovery, economists and analysts are befuddled and apparently fascinated by the fact that whole groups of people are experiencing nothing of the sort. In fact their prospects remain distinctly dim. So used are they to speaking in abstract and aggregate terms that they have forgotten that the economy is a very fragmented and diverse thing. It is full of contradictions and tensions that modern theory cannot cope with and, indeed, ignores for the sake of analytical purity.

To a worker whose job has just been eliminated so that an employer business can remain profitable and thus meet the stock market’s expectations of profit, the notion that we are now recovering is surely absurd. That there are nearly 7 million such people, and we can still speak of recovery, is preposterous. But that’s what we are doing.

It doesn’t take too much thought to realize that the recovery most likely will be fragile as long as there is such a large number of people who remain outside looking in as business gets underway.

I suppose it is not unusual for the business press to be so oblivious to this dichotomy within the economy, after all Wall Street obsesses over short term profits rather than long term themes, but now to listen to breathless discussions about how ‘suddenly’ we have two, or more, economies is just insulting. The enormous shift in the distribution of wealth in America over the past two or three decades implies that there are great rifts emerging in the fabric of society. Whole swathes of America are not just excluded from recovery, but they didn’t experience much of the prior growth. To those groups the notion of a diminution in wealth as a result of a stock market or house price collapse is simply irrelevant. They weren’t on that train.

The problem is that our economic theories treat distribution as irrelevant. This is a trace of that Marxist/Capitalist debate back in the late 1800’s: in order to eliminate the notion of ‘groups’ or ‘classes’ from theory we had also to eliminate any impact of a distribution between those groups. Everything was reduced to allocative efficiency: we don’t care who ends up with the wealth, as long as the process was ‘efficient’.

And because modern economics doesn’t give a hoot about distribution it is blind to differential experience that results from different distributions.

Consequently analysts brought up in the modern tradition get excited by the prospect of recovery and bid up stock prices in anticipation of the new wealth they see being generated over the next year or so. Articles trumpet recovery. Central bankers are lauded – or they laud themselves – for a job well done. Managers collect bonuses for ‘protecting profits’ and so on.

But not all the train leaves the station.

And, in our current case, enough of it sits stubbornly in decline.

Then suddenly those who are on the forefront of recovery realize their vulnerability: unless those rear cars get going we will fall back towards them.

Hence the ‘two economies’ discussion.

There have always been two economies. Perhaps even more. We just wanted to avoid the embarrassment of having to confront that fact.

Now we must.

We need jobs before we can return to the illusion that the American economy is a single entity.

A lot of jobs.