Here Ricardo made a fundamental point about consumption, by which he means consumption by capitalists, not just households. As with production, consumption can be productive or unproductive. The productive kind might be a capitalist who ‘consumes’ his capital to buy labour, which in turn reproduces that capital and turns a profit. The alternative – unproductive consumption – is capital spent on luxuries that do not lead to reproduction of that capital expenditure. On this matter, Ricardo is absolutely clear: ‘It makes the greatest difference imaginable whether they are consumed by those who reproduce, or by those who do not reproduce another value.’43
So Ricardo’s heroes are the industrial capitalists, ‘those who reproduce’, who can ensure that workers subsist and generate a surplus that is free for the capitalist to use as he or she sees fit. His villains are those ‘who do not reproduce’ – the landed nobility, the owners of scarce land who charge very high rents and appropriate the surplus.44 For Ricardo, capitalists would put that surplus to productive use, but landlords – including the nobility – would waste it on lavish lifestyles. Ricardo echoes Smith here. Both had seen with their own eyes the extravagance of the aristocracy, a class which often seemed better at spending money than making it and was addicted to that ultimate unproductive activity – gambling. But Ricardo parted company from Smith because he was not concerned about whether production activities were ‘material’ (making cloth) or ‘immaterial’ (selling cloth). To Ricardo, it was more important that, if a surplus was produced, it was consumed productively.
Significantly for our discussion, Ricardo singled out government as the ultimate example of unproductive consumption. Government, in his view, is a dangerous leech on the surplus. Most of government spending comes from taxes, and if it consumes – by spending on armies, for example – too large a share of the national income, ‘the resources of the people and the state will fall away with increasing rapidity, and distress and ruin will follow’.45 Ricardo believed that government is by nature unproductive.
At the time Ricardo was writing, such issues were uppermost. Only a few years earlier, the British government had had to raise unprecedented amounts of money from taxes and issuing bonds to wage the war against Napoleon, from which the nation emerged heavily in debt. Could it afford the immense military expenditure which Ricardo’s theory deemed unproductive? He found to his relief that the increase in value production by private companies more than compensated for the increase in unproductive government consumption. Unlike Smith, Ricardo did not write about that part of government expenditure which creates the conditions for productivity in the first place: infrastructure (bridges, roads, ports and so on), national defence and the rule of law. By omitting to discuss the role of government in productivity, he paved the way for generations of economists to be equally oblivious – with hugely significant consequences that we will look at in Chapter 8.
In essence, Ricardo’s theory of value and growth led to a production boundary that does not depend on a job or profession itself (manufacturer, farmer or vicar) or on whether the activity is material or immaterial. He believed that industrial production in general leads to surpluses, but for him the real question is how those surpluses are used. If the surpluses finance productive consumption, they are productive; if not, they are unproductive.
Ricardo focused on the ‘plight’ of capitalists and their struggle against landlords. However, he never addressed the awkward fact that labour creates value but the capitalists get the spoils – the surplus over and above the subsistence wages paid to labourers. In the course of the nineteenth century, as England industrialized, inequalities and injustices multiplied. The labour theory of value was to interpret production in a way that cast capitalists in a much less favourable light.
Karl Marx on ‘Production’ Labour
Ricardo’s appreciation of the dynamism of capitalism compared with past eras prefigures the emphasis Marx placed a generation later on the system’s unprecedented power to transform societies. Born in 1818, Marx grew up in the German city of Trier, one of nine children of Jewish parents, both lawyers. In his own legal studies at university, Marx was drawn to a critical version of Hegel’s philosophy of dialectics, propounded by Hegel’s disciples, which set out how intellectual thought proceeds via negation and contradiction, through a thesis, its antithesis, and then a synthesis. Marx was particularly interested in how history is shaped by contradictions between material forces – such as capital and labour – and by the resolution or synthesis of those contradictions. After being barred from taking a professorship at the University of Jena because of his radical political leanings, he became editor of a progressive newspaper, Rheinische Zeitung. Then in 1843 he moved to Paris, where he met Friedrich Engels, his future co-author and collaborator. Two years later Marx was expelled from France because of his socialist political activities and settled in Brussels. There in 1848 he published with Engels the Communist Manifesto. Marx wrote voluminously on politics for the rest of his life but it is remarkable that, despite being opposed to capitalism, he analysed it objectively in order to understand where it was taking humankind and what the alternatives might be.
Marx developed his own version of the labour theory of value. He emphasized how definitions of ‘productive’ activity depend on historical circumstances – the society of any given time. He also focused on the nature of productive activity within the capitalist system. Under capitalism, firms produce commodities – a general term for anything from nuts and bolts to complete machines. If commodities are exchanged – sold – they are said to have an exchange value. If you produce a commodity which you consume yourself it does not have an exchange value. Exchange value crystallizes the value inherent in commodities.
The source of that inherent value is the one special commodity workers own: their labour power, or – put another way – their capacity to work. Capitalists buy labour power with their capital. In exchange, they pay workers a wage. Workers’ wages buy the commodities such as food and housing needed to restore a worker’s strength to work. In this way, wages express the value of the goods that restore labour power.
This description of the source of value largely followed Ricardo. But Ricardo had tried unsuccessfully to find an external commodity that could serve as an ‘invariable standard of value’ by which the value of all other products could be determined. Marx solved this problem by locating this invariable measure in workers themselves. He was careful to distinguish labour expended in production from labour power, which is the capacity to work. Workers expend labour, not labour power. And in this distinction lies the secret of Marx’s theory of value. Humans can create more value than they need to restore their labour power. For instance, if a worker has to work five hours to produce the value needed to restore labour power per day, the labour power’s value is equivalent to the five hours of work. However, if the working day lasts ten hours, the additional five hours’ work will create value over and above that needed to restore labour power. Labour power creates surplus value.
The ingenuity of capitalism, according to Marx, is that it can organize production to make workers generate unprecedented amounts of this surplus value. In early societies of hunter-gatherers and subsistence farmers, people worked enough to create the value that would allow them to survive, but no surplus over and above that. Later, under feudalism, they could be forced to produce enough surplus to satisfy the (unproductive) consumption of the feudal lord, which, as Smith and Ricardo knew, could be substantial. But after the means of production were taken away from independent producers – mostly by violence and expropriation through property rights legislation, such as enclosures of common land in England by big landowners – they became workers, ‘free’ and without property.
Capitalists were able to purchase the workers’ labour power because workers lost their independent means of subsistence and needed a wage to survive. The trick is to get them to work longer than needed to produce value (wages) that they spend on their subsistence ne
eds – again, food and housing.46 Workers, in other words, are exploited because capitalists pocket the surplus value workers produce over and above their subsistence requirements. And, unlike the feudal lords, capitalists will not squander all of the surplus on consumption, but will have incentives to reinvest part of it in expanding production to make yet more profits. However, Marx noted that there was a contradiction in the system. The drive to increase productivity would increase mechanization, which, in displacing labour (machines taking over human work), would then eventually reduce the key source of profits: labour power. He also foresaw the problem of growing financialization, which could potentially undermine industrial production. Throughout his analysis, his focus was on change, and the effects of change on the creation of value.
Indeed, the extraordinary aspect of Marx’s theory is his fundamental insight that capitalism is dynamic and constantly changing. But it was not just economically dynamic. Marx was struck by the social upheavals he could see all around him, such as the mass movement of rural workers into cities, which created an urban proletariat. He saw that capitalist society, not just the capitalist economy, was utterly different from preceding societies and was in permanent flux – a very evident phenomenon today as we struggle to come to terms with the massive changes brought by digital, nano, biological and other technologies.
Economists had previously thought of ‘capital’ as purely physical – machinery and buildings, for example – and surplus as solely positive, helping the economy to reproduce itself and grow. But Marx gives capital a social dimension and surplus a negative connotation. Labour produces surplus value, which fuels capital accumulation and economic growth. But capital accumulation is not just due to productive labour. It is also deeply social. Because workers do not own the means of production they are ‘alienated’ from their work. The surplus they produce is taken away from them. Work is necessary for earning the wages they receive to buy the food, shelter and clothes they need to survive.47 Moreover, in a capitalist market society, relations between people are mediated by commodity exchange. In a specialized society with division of labour, humans produce the social product – net national income – together and depend on other humans. But precisely because the division of labour, which Smith extolled, left most workers overly specializing in discrete aspects of the production process, he believed that social relations became relations between commodities (things).48
Marx was so fascinated by the dynamics of capitalism that he produced his own theory of value to explain how it works. Unlike earlier economists, who tended to define production by sector or occupation (agriculture or manufacturing, merchant or clergyman), Marx defined the production boundary in terms of how profits are made. Marx asked how, by owning the means of production, the capitalist could appropriate surplus value while the workers who provided the labour received barely enough to live on – exactly the question Big Bill Heywood posed. By placing this distinction at the heart of value theory, Marx generated a new and unprecedented production boundary. Marx’s value theory changed economics – at least for a time.
Marx argued that workers are productive if they create surplus value which the capitalist class then retains. For Marx, while workers in capitalist production are productive, the key questions when drawing his production boundary are: who participates in capitalist production? And who receives the surplus that is produced?
Figure 6 gives a graphical answer to these questions. The production sphere, the light grey blob, includes three basic sectors: primary, comprising essential materials such as food and minerals (the only source of value for Quesnay); secondary, which is industry, the basis of value creation in Smith and Ricardo; and tertiary, the services considered by Smith to be ‘immaterial’. The darker blob within, called the ‘circulation sphere’, reflects Marx’s analysis, which we will discuss later, that some aspects of finance are essential to production and deserve to be placed on that side of the production boundary. On the other side of the boundary, Marx followed Smith and Ricardo in regarding government and households as unproductive.
Figure 6. The production boundary according to Karl Marx
At any moment in a capitalist economy, there is a ratio of surplus value to value used for workers’ subsistence – what Marx calls simply the rate of surplus value. It determines what share of the economic product can potentially be used for accumulation and growth. Marx referred to capital that is used to hire labour as ‘variable’ capital: the workers produce more capital than is invested in them, so the capital that hires them ‘varies’ in relation to the capitalist’s total capital. Capital not used to hire workers is invested in other means of production that are ‘constant’ capital – including machinery, land, buildings and raw materials – whose value is preserved but not increased during production.49
The value used for workers’ subsistence, the ‘wage share’, could not be less than was needed to restore labour power or workers would perish, leaving the capitalist unable to produce surplus value. Historically, the wages of the poor had tended to be at subsistence level. But here Marx introduces a powerful new idea which has informed thinking ever since: class struggle. Workers’ wages were set by class struggle. The side with more power could force through a wage rate favourable to itself. Which class had more power was related to what we would call today the tightness of the labour market. If wages increased because workers had a lot of bargaining power in a tight labour market, capitalists would substitute more machines for labour, creating more unemployment and competition among workers for jobs. Marx thought that capitalists would try to keep a ‘reserve army’ of the unemployed to hold down wages and maintain or increase their own share of the value workers created.
The value of labour power is expressed to workers as wages, to capitalists as profits. The rate of profit for an enterprise is the surplus value divided by variable and constant capital – roughly what today we call the rate of return on a company’s assets. The average profit rate of the economy as a whole is total surplus value divided by total variable and constant capital. But the size of the average profit rate depends on the composition of capital (how much variable and constant capital) and on class struggle – effectively, the size of workers’ wages relative to value produced. The average profit rate is also affected by economies of scale as the productivity of workers rises with a growing market and the increasing specialization of workers.50 In particular, Marx believed that increasing agricultural production would not lead to Ricardo’s stationary, food-constrained world.51 He was right: broadly speaking, food production has kept pace with population increase. Marx was also acute in his understanding of the capacity of technology to transform society. He would not have been surprised by the extent to which automation has replaced people, nor perhaps by the possibility of machines more intelligent than their human creators.
Marx’s analysis of who got what in capitalism did not stop there. He also distinguished between different functions of various capitalist actors in the economy. In doing so he used his value theory shrewdly to identify those who produce value and those who do not.
Like economists before him, Marx believed that competition would tend to equalize rates of profits across the economy.52 But at this point Marx introduced a distinction that is critically important for his and for subsequent theories of value: the way in which different kinds of capitalists came by their profits. The first two categories Marx identified were production (or industrial) capital and commercial capital. The first produces commodities; the second circulates commodities by selling them, making the money received available to production capital for buying the means of production (the dark grey sphere in the lighter blob in Figure 6). As Marx explained, the first creates surplus value, the second ‘realizes’ it. Any unsold commodity will therefore be of no use to a capitalist, regardless of how much he or she exploits his or her workers, because no surplus value is realized. Commercial capital, Marx noted, had existed for millennia: international merchants such as t
he Phoenicians and the Hanse bought cheap and sold dear. What they did not do was to add value by capitalist production. Under capitalism, the commercial capitalists realize the value produced by the production capitalists. To apply Marx’s theory to a modern-world example, Amazon is a commercial capitalist because it is a means by which production capitalists sell their goods and realize surplus value. Banks’ money transfer services are also an example of commercial capital.53
Marx suggested that, initially, production enterprises might also carry out commercial capital activities. As production expands, however, separate capitalist enterprises will probably emerge to carry out these functions as commodity or money capitalists. Crucially, these capitalists and the labour they employ are purely concerned with the ‘circulation’ of capital; they do not produce commodities which generate surplus value and therefore they are unproductive.54 However, because they are also capitalist firms, they require the same rate of profit as does production capital. Consequently, some surplus value is diverted to become their income, diminishing the average profit rate in the economy.55 Although labour in firms engaged in the circulation of capital does not create surplus value, it is seen by the commercial capitalist as productive because it secures the capitalist’s share in existing surplus value and becomes a profit.56 The emergence of distinct commercial capital enterprises alters the structure of the whole economy and the amount of surplus value available to production capitalists.
Marx then identified ‘interest-bearing’ capital – capitalists such as banks who earned interest on loans that production capitalists took out to expand production. The generation of interest is possible because, in capitalism, money represents not just purchasing power – buying commodities for consumption – but also the potential to generate more profit in the future through investment as capital.57 The interest is deducted from the production capitalist’s profit rate. Interest-bearing capital, unlike commercial capital, does not lower the general rate of profit; it just subdivides it between recipients of interest and earners of profit.
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