The Lump-of-Capital Fallacy

Dean Baker gives me the courage, in his recent post on Pikkety, to reiterate a statement I’ve made some few times in the past:

Economists have no coherent or consistent idea of what they’re talking about when they use the word “capital.”

They lump together real capital — fixed, human, organizational, whatever — with “financial capital,” an oxymoron that confutes actual productive stuff with financial claims on that stuff.

Dean (emphasis mine):

This relates to the Cambridge controversies since the Cambridge U.K. people argued that the idea of an aggregate production function did not make sense. They pointed out that there was no way to aggregate different types of capital independent of the rate of return. The equilibirum price of any capital good depended on the rate of return. Therefore we can’t tell a simple story about how the rate of return will change as we get more capital, since we can’t even say what is more capital independent of the rate of return.

The takeaway from this, or at least my takeaway, is that we don’t have a theoretical construct that we can hope more or less approximates how the economy actually works. The theoretical construct doesn’t make sense. This means if we want to determine the rate of return to capital we should not be looking to elasticities of substitution, but rather the institutional and political factors that determine the rate of profit.

So it’s not just Steve Roth, internet econocrank, making this wild-eyed claim. You’ll find similar in Jamie Galbraith’s review of Pikkety. (His opening line? “What is capital?”), and I would suggest that every other review you’ve read wallows in the same quagmire of non- or multiple-definition.

As does Pikkety, unfortunately. He explicitly defines capital as being synonymous with wealth, which is a very tricky and messy conceptual proposition indeed. That does not obviate his work’s incredible value, but he should have called his book Wealth in the 21st Century.

“Capital” means, should mean, real, productive assets: real inputs to production that require real resources to produce, and that are consumed over time (through use, decay, obsolescence, and death). There’s the obvious “fixed capital” as tallied in the national accounts (broken out as structures, equipment (hardware), and software) and there’s all that other real capital that arguably constitute the great bulk of real capital, but that is so deucedly hard to measure — skills, knowledge, ideas, organizational structures and processes, human ability, etc. Then there’s all the tricky stuff that sits on the borderline between real assets and financial assets (thing which have exchange value but cannot be, are not, consumed): land, art and collectibles, etc.

“Financial capital” — all the financial assets out there, embodying all the “money” out there — is, roughly, all the outstanding claims on that real capital, or on the future production from that capital. Financial assets are not inputs to production (though they can be exchanged for such inputs), and they cannot be, are not, consumed.

The stock of financial assets can increase in several ways. 1. A sovereign currency issuer can deficit-spend. 2. A bank can print new money for lending ex nihilo (with the help of borrowers who want to monetize their real assets; think: student loans). 3. The market can decide that the real assets out there are worth more than the outstanding claims against them, and bid up financial-asset prices. Voila, more money, more financial assets, more so-called “financial capital.”

All of this points to the fundamental problem in economic thinking that Dean states so clearly: you can’t lump together, or really even measure, real capital in dollar terms. You certainly can’t just add together the value of real capital and the value of financial capital, which constitutes claims on that real capital.

And: The outstanding value of financial assets/”capital” is not any kind of reliable representation of the value of outstanding real capital. It’s all over the map, depending on how much of that real capital has been monetized/indebted/financialized (via private and public debt and money issuances), and based on the current state of investors’ “animal spirits” — their beliefs about future returns to that financial capital.

A minor aside: The whole “reswitching” business in the Cambridge Capital Controversy is just a carefully explicated special case, or example, of the fundamental confusion that the U.K. gang pointed out (and that Samuelson admitted to): the value of capital is a function of its future returns, and future returns are a function of the value of capital. Economics is based on a circular definition.

Or in Dean’s words, “The theoretical concept doesn’t make sense.” (This is some significant relief to me, because after more a decade of really struggling to make it make sense to me, it still doesn’t make sense to me.)

I’ve made some efforts to sort out this confusion is previous posts, which you can find by wandering through Related Posts, below. I would be more than pleased if those more worthy than I were to take up this task, and deliver an adequately and convincingly theorized understanding of the relationship between real capital and “financial capital.”

Cross-posted at Angry Bear.