by Migeru
Sat Feb 13th, 2010 at 03:15:04 AM EST
A couple of years ago, at the suggestion of ETer BruceMcF, I read Veblen's (1904) Theory of Business Enterprise. This substantially changed my outlook on economics.
The book basically lays bare that the business community and the capital markets are two steps removed from the welfare of the community, and also how economic theory was devised for the "money economy" ca. 1800 and how its assumptions are inadequate for the economy of 1900 (and since). The book also touches on a topic that is popular here, which is how important narratives are and how they interact with institutions and the daily life people lead. The book resonates with Jerome's old dictum Wealth capture is not wealth creation.
Veblen (apparently following late-19th-century German economic historians) distinguishes between the natural economy, the money economy and credit economy. The natural economy is before trade fully develops, say Europe's Early Modern period. In the natural economy, most business is done on a small scale to earn a living. Then comes the money economy of the first Industrial Revolution, centering around the the market (commerce) and money (banking). In the money economy, you get partnerships and private ownership of industrial enterprises. And finally we get the credit economy, business is done by corporations and we see the rise of a management class. We're not talking about one kind of activity or firm organization replacing others, but about what is the main driver of the economy. Another way to refer to these three economies might be pre-industrial, industrial, and post-industrial.
Now, Neoclassical Economics has been a successful attempt to keep economic thought stuck in an industrial, money economy, partnership and private business, market narrative; while the world moved on to a post-industrial, credit economy, corporation-based economic reality. This mismatch between economic ideology and reality allows wealth capture by the management class.
It is somewhat striking to realise that this was written fully 60 years before Galbraith's New Industrial State and then completely ignored by economists. If people reasoned about the credit economy like Veblen does, it would be curtailed politically very quickly. Maybe that's why we got NCE and it was Veblen's line of thought that was curtailed.
Update [2010-2-13 4:53:16 by Migeru]:
Veblen focuses in particular on the rate of profit, namely a putatively stable time-rate of return on capital. In the natural economy this concept doesn't make sense, among other thing because there is not enough capital accumulated for anyone to bother attributing it a separate contribution to income. But Veblen argues that the concept doesn't even make sense in the credit economy. The clearest example is the business of Mergers and Acquisitions, where an operation is financed and profit is booked as a single event. Here the meaningful concept is the margin obtained in a single operation, and total profit depends more on turnover or volume than it does on time. In addition, he explains how mergers and acquisitions can, as often as not, destroy value, even from the point of view of "rate of return".
Now, a mismatch between economic narrative and reality has practical consequences. In the case of the rate of return, people schooled in the concepts of the "money economy" will go around calculating time-rates of return for everything and, what is more important, demanding particular rates of return on credit where they have no right to expect them. There will be an "accepted rate of return" at any given time, set by the capital markets, and firms value investments with respect to a "required rate of return" which is pulled out of thin air.
Veblen also discusses how the capital markets (and the capitalization of the economy) bear little relation to the functioning of the industrial complex or the aggregate value of the plant. Basically, because they are asset price movements, increases in capitalization don't necessarily reflect new investment. Occasionally there's new capital raised for investment but that's a marginal part of the operation of the capital markets, which trade in claims on existing capital.
According to the conventional wisdom, asset price movements adjust valuations to take account of perceived likely changes in value. The key here is in the word "perceived": it's all in people's heads. Unless a company loses capitalization to the point of making it insolvent because of lack of access to credit, it will still have the same operations - just the plant will have a lower asset value. Now, low capitalization makes the company vulnerable to a takeover, which is bad for management as they would get replaced. But here we see the divorce between the interests of management and the interests of the firm as a going concern. The conventional wisdom posits that there is, nonetheless, a relationship between the plant's value in the capital markets and its ability to sell goods, but this "ability to sell goods" is encompassed by Veblen under the concept of "goodwill" or "intangible assets" (brands, reputation, customer fidelity...). Veblen's point is that the credit economy is all about goodwill, not about industry, whereas the money economy was about industry and commerce. He also implies that, as soon as a private company (the main actor in the money economy) grows to the point where it accumulates a sufficient amount of "goodwill" (or a monopoly position) it will incorporate, go public and join the credit economy, and from that point on it will generate a lot of financial activity around its "goodwill", decoupled from its going concern.
