Economics and Socialism Don’t Mix

I started on the Left. My dad was a motor mechanic for the local ambulance service and voted for the British Labour Party. I think his affiliation was tribal, primarily based around ensuring that the working man was not exploited; an honourable objective and understandable in the context of the times in which he worked—the 1930s to the 1960s. If I had not studied economics at a postgraduate level I might well have remained on the Left. As evidence of this, my political position survived an economics honours degree. As further evidence, my dad supported Liverpool football team and I remain a loyal fan to this day; I am not prone to change my tribal loyalties.

At some middle point in my postgraduate studies I found that my economic thinking was increasingly coming into conflict with my advocacy of left-wing arguments even though, in keeping with a university environment, I continued to prosecute those arguments with vigour. I recall bringing my concerns to my supervisor, Professor Geoffrey Harcourt, of the Left himself but a true scholar of the old school. He generously and open-mindedly suggested that I read Hayek. I didn’t go to The Road to Serfdom, thankfully, because it is (I think) a turgid read, but to a later book, New Studies in Philosophy, Politics, Economics and the History of Ideas. Quite literally it changed my political view, but this is by the way. Pertinently from the standpoint of this article it wove economics and politics together in a consistent way, and eventually led me to the view that it is not possible to be both a socialist and an economist; it would be a species of Orwell’s double-think, of simultaneously believing conflicting stories. On the surface this is nonsense, because surely there have been, and are, many learned and respected left-wing economists. So where does this leave my view? It leaves it with a heavy burden of explanation; going to what economics is, to what economists do, and to what socialists do to bring them into conflict with economics.

Professor Joan Robinson of Cambridge University—one of those respected left-wing economists referred to above—when asked to define economics quipped that economics is what economists do. This is interesting, not so much because of its connotation that economics is difficult to define but because of its emphasis on what economists do. Doing is important. There is an important distinction between knowledge and its application. Take civil engineering and the science of building a stone self-supporting arch. Someone may know a lot about arches; about the shapes that work; about the required shape and density of the stones; about the role of the keystone. Suppose nonetheless this someone, believing in levitation, insists on actually building arches which defy the underlying science and fall down. We would probably decide in such a case that the appellation of civil engineer was inappropriate. We might reserve our right to disqualify a doctor who knew everything about modern medicine but insisted on prescribing the homespun remedies handed down by his dear old grandmother.

Knowledge is not enough; it’s the doing that counts. Professor Robinson was right about that, even if unconsciously. But we can’t use her circular device to define economics because we will then have no objective measure of what an economist must do to be called an economist. On the other hand, if defining economics were easy, Professor Robinson’s quip would have seemed pointless whereas, in fact, it has taken a place, albeit a modest one, in the folklore of economics.

Economics might be defined by pointing to the material in standard university texts. This would be unwieldy and fortunately unnecessary. Economics has a standard bearer within it which will do the job nicely. That standard bearer is price theory. There is nothing else within economics which is as pervasive and fundamental. Prices are at the heart of economics: prices of materials and labour, goods and services; present and forward prices; actual and expected prices. If you understand the role of prices then you understand a great deal about economics and about what economists do.

Price and value are not the same. One of Oscar Wilde’s fictional characters said that a cynic knew the price of everything but the value of nothing. Value is the benefit we get from having something; it is subjective and can vary from person to person. Price is what everyone has to pay to get something. Price settles at the point where the supply of something from those wanting to supply it equals the demand for that something from those wanting to buy it.

Prices have two main roles. One is to ration demand; the other to allocate resources.

When the price of any product (raw material, manufactured good or service) rises, businesses and people tend to buy less of it because it is more expensive. If more of a product is demanded than is available, its price rises to reduce the demand to the available supply. Demand is rationed.

The second role of prices is to allocate resources. When the price of a particular product rises or is expected to rise, suppliers of the product in question have an incentive to order or produce more of it. In turn, this results in more resources—labour and capital equipment—being applied to its production. It works the same way the other way around. If a price falls, less of the product is produced. As simple as it is to describe, this role of prices is fundamental to the growth and development of an economy; to its preservation of scarce resources and to its efficiency in producing the goods and services of most value to those in the economy.

An economist, to be an economist—that is, to be doing economics—must understand the role of prices; must always take that role fully and explicitly into account and must always understand the consequences of putting obstacles in the way of prices working to bring demand and supply into balance. If this is not done then, as with our dodgy arch builder and doctor, the appellation economist is suspect.

What does a socialist have to do to be a socialist? There are varieties of socialism. The question is whether there is within socialism a standard bearer to compare with prices in economics. I suggest that as the role of prices is central to economics, so state intervention to alter the outcome that free markets would otherwise produce is central to socialism. Would everyone agree with this way of putting things? Probably not; disagreement about most things is endemic among socialists and economists. It is nevertheless the framework that I will use to assess whether economics and socialism are in conflict and therefore whether being an economist is in conflict with being a socialist. A number of examples of state intervention will be considered to make the case that in fact economics and socialism don’t mix.

A common way in which the state intervenes is to provide particular products free or below cost. In these cases demand must be rationed other than through price. Rationing demand by price means that some who want a particular product are unable to buy it, because its price is too high. If that product is a motor car or overseas holiday or manicure, rationing through price is not contentious. No one objects. Contention arises for things like medical services, education, shelter, and child-minding. There is a view that these products should not be rationed by price alone. There is a view among some, it sometimes seems, that perhaps these products should not be rationed at all. This latter view is plain silly and leads to unrealistic expectations. The truth of the matter is that no existing society could get close to affording all of the medical/education/housing/child-minding that would be demanded if their price were zero; not faintly close. So rationing has to occur in one way or another.

If rationing is to occur in some other way than by price, then an economist must point out that the rationing process will lead to windfall gains for some and losses for others; will have ripple effects on other markets outside of the rationed market; will have taxation or interest rate effects, but that economics can offer no guide on the overall impact of the outcome and therefore cannot promote the process. Economists need to talk their book and make the point that rationing by price has an openness and predictability about it that other means of rationing seldom have. This is not to say that non-price rationing should never occur; only that economics has little to say on its merits. It may well be that sociology and psychology or other disciplines have something valuable to say, but not economics.

To elaborate, if a product is to be delivered at a market price economists can look at the likely response of supply and demand, on the effect on substitute and complementary products, and assess the impact and merits of the proposal. The difficulty of assessing a proposed subsidised product (to be delivered below cost and below a market price) is that there is unlikely to be any hard information on who exactly will pay for it, and no hard information on who will obtain the service and on what basis.

Usually provision of a subsidised product is subject to an arbiter—perhaps it is provided on a needs basis. Take public housing. Who should get the house—the single mother with two children who has waited six months, or the single mother with one child who has waited twelve months? Economics has nothing to offer here. Also rationing other than by price is open to abuse. It can lead to nepotism, cronyism and corruption or just simple unfairness. Ask this question: a child-minding place becomes available in the local child centre and you and your neighbour approach the manager. First situation: you are told the cost and cannot afford it; your neighbour can, and takes the place. Second situation: neither of you can afford the cost but your neighbour is given the place because he knows the manager’s second cousin, or is of the same religion as the manager, or was born in the same town, or belongs to the same club, or gives a kickback to the manager, or is better looking than you are. The question here is not which of the two situations is more disreputable and less consistent with a harmonious society; the answer to that is obvious; it is whether an economist as an economist should still be in the picture. Quite clearly, economists should have bowed out long before, having drawn attention to the possible economic implications of fixing markets. Moreover, economists ought not to be promoting such arrangements because they are out of their depth. Socialists might promote such arrangements, but they should not disguise themselves as economists when doing so.

Another way in which the state intervenes is by regulation. Financial regulation is a topical example. There is a compelling view that there should be a set of relatively “undoubted” financial institutions to underpin financial intermediation. Accordingly, banks are particularly subject to regulation because of their central role in the financial system and the economy. The GFC has thrown fresh perspectives on financial regulation. Governments and regulators are considering the imposition of more stringent capital requirements on banks and the extension of banking-style regulations to near-banks.

In part this issue has been politicised because of charges—characterised by Prime Minister Rudd’s writings—that the capitalist system or neo-liberalism and its offspring, greed, caused the crisis. Some on the other side of the political divide, more prosaically and practically, point to legislation in the USA, “The Community Reinvestment Act”, passed by Jimmy Carter in 1977 and strengthened by Bill Clinton, which cajoled banks and Freddie Mac and Fannie Mae to lend imprudently into poorer communities.

The socialists’ response appears to be to bear down hard on banks and other financial institutions and to control how much they can pay their executives. An economist can add value, and must add value, to the debate by reference to the price system. An economist should point out that the imposition of discriminatory costs, through regulation, on one set of institutions will always tend to lead in a free market to the relative growth of competing institutions not so burdened. Because of this, an economist should also point out that the regulation of a wider set of institutions, in this case near-banks, will always lead to the development and growth of a still wider set of institutions (in this case, near-near-banks). Someone of any discipline should point out that human greed is endemic and incurable, will always exist, and can’t be regulated away. Finally, an economist should point out that the free market with its greed, adventurism and risk-taking on one side and insatiable demand for goods and services on the other is the nature of the beast; that it has given us great wealth compared with our forebears; and that the alternative is relative impoverishment and, in the extreme, despotism. Set against this, the odd financial crisis doesn’t look too bad.

It is simplistic to think that the GFC calls for more onerous and extensive regulation. It might be the remedy of choice for the socialist. An economist should see the flaws in it by simply referring to the role of prices. It is counterproductive to impose onerous costs and thereby reduce the relative dominance of institutions which form the core of the financial system, and which contribute to its safety. Perhaps we need less regulation of banks in terms of imposing additional capital costs, which will only diminish their role in the financial system, and more assiduous oversight on the part of bank boards and regulators. Addition-ally, whatever the contribution the US legislation played, it is surely best if prudential regulation on the one hand is not undermined by legislation calling for imprudent lending on the other.

Another example of state intervention, stimulus spending, which used to be called “pump priming”, offers a different perspective on socialist and economic thinking and one that is far from straightforward.

Any modern first-year university economics text has a sharp division between micro-economics (which is usually covered first), where prices in all their variety and complexity are on view, and macro-economics, where for the most part only two prices are on view: interest rates (the price of credit) and exchange rates. Why? Basically it is because Keynes happened and the rest, as they say, is history. Keynes viewed the economy topographically from a height, and from height detail becomes blurred. From a height, production and demand are amorphous masses; they are aggregates and detail falls away. This is a useful way of viewing things because detail sometimes gets in the way of understanding, but detail does not go away simply because we are too high to see it.

While stimulus spending may satisfy a socialist view that government spending is inherently virtuous, and that capitalism needs to be periodically saved from itself, there is no getting away from the fact that such spending is promoted and cheered on by most economic policy-makers, advisers and commentators. It would be wrong to say that these economists are not following an established economics script; they are—it is in the second part of economics textbooks. But it would be right, at the same time, to say that they are proceeding half-cocked unless they also take account of the first part of the textbook.

The two parts of the economics text are meant to be read separately but considered together. Take the example of the Rudd government’s substantial spending on school classrooms and halls. This will undoubtedly stimulate the activity of builders and builders’ suppliers and they in turn will spend some of the extra money they earn and encourage a further production response. This is put forward as evidence that the stimulus works. Often this view is countered by arguments that the resultant build-up of government debt, and the need to finance it, will tend to crowd out productive business investment. And this is true, but economists are even more enquiring. For example, occupying builders on school projects will tend to increase building costs and a range of other costs and thereby make it more expensive for businesses to acquire the resources they need to expand. Government spending has price effects, and therefore resource allocation effects, that may result in lower growth than would otherwise be the case, after the initial impact of the stimulus spending has petered out.

The implications and costs of not taking prices and resource allocation into account are twofold. First, a dollar of government expenditure is regarded as though it were as good as a dollar of business investment expenditure. Socialists might embrace such a concept; economists would be wary. They would be wary because they know that resources move best when in response to price signals, not by fiat. Second, there is a studied indifference apparently as to what the government dollar is spent on. It might as well be spent on school halls and ceiling batts, for example, as on, say, improving transport and port facilities.

When economists take into account only half the textbook they do a disservice to economics and more easily wear the socialists’ mantle than they do the economists’. Taking account of only the Keynesian topographical view in understanding the effect of macro-economic policy is not “doing” economics.

When micro-economics and the role of prices are embraced, economics is a powerful tool for looking at the world. It makes for better policy-making because it makes for a more informed and often less scary view of the world. In that way, it counters inappropriate and counterproductive state intervention. “The world is running out of resources” scary story illustrates the case.

The so-called Club of Rome scared a lot of people in the early 1970s. Frequent iterations from various conservation groups have kept the story up to date. The Worldwide Fund for Nature is particularly prone to producing studies and issuing warnings about resources running out. Fortunately, we have prices and forward markets. A forward market sets the price for delivery at some specified future date, say, in three, six or twelve months time. Such markets exist for all important resources. We can have confidence that the price of any resource (current and forward) will respond well before the resource runs out. All mines will not simply run out overnight. The available supply will start to tighten. What will then happen? First, the resource in question will be used more sparingly as its price rises. Second, existing substitutes will be brought more into use. Third, more efficient means of using the resource will be developed or new substitutes developed.

The question is whether you bow to scary talk and superstition and concede that our progress and economic development are an affront to nature which will, in due course, bring our comeuppance; or you apply a perspective informed by the record of human progress and ingenuity in overcoming difficulties. If free markets are allowed to work, the price mechanism will underpin our future economic development, growth and prosperity without too much angst. Economists know this; socialists seem not to.

Socialists are primarily concerned about equity and fairness. They condemn what they see as the rapacious nature of capitalism, which presumably leaves them prone to supporting environmental and conservation causes; else why would they support policies which may put people working in, say, fossil fuel industries out of work? Economists occupy a quite different place in the scheme of things.

Economists must have a level of detachment from what might be fair or unfair, equitable or inequitable. They know that the price system works. Supply and demand are brought into equality by price movements and markets are cleared. Noticeable gluts or shortages of particular goods or services are uncommon. Sellers of goods and services are informed by past demand and try to match the availability of supply with the pattern of demand they expect based on experience. Sellers are driven by self-interest to satisfy buyers. As Adam Smith famously pointed out, “it is not from the benevolence of the butcher, the brewer or the baker that we expect our dinner, but from regard to their own self-interest”.

Economists know that free markets and price movements drive economic growth by rewarding human ingenuity and entrepreneurship. New and innovative products are produced because those producing them believe that they can charge a price in excess, often well in excess initially, of the costs of production and sell a lot of them. If they are wrong, we hear little more about it. If they are right, their product tends to crowd out existing competing products whose price tends to decline as the demand for them falls: gas filaments to light bulbs; carts to motor cars; typewriters to word processors to desktop computers; and millions of more subtle examples. In all cases, it is price that guides and determines the pattern of production that best meets the needs of businesses and individuals in an economy. Economists know this and it guides their thinking.