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Issue no. 72
30 September 2015
Income inequality in the U.S. from 1950 to 2010: The neglect of the political
Holger Apel
A never ending recession? The vicissitudes of economics and economic policies

from a Latin American perspective
Alicia Puyana
16
Capital accumulation: fiction and reality

Shimshon Bichler and Jonathan Nitzan
47
Amartya Sen and the media

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A critique of Keen on effective demand and changes in debt

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96
Commodities do not produce commodities:

A critical view of Sraffas theory of production and prices
Christian Flamant
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Economic consequences of location: Integration and crisis recovery reconsidered

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135
Global production shifts, the transformation of finance

and Latin Americas performance in the 2000s
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Two proposals for creating a parallel currency in Greece
174
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Income inequality in the U.S. from 1950 to 2010

the neglect of the political
Holger Apel
[Erasmus University Rotterdam, The Netherlands]

Copyright: Holger Apel, 2015
You may post comments on this paper at

http://rwer.wordpress.com/comments-on-rwer-issue-no-72/
Abstract
Based on the empirical observation of a global trend towards increasing income
inequality across developing and developed economies, this article analyses the
causes of increasing income inequality. Surprisingly, the role of institutions and
policies with regards to rising income inequality have been under-researched. A case
study of the U.S. from 1950 to 2010 reveals the substantial role of political institutions
in increasing and perpetuating income inequality. Policies have a major impact on the
distribution of income and thus influence income inequality. The case study reveals
empirical evidence of two trends which are politically induced and reinforce income
inequality. First, stagnating real wages for the majority of the population despite
increasing productivity due to anti-labour policies which undermine collective
bargaining. Second, increasing accumulation of wealth at the top of the income
distribution through decreasing taxes for high incomes and corporations.
Introduction 1
This article analyses causes of high and persistent income inequality in the U.S. 2 The
analysis provides an explanation of the interconnected factors behind rising income inequality
and the upward redistribution of national income from labour to capital. Followed by a series
of reports about rising inequalities from various International Organisations (IO) (ILO 2011;
UNCTAD 2012; OECD 2011b), the interest peaked after the publication of the English
translation of Pikettys (2014) Capital in the Twenty-First Century. The publication triggered a
heated debate and brought widespread attention to the issue also from non-academic circles
ever since. Not surprisingly, there is as much empirical evidence supporting as broad a
variety of arguments as scholars working on the subject.
The interaction between exogenous and endogenous drivers of inequality is of particular
interest. At first sight the global trend towards increasing inequality across developed and
developing economies suggests that exogenous forces are the main driver of inequality.
However, the impact of exogenous drivers can be counteracted or reinforced by national
policies and are thus highly country-specific. For example the experience of most countries in
Latin America which successfully reduced inequality while being subject to the same
exogenous drivers as other countries, suggests that countries do have the means to reduce
inequality. One major influence on inequality are the policies adopted (or not adopted) by the
respective governments. Those vary considerably across regions and countries and alter the
distribution of income significantly. It is argued that the political dimension as an endogenous
driver of inequality has been neglected to the benefit of economic-based explanations. Some
political scientists and sociologists have explored possible political explanations of increasing
inequality (DiNardo, Fortin, and Lemieux 1995; Bartels 2010; DiPrete 2007; Rosenthal 2004),
while economists have mostly neglected the role of the political.
I would like to thank Howard Nicholas and Rolph van der Hoeven for their support and critical remarks.
If not further specified inequality refers to income inequality and growth to economic growth as
measured by the Gross Domestic Product (GDP) throughout the remainder of this article.

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How and to what extent the political dimension has contributed to increasing inequality has
been under-researched. In order to analyse the political causes of increasing inequality the
U.S. has been chosen as a case study. The research question reads as follows: Which
factors are the main drivers of income inequality in the U.S.? The U.S. is of particular interest
because the country has experienced a sharp increase of inequality relative to other
countries. In addition to that the U.S. is one of the few countries where continuous and
reliable data is available. This enables the analysis and comparison of the changing patterns
of income inequality from the early 1950s onwards.
Partly, as it is argued, inequality has been caused by politically induced decisions. Certain
policies, such as the decreased support for unions and tax cuts favouring the relatively welloff and corporations, have benefitted a small minority of the population at the expense of the
majority and have thus contributed to widening income inequality. It is argued that this
particular type of income inequality leads to representational inequality. High and persisting
inequality in the U.S. has contributed to the strengthening of an economic elite who have a
vested interest and the means to influence policies accordingly which increases and
perpetuates inequality. This in turn reduces the purchasing power of the majority of the U.S.
population (and hence aggregate demand). Thus, growth stalls also due to decreasing means
of purchasing goods and services for the majority, or, contributes to economic and financial
instability because the stagnating real wages are compensated by increasing accumulation of
debts (Onaran and Galanis 2013, 88).
The overall argument is that an influential driver of increasing inequality is the capability of the
relatively well-off to capture large parts of the national income at the expense of the majority
of the population through political influence. While the real wages of the economic elite
increase, the majority of the population experiences stagnating real wages. In this regard, the
changing shares of national income as measured by the functional income distribution (FID),
which distinguishes between the factors labour and capital, have been neglected so far. The
former measures the return to labour which is a major source of income for the majority of the
population, whereas the latter measures the return to ownership which accrues mostly to a
wealthy minority of the population. There is a gap in the empirical analysis which connects
increasing inequality with changing factor shares of national income. The FID provides a
different angle on how economic gains and losses are distributed in an economy.
Main drivers of U.S. income inequality

There is agreement among scholars about the trend towards higher income inequality in the
U.S. The increase, although present in many other wealthy democracies, has not been as
substantial elsewhere (Jacobs and Myers 2014, 752). While there is agreement regarding
the trend, the causes or drivers of increasing income inequality are widely debated. Palma
(2011) pointed out the importance to focus on the tails of the distribution when analysing
inequality. This paper first analyses the consequences of inequality on growth in the U.S. and
then how political measures, for example the introduction of decreasing corporate and high
income tax, have contributed to an upward redistribution.
The trend commonly agreed by scholars is that [i]nequality in wages, earnings, and total
family incomes [] has increased markedly since 1980 and that the level of inequality
today, for both market income and disposable income, is greater than at any point in the past
40 years or longer (McCall and Percheski 2010, 332). Taking 1979 as the baseline the

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upward trend is reflected by a variety of inequality indicators (Figure 1). While in the
intermediate post-World War period inequality decreased the trend was reversed. Trend
reversals began in 1960s, gathered pace throughout the 1980s, to contemporarily remain at
an all-time high. [T]rends for all units of analysis, measures of inequality, and types of income
show that inequality in the United States increased from 1970 through the present (332).
One major driver of increasing inequality was the shift of the focus of macroeconomic policies
in the late 1970s and early 1980s intended to combat high inflation and low output induced by
the oil shocks in 1973 and 1979. This period saw the launch of structural reforms to make
OECD economies more efficient, flexible and competitive although modestly at first and with
the United States [] leading the way(OECD, 2011b, 314). Whereas in the 1960s and 1970s
macroeconomic policies were aiming at full employment, external balances and low inflation,
the early 1980s witnessed a shift towards a focus on the medium-term. The focus shifted
towards structural reforms to liberalise markets in order to make the economy more efficient
(OECD 2011a, 310311).
Figure 1: U.S. Trends in Economic Inequality, 1979-2006
(Source: McCall and Percheski 2010, 334.)
However, the shift of macroeconomic policies in the late 1970s and early 1980s in most
developed economies had a deeper structural impact which entailed a more general
redefinition of the role of the State in the economy, which favoured significantly reducing the
extent of State intervention and public sector involvement in the economy (UNCTAD, 2012b,
12). This change of macroeconomic focus also had redistributive consequences which
resulted in an upward redistribution benefitting the already relatively rich parts of the U.S.
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population mostly. [R]ising inequality is the direct result of a range of policy choices that
predictably boosted bargaining power for those at the top of the income and wage
distributions (Bivens 2013, 21). The upward redistribution is visible in the changing FID
(Figure 2) where the income of labour decreases which implies an increase of the capital
share of national income. The analysis of the FID is indispensable because the type of
income inequality witnessed ever since the early 1980s lends itself a clear class feature
where the relatively rich extensively gain at the expense of the broad parts of the population
who experience decreasing shares of national income. The decline of the wage share in the
FID does not seem be to limited to any particular set of countries and appears to be a
general phenomenon (Rodriguez and Jayadev 2010, 3).
Figure 2: U.S. adjusted wage share, 1960-2013
(Source: authors compilation, data retrieved from AMECO (2014). 3)
As Stockhammer (2013, 44) argues only recently the determinants of FID have attracted
researchers attention. Theoretical models, such as the Heckscher-Ohlin model and the
Cobb-Douglas production function, assume the share of labour and capital to remain
constant. However, the adjusted wage share of the total economy of the U.S. peaked in 1969
and then declined by 7.7 percentage points. The decline of the wage share has not been as
pronounced as in other advanced economies but the increase of top incomes has been even
higher. In the Anglo-Saxon countries a sharp polarization of personal income distribution has
occurred, combined with a modest decline in the wage share (41). This is partly explained by
the fact that high incomes partly offset the negative trend of the FID. They nevertheless, only
occur to a small minority of the work force. What are the drivers of the skewed FID? Until the
early 1970s productivity gains were passed onto labour in terms of real wage increases
(Fleck, Glaser, and Sprague 2011, 59). From 1947 until the late 1960s real hourly
compensation and productivity increased and followed a very similar trend. However, as of
1973 real hourly compensation and productivity started to diverge. A trend which has
continued until today (ILO 2013, 46).
Figure 3: U.S. decile shares of national income, 1947-2007
Refer to Appendix A for a more detailed description of the data.

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(Source: Wade 2011, 66.)
Another reason identified by scholars as possible driver of inequality in the U.S. is the marked
increase of salaries of top-income earners (Reardon and Bischoff 2011, 1095; Piketty and
Saez 2003) which is also referred to as upper-tail inequality. Growing concentration at the
top of the distribution is a striking departure from earlier patterns of inequality (Neckerman
and Torche 2007, 337). Another OECD report finds evidence for a stark increase of top
incomes especially for the U.S. (OECD 2011b, 39). The top decile of income earners could
expand their share of national income drastically reaching similar levels as before the Great
Depression in the late 1920s (Atkinson, Piketty, and Saez 2011, 6). Wade (2011) presents a
detailed analysis of the size of the distribution of national income which tracks the whole
income distribution over time (Figure 3). The author divides the population into ten deciles.
The first decile (D1) represents the first ten percent of U.S. population who are at the bottom
of the income distribution. D2 represents the second most unequal ten percent of the
population and so forth. His observation begins in 1947 and ends in 2007. Wades (2011)
findings show that until the late 1970s the distribution of national income among the deciles
remained relatively constant although there were some minor fluctuations. From 1980
onwards D4 to D9 (which represent half of the population) continue to have a relatively
constant share of slightly more than 50 percent of national income. However, at the same
time the shares of the upper decile D10 diverges from D1 to D4. This means that those who
were already at the top end of the income distribution could further gain at the expense of 40
percent of the people at the lower end of the distribution and of the middle class which saw
their share of the national income stagnate (Palma 2011). Consequently, a small minority at
the top of the income distribution captures most parts of national income, forcing the wages of
the majority to stagnate or even decline.
Another trend that contributes to rising inequality is decreasing unionisation. Declining power
of labour vis--vis capital can be one reason for the declining labour share of total national
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income. In contrast to asymmetric income gains of top earners this pushes the lower-end of
the income distribution downwards. In the case of the U.S. stagnating real and minimum
wages contributed to growing inequality and amplified the trend towards diverging incomes.
[T]he weakening of U.S. labor market institutions is a source of income
inequality. [] Weakening unions may also contribute to the stagnant
minimum wage (Park 2013, 18).
National policies in the U.S. have supported this trend. OECD (2014, 7) found a high
correlation between top tax rates and pre-tax income inequality: The higher the top tax rate
the lower the share of top percentile of national income. This goes hand in hand with another
long-term trend of decreasing top income tax rate in OECD countries. The OECD average of
top income tax rate fell from 66 percent in 1981 to 43 percent in 2013. A similar development
happened in the U.S. where the top marginal income tax rate steadily decreased from slightly
above 80 percent in 1950 to 35 percent in 2011 (Piketty 2014, 499). [T]he evolution of top tax
rates is a good predictor of changes in pre-tax income concentration (Saez and Piketty
2013). The reduction of top tax rates either for business or for top income individuals is based
on arguments that less taxes induce higher investments and thus translate into higher growth.
However, expected higher investments through a reduction of top marginal income tax rates
which translate into growth have not materialised (Piketty, Saez, and Stantcheva 2013, i).
Another example of such policies next to the decrease of top income tax rates is the decrease
in corporation income tax which has diminished constantly as a share of GDP. However,
corporate profits as a share of GDP have been growing which benefited the upper-tail of the
income distribution disproportionally and supported accumulation. Piketty & Saez (2006, 21)
find that the progressivity of the U.S. federal tax system at the top of the income distribution
has declined dramatically since the 1960s while the average tax rate for the middle class
remained constant. This dramatic drop in progressivity at the upper end of the income
distribution is due primarily to a drop in corporate taxes (Piketty and Saez 2006, 21). This
leads to a situation where the [c]orporate profits are at their highest level in at least 85 years.
Employee compensation is at the lowest level in 65 years (Norris 2014). As it is the case with
the below analysed top income tax rate and the increasingly hostile behaviour towards unions
the beginning of those favourable policies can be found during the Reagan administration.
These large reductions in tax progressivity since the 1960s took place
primarily during two periods: the Reagan presidency in the 1980s and the
Bush administration in the early 2000s (Piketty and Saez 2006, 22).
These union-hostile and business-friendly policies had a major impact on the income
distribution between factor shares and on which part of the population receives how much of
national income. For example, these policies have contributed to a decreasing compensation
of employees as a share of national income (Figure 4). Corporate profits as a share of
national income remained fairly stable at around 2% with some minor fluctuations between
1950 and 1988. However, after 1988 the share of corporate profits experienced a steady
increase to 4.9% of national income, only interrupted by two sharp drops in 2004 and in 2007.
Profits bounced back to pre-crisis levels within one year and less than three years
respectively. Besides, the long-term trends of sources of tax receipts as a percentage of GDP
which distinguish between individual income taxes and taxes paid by corporations is also
interesting (Figure 5). Taxes received from individual income tax payers increased slightly
from 7.8% (1952) to 7.9% (2013). However, the taxes received from corporations experienced
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a steady decrease. They dropped from 5.9% (1952) to 1.6% (2013). Despite increasing profits
the share of tax receipts as percentage of national income decreased constantly. Thus, the
corporations tax burden has decreased relative to the burden of the individuals.
Figure 4: U.S. Compensation of Employees and Profits, 1950-2012
(Source: authors compilation, date retrieved from FRED (2014). 4)
Figure 5: U.S. Tax Receipts by Source as Percentage of GDP, 1950-2013
(Source: authors compilation, data retrieved from Historical Tables (2014).)
Refer to Appendix B for a more detailed description of the data.

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Figure 6: U.S. Effective Corporate Tax Rate, 1950-2013
(Source: authors own compilation, based on FRED (2014). 5)
Another consequence is the continuous reduction of the effective tax rate paid by
corporations during the same time period (Figure 6) It peaked at 48% (1950) to drop to its
lowest point at 14% (2009) and slightly increased to 17% (2013). The corporate profits
steadily increased from 1950 to late 1960s, however, in the early 1970s they increased at a
faster pace. The trend experienced another sharp increase from 1986 onwards. The shift of
focus of macroeconomic policies in the early 1980s in general and the increase in top
salaries, the decrease in union power, the decrease in top income tax rate and the decrease
in corporation income tax in particular have contributed to the divergent factor shares of
income. The explicit pro-capital and labour hostile nature of policies governing the unions put
downward pressure on real wages. Productivity gains are not passed on to labour in terms of
real wage increases anymore (Figure 7). It furthermore shows that stagnating real wages are
not related to falling productivity of labour. On the contrary, gains from increasing productivity
have not been passed on to labour.
Figure 7: U.S. Growth, Productivity Growth and Real-Hourly Compensation
(Source: authors own compilation, date retrieved from Fleck et al. (2011) and FRED (2014). 6)
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In order to justify the upward redistribution often the argument of increased investments and
the consequent trickle-down effect are advanced. However, neither the decrease in high
income taxes nor the decrease in corporation tax have increased the savings ratio. In the
post-World War period the:
top marginal tax rate and the top capital gains tax rate do not appear
correlated with economic growth [] saving, investment, and productivity
growth (Hungerford 2012, 17).
At the same time, these policies have enabled the upper end of the income distribution to gain
large and disproportional shares of national income (capturing most of the productivity
increases). The share of national income increases the closer one moves to the upper end of
the distribution. Atkinson et al. (2011, 9) calculate annual real income growth for the top 1% of
the income distribution in the period from 1976 to 2007 at 4.4%, whereas the real income for
the remaining 99% increased by 0.6% only. OECD (2014) provides data showing the growth
capture of national income according to income groups (Figure 8). The bottom 90% of the
income distribution received less than 20 percent of national income growth from 1975 to
2007, whereas the top 1 percent of the income distribution received the lion share of nearly
half of national income growth. Another 30 percent of national income growth is received by
the top 10 percent to 1 percent. The top tax rate reductions appear to be correlated with the
increasing concentration of income at the top of the income distribution (Hungerford 2012,
17). Thus, both, the marked increase in the share of top income earners of national income
(upward trend in upper-end income distribution) and the stagnation of real wages (downward
pressure on the lower-end income distribution) reinforce the trend towards inequality and
result in changing factor shares of the FID.
Figure 8: Growth Capture of Total Income, OECD Countries, 1975-2007
(Source: OECD 2014, 3)
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Analysing the FID in the U.S. reveals an increasing share of capital to the detriment of labour.
This section has shown how drivers of income inequality impact the distribution of income
within the U.S. The top income earners successfully captured most parts of the income
generated by the economy while the income of labour stagnated. Productivity gains were not
passed on to labour as it was the case in the intermediate post-World War period. The
upward redistribution is actively supported by U.S. policies which decreased the top income
taxes constantly; discouraged unionisation which decreased the means of unions to
successfully bargain for increasing real wages. Thus, it is important to look at the FID for the
general trend. More detailed causes of changes in the income distribution can be derived by
analysing to which income group accrues how much of national income.
As it is not possible to argue, based on the empirical evidence provided above, for a direct
causal relationship between the policies favouring the already rich disproportionally at the
expense of decreasing the aggregate demand of the majority, the pattern is nevertheless
remarkable. However, upward redistribution from large parts of the population to the benefit of
a few at the top of the income distribution must have (had) an impact on aggregate demand.
During the same period in which globalisation supposedly increases the competition among
companies corporate profits in absolute numbers and in relation to GDP as well as high
incomes soar. However, if those income gains had not been made at the expense of the
majority aggregate demand would have grown faster and the recovery would be stronger
(Bivens, 2013, 20). This contradicts the austerity policies. Growth policies which increase the
demand of the majority through increases in real wages would be more fruitful (Onaran and
Galanis 2013, 89). The low purchasing power of the majority and the lack of demand for
goods and services has attracted the attention of other traditionally more conservative actors
(Reuters 2014a; Reuters 2014b; S&P 2014).
To conclude, the politically induced decrease in unionisation, the decrease in high income
and corporation tax have been the main drivers of increasing inequality. These trends lead to
a decrease of the labour share of national income and reduced the aggregate demand for the
majority of the population. One of the (arguably many) necessary preconditions for constant
and sustainable growth is a certain degree of an equal distribution of national income. Which
degree of equality is sufficient as a precondition for sustained growth is difficult to determine.
However, if the labour share of national income in the U.S. does not increase it is unlikely that
aggregate demand will be able to sustain a modest growth of the economy. The most efficient
way to stimulate aggregate demand is to increase the real wages of the majority. For
economic and normative reasons alike more equality, instead of higher inequality, is the
foundation of sustained growth.
Conclusion
Several trends which contributed to this phenomenon of increasing income inequality started
around 1980 and were politically induced. Some trends have contributed to a greater, others
to a lesser extent and there might be others which have not been considered in this analysis.
However, if income inequality is seen through the FID and income groups, a clear picture
emerges. Politically induced decreasing unionisation and the fact that the gains in productivity
are not passed on to workers translate into stagnating real wages for large parts at the lower
end of the income distribution. At the upper-end, however, income increases in real terms
through the politically induced decrease in top income tax rates and the marked increase of
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top-income salaries. Both trends reinforce the divergence between labour and capital. The
share of the middle-class stagnates.
Despite the fact that exogenous drivers play an important role in the determination of
inequality, countries do have the necessary policy tools in order to prevent, or at least, curb
the trend of increasing inequality posed by the exogenous drivers. However, the tools that
were employed by the U.S. governments turn out to be catalysers of the upward trend instead
of absorbing the starkest increase. One such example is the shift of macroeconomic policies
away from the traditional focus of overall macroeconomic stability and full employment
towards price stability which has a direct bearing on the distribution of income and increases
the divergence of income between upper- and lower end of the distribution. But why are the
exogenous drivers of increasing inequality reinforced by endogenous drivers (meaning
political decisions) which instead could have been employed to diminish the effects of
exogenous drivers?
Partly, this question can be answered with the growing influence of economic elites on the
decision-making legislative process in the U.S. High and persistent income inequality has led
to representational inequality. In the case of the U.S. economic elites influence policies to
their advantage and do so successfully even in those cases where the majority of citizens
disagree on particular matters. This finding hints at a more fundamental issue in the analysis
of income inequality: the neglect of the political dimension as a major contributor to increasing
income inequality. The political dimension is not the only driver of income inequality in a
country but again it plays an important role to which academic attention has failed to do
justice to.
The analytical neglect of the political dimension has severe consequences. Being an underresearched but definitely important dimension it is not well-understood by scholars to what
extent and how the political dimension affects income inequality. The argument put forward in
this analysis is that institutions actively contribute to the sharp divergence of the income
distribution. Since the impact of the political dimension on inequality has been neglected by
researchers it is not possible to include it in growth models or regression analysis in a
meaningful way. However, if a variable for which empirical evidence finds a major role in the
determination of income inequality is not included in such models or regression analyses the
outcome is less reliable. Thus, further research needs to focus on how to include the political
dimension in growth models and regression analyses in a meaningful way.
It has to be acknowledged that structural changes create more competition and lead to
tectonic shifts in the process of economic organisation. Globalisation allows to shift labour
intensive production from developed economies to other economies more easily. These
arguments are often advanced to explain the decreasing share of labour income and to
legitimise policies which favour corporations and high-income individuals disproportionally.
However, why is accumulation at the top soaring? Why do corporations have increasing
revenues in absolute terms as well as a share of GDP while at the same time the real wages
of large parts of the population are stagnating? There is an undeniable influence of the
economic elite on legislative processes. Redistribution always takes place what changes are
the groups which benefit.
Most importantly, decreasing inequality is not an automatic outcome of growth. Redistribution
always takes place and institutions (the political dimension) determine whether national
income is redistributed upwards or is more equally shared among the population. In the case
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of the U.S. various policies since 1980 have favoured an upward redistribution which
benefited a few at the expense of the majority. If compared to the intermediate post-World
War period, where economic growth came along with decreasing inequality, a clear faultline
can be established. After 1980 a trend towards growth and increasing inequality began to
emerge. The concentration of income at the top of the income distribution turned into means
which increased the political influence of the economic elite and perpetuated inequality even
further.
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Appendix A: Description of Data based on AMECO (2014)
Variable
Acronym
Adjusted Wage
Share
ALCD0
Description
Adjusted wage share: total economy:
as percentage of GDP at current
market prices (Compensation per
employee as percentage of GDP at
market prices per person employed.)
(Source: AMECO (2014).)
Appendix B: Description of Data based on FRED (2014)
Variable
Acronym / Formula
Corporate Income
Tax
FCTAX
Corporate Profit
A053RC1A027NBEA
Effective Tax Rate
FCTAX/A053RC1A027NBEA*100
Compensation of
employees
W269RE1A156NBEA
Profits
A449RE1A156NBEA
Description
Federal Government: Tax
Receipts on Corporate
Income
Corporate profits: Profits
before taxes, NIPAs
See above
Shares of gross domestic
income: Compensation of
employees, paid: Wage and
salary accruals:
Disbursements
Shares of gross domestic
income: Corporate profits
with inventory valuation and
capital consumption
adjustments, domestic
industries: Profits after tax
with inventory valuation and
capital consumption
adjustments: Net dividends
(Source: FRED (2014).)
Author contact: [email protected]

___________________________
SUGGESTED CITATION: Holger Apel, Income inequality in the U.S. from 1950 to 2010 the neglect of the
political, real-world economics review, issue no. 72, 30 September 2015, pp. 2-15,
http://www.paecon.net/PAEReview/issue72/Apel72.pdf
You may post and read comments on this paper at http://rwer.wordpress.com/comments-on-rwer-issue-no-72/
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A never ending recession? The vicissitudes of

economics and economic policies from a Latin
American perspective 1
Alicia Puyana
[FLACSO- Mexico]
Copyright: Alicia Puyana, 2015

1 Introduction
The crisis facing the world economy since the end of 2007 has shaken to the core the
economic paradigms that were the basis of models for economic policies and governmental
roles for the past 30 years. The elusive recovery of the economies of the European Union and
the United States and the instability of China, Brazil are causing alarm. Moreover, the latest
economic forecasts published by multilateral organizations 2, suggest the world is facing an
economic secular stagnation, a long-lasting period of low interests rates, low inflation, low
growth and high unemployment (Summers, 2013), with dramatic negative impacts on
incomes and equality.
Due to the global financial crisis, the ability of the market to unleash politically, socially and
environmentally sustainable growth has been called into question, given that to be
sustainable, growth must be inclusive, be able to reduce inequality and poverty, extend
universal citizenship rights, and promote the rational use of the factors of production. The
crisis has challenged the unconditional acceptance of the democratizing effects of the free
market and the foundations of the macro economy, based on the assumptions of classical
and neoclassical economic theory and subjected to the fundamentals of microeconomics.
This has led to questioning the nature of the policies supported by these principles. The
alleged credentials of economic theory as an exact science, politically neutral, and with
predictive capacities have been essentially called into question. One of the few, if not the
only, positive effects of the crisis has been the return of economics to the social sciences.
This return is especially important for macroeconomics, in which economic theory cannot be
separated from politics.
There is concern about the future of capitalism, that the progress in economic liberalization
will be reversed, and populism beaten down when observed in developing countries and
tolerated when applied in developed countries will return. The crisis has been confronted
with some monetary quantitative easing to save banks, plus austerity measures, deep cuts in
public spending, which constitute one more step towards dismantling the welfare state that
was initiated with structural reforms 20 years back. These cuts eliminated inalienable civil
rights won by workers in long and hard struggles, and replaced them with the right to obtain
credit to meet basic needs or acquire public goods.
This paper is an expanded and updated version of the conference at the authors inauguration as
member of the Colombian Academy of Economic Sciences, Bogot, in April 2013.The author thanks
Jos Antonio Ocampo, Rosemary Thorp, Martin Puchet, Jos Romero, Eva Paus and Nelson Arteaga
for their useful and generous comments which helped to clarify the arguments. She also acknowledges
Agostina Costantino for her assistance in the preparation of an earlier version of this work. All errors and
omissions are the authors sole responsibility.
2 See: IMF (2014, 2015), OECD (2014, 2015) and ICMBS (2014).
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The economic crisis of 2007-8, which affected the global order, was not widely predicted. The
surprise was best expressed by Queen Elizabeths question, during a visit to the London
School of Economics in November 2007: It's awful! Why did nobody see it coming? (RDMP,
2009). UKs monarch sparked an intense exchange of communications among leading
economists, competing to give the sovereign a satisfactory answer. 3 It highlighted the crisis in
economic theory as a social science and opened a still ongoing debate. The political
establishment and the media mirrored this race for explanations and justifications.
What remains of all this eagerness to ask questions and seek answers? It seemed that at
least the financial arrangements would be reordered. Neither Europe nor the United States
have emerged from the crisis (IMF, 2014; ICBM, 2014), nor has the power of the large
financial institutions weakened. Or so it seems.
Governments fall and citizens are impoverished, but the liberal orthodoxy responsible remains
in place. However, it would be inaccurate, or perhaps fallacious, to claim that nobody saw the
crisis coming. Many predicted it and raised the alarm (Galbraith, 2009). These voices were
ignored by the carriers of politically correct economic thought, in an exercise of intolerance
towards positions critical of the orthodoxy of the neoclassical repression (Rogoff, 2002), 4 by
which papers challenging the orthodoxy were not accepted in leading mainstream economic
journals.
The limitation of macroeconomic theory, of modelling only that which can be sustained by the
microeconomic foundations of the representative agent in a general equilibrium frame, led to
the predominance of econometrics over economic theory, and to deviations in its teaching
which aroused concern years before the current crisis. In 1988, the American Economic
Association formed a commission 5 to assess graduate economic theory programmes in
American universities. In its report, the commission (American Economic Association
Commission, 1991) lamented the fact that economic theory had become a branch of applied
mathematics, detached from real world events and institutions. According to the commission,
U.S. graduate programmes produce generations of economists, idiot savants, well versed in
techniques but innocent of real economic facts (American Economic Association
Commission, 1991). The major flaws described were a lack of teaching in history, philosophy,
geography, institutions, and of course, economic theory, as well as not reading the classics.
This trajectory continued, programmes were not modified, and deficiencies identified by the
commission even intensified to the extent that in September 2000, students of economics at
the cole Normale Suprieure in France protested against the excessive mathematical
formalization in the teaching of economic theory, not due to a rejection or fear of mathematics
but to the schizophrenia created by choosing modelling, in place of reality, as the route to
developing theory. They called for the end of the hegemony of neoclassical theory and the
return to pluralism and a willingness to consider concrete reality (Post Autistic Economics,
3
The Financial Times established a panel to debate the future of capitalism and the measures to save it,
and maintains the blog The Future of Capitalism: http://blogs.ft.com/capitalismblog. President Sarkozy
convened heads of states and social scientists for a discussion on New World, New Capitalism, and
The Economist devoted several issues to the crisis of macro-economic theory and financial economics,
including comments by Nobel Prize winner R.F. Lucas. The OECD created the forum Measuring the
Progress of Societies to find ways to measure the progress of nations.
4 There are more than a few of us in my generation of international economists who still bear the scars
of not being able to publish sticky-price papers during the years of new neoclassical repression
Rogoff, K. (2002, page 9).
5 Journal of Economic Literature, September 1991.
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2000). Similar movements were launched in Argentine universities, and also called for
supporting social movements that rejected the FMI mandated adjustment. The inequality
resulting from policies backed by the neoclassical theory model has now been exacerbated
by the crisis. 6
It does not appear that a great amount of progress has been made down the route of return to
pluralism and considering concrete reality, at least not in the USA or the UK. Simon WrenLewis (2010), of the London School of Economics, describes the depression he feels when
listening to brilliant economics students saying they would love to explore some real-life
problems, but refrain from doing so because the microeconomic assumptions are unclear.
This essay first discusses recent changes in economic theory and the paradigms that were
the basis for economic development. The economic crisis, past and present, destroyed
economic theory paradigms. Second, some not wholly flattering observations are presented,
regarding the trajectory followed by Latin American economies following the implementation
of structural and liberalization reforms, closely related to the neoliberal paradigms installed as
dominant ideas and which in Latin America were first instrumented in Chile and Argentina in
the seventies.
2 Economic crises and the crisis of economic theory

Towards explaining the current crisis, two processes can be identified that feed one on the
other: firstly, the transformation of economic theory since the end of World War II; secondly,
the transition from pluralist concepts to analytical reductionism with the enthronement of the
neoclassical school as the dominant theory. As the economy moved from the post-war golden
age of capitalism, to the post debt crisis great moderation era, and from there to the great
recession of today, economic theory and macroeconomics adopted metaphors from physics
and applied them to society, under the principles of perfect competition and rationality based
on complete information.
Economic crises, like any type of crisis, demand reflection on the course of events. Crises
have led to profound changes in the political and economic standards of societies and the
institutions that regulate them (Alesina et al., 2006). However, other interpretations suggest
that prevailing paradigms remain and survive longer than they should, and society invests
resources and wastes time trying to adjust the irreparable (Stigler, 1982).
3 From the classics to the neoclassics: what is economic science for?

Economic theory, since Smith and Ricardo, is based on physics metaphors (Jomo, 2005) in
the idealization of markets and in the reduction of individual behaviour to fully predictable
selfish rationalism. In these metaphors, society, like the universe, is governed by the invisible
In the recent book Beyond Outrage: What Has Gone Wrong With Our Economy and Our Democracy,
and How to Fix It (2012), Robert B. Reich, professor at Berkeley, documents that modern capitalism,
consolidated over the past three decades by concentrating wealth, erodes its sources of growth and
undermines democracy. The richest 1% of the US population accumulated 45, 65 and 93 per cent of the
income growth during the Clinton, Bush and Obama administrations. The OECD (2011) laments the
concentration of income and warns of the damage to social cohesion and the system that it implies.
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hand 7, which in the universe keeps the cosmos in order and, after disasters, restores balance.
The rising of the sun, and the phases of the moon or eclipses take place and no human action
can avoid them although they may be predicted with relative accuracy. In the economy, and in
society, the invisible hand conserves and restores balance at a lower cost than that incurred if
visible hands were to intervene.
According to Davidson (2012), Paul Samuelson is responsible for the proposal that in order to
ascend from the realm of history to that of science, economic theory must adopt the methods
of the natural sciences and build ergodic axioms which demonstrate that the economic future
is predetermined by an ergodic stochastic process. Therefore, he states, the function of
economists should be reduced to calculating the probability distributions of future prices and
productivity. For Samuelson, Davidson goes on to say, economic events are repeated
inexorably on a predictable path, so that based on past events, without considering the initial
conditions, it is possible to predict events and respond to them without trying to alter their
course. Therefore, once economic actors, motivated by individual interest, have reliable
information about the future, they will correctly invest in what gives higher returns and
therefore ensure global prosperity (Davidson, 2012: 3). Economists such as Lucas and
Sergent, Cochrane, Mankiw, M. Friedman, and Scholes based their theoretical contributions
on these axioms, and consecrated this method as the only approach to scientific research in
economic theory, and as the rational basis of public policy (Ibid). This was the intellectual
response to meet the demand for security and certainty of the animal spirits, without which
capitalism cannot be sustained. Of course, there are departures of neoclassical theory
emphasizing market imperfections. Stiglitz, for example, being a neoclassical, the problems of
information and other market imperfections are dominant and turn the market pathologically
imperfect. 8
Ergodic models elevated economics to the rank of the natural sciences and dressed some
economists in the emperor's new clothes of political neutrality; and the models proposals
became irrefutable axioms, beyond all social, political, and historical context.
Stigler, in 1982, in his Nobel Prize acceptance speech, explored the sociology of economists
as powerful actors, and declared them responsible for the stagnation that economic theory
had suffered since the scientific method of testing theories against reality had been
abandoned. Thus, for Stigler, today good economists are no longer those who are correct, but
those that affect the profession as a whole. Which means that, since it is harder to sell new
ideas than new products, they apply the persuasion techniques of a street vendor: repetition,
exaggerated claims, and disproportionate emphasis, and become preachers instead of
scholars and theorists (Stigler, 1955).
This metamorphosis of economic theory as noted by Galbraith (1974) in his first conference
as President of the American Economic Association responds to the need to supposedly
7
Since Smith and Ricardo, the metaphors are present in the language of economics: the invisible hand,
time is money, bubbles, reheating, the labour market. Econometric models are the mathematical
formulation of these. The problem is not the use of metaphors, but rather which, why, and to what end
they are used and, most seriously, that they obscure rather than help research. Krugman (1997) and
Steven Landsburg (2010) suggest that the economic rhetoric comes from parables, and like those of
Aesop, in order to have a clear moral it is not necessary for them to be true, or even realistic. They just
need to be well told. On the role of metaphors in the process of knowledge and learning and the
development of economic thought: Deirdre N. McCloskey The Rhetoric of Economics or Philip Mirowski
(1994), as well as Arjo Klamer, Donald N. McCloskey, Robert M. Solow, 1989 or Arjo Klamer, 2007.
8 Stiglitz, J. (1991), The Invisible Hand and Modern Welfare Economics, NBER Working Paper No.
w3641.
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manage and reduce risk, as well as to the aspiration of subordinating the state and society to
the dictums of the market and to
reject all heresies, in any organized form, that is to say, anything that seems
to threaten the sanctity of property, profits, appropriate tariff policy, or the
balanced budget, or implied sympathy for unions, public property, public
regulation, or the poor (Galbraith, 1974: 239).
He adds that by excluding power from the analysis and
...converting economic theory into a non-political discipline neoclassical
theory destroyed, by the same process, its relation to the real world
(Galbratih, 1974: 240).
By distancing itself from the serious problems of the real world, Galbraith goes on to say,
classical and neo-Keynesian economic theories limited themselves to proposing models that
explain nothing and suggest incorrect solutions (Ibid.). Such proposals include, for example,
the two most consolidated proposals in relation to global warming. On the one hand, that
which prioritizes adaptation that is, there is no need to intervene because it is the normal
course of the planet and humanity can adjust to its changes and on the other hand, that
while accepting the need to reverse or least contain warming, focuses the solutions on market
mechanisms and pricing systems.
This state of affairs in economic theory can be traced to the 1970s, when economic science
plunged into the great project of assimilating macroeconomics to microeconomics, which
implies that from the study of the behaviour of individuals, it is scientific and feasible to
analyse and solve problems related to growth, inflation, business cycles, external shocks,
unemployment and income concentration (Jomo and von Arnim, 2009). In this effort,
economists, armed with physics metaphors and the arsenal of long term time-series for wide
universes, with dozens of countries, multiple variables, powerful machines and sophisticated
software, tried, like physicists, to find a law, the universal law that explained everything.
If there were to be such an economic theory, there is really only one
candidate, based on extreme rationality and market efficiency. Any other
theory would have to account for the evolution of individual beliefs and the
advance of human knowledge, and no one imagines that there could be a
single theory of all human behaviour (Kay, 2009).
To account for scale economies, increasing marginal returns, involuntary unemployment and
waste of resources would lay to rest the axiom of perfectly competitive markets.
Macroeconomic theory abandoned the complexity of the real world and distanced itself from
the issues explored by the pioneers of development economics, such as Prebisch and
Furtado, and by the structuralist school (notions such as increasing economies of scale, or
the role of history and institutions as historical creations), variables that were difficult to
model at the time (Krugman, 1999). Orthodox economics, evolved under the premises of
perfect competition and diminishing returns, took the simplification that could be modelled as
if it was reality and consigned to oblivion the progress from the 30s and 40s (Krugman,
2009a).
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In due course, the scientific method of testing hypotheses against reality was sacrificed for
the sake of elegance, and gradually, economists have become more worried about making
an impact than about research quality.
4 The forgotten lessons

Three transcendental events marked the end of three models of economic theory, revealing
that the theoretical economic paradigms are neither eternal nor immutable. In fact, at all
times, a number of theories have coexisted and it is feasible to apply multiple perspectives to
explain the same event. However, for diverse reasons, not all of them economic, only one
overrules the rest. The epistemological fatigue produced by alternative approaches gained
strength during the crises and forced advocates of the prevailing paradigm to face its
limitations.
The first event was the crisis of the 30s, the great depression, which marked the end of an era
of rapid growth in productivity, global trade and technological advances; the second, the
stagflation of the mid-70s, which led to the debt crisis which ended the golden age of
capitalism, or of the rebuilding of the economies devastated by World War II; and the third,
the great stock market crash of 2008, which led to the great recession and gave the final blow
to the period of the Great Moderation, the long period from the early 1980s to mid2007, during
which inflation was controlled and recessions in developed countries were relatively mild but
intense and frequent in the developing world (Ocampo et al., 2010b). Several crises affected
developing countries: the debt crisis at the dawn of the 80s, the Tequila from 1994-1995, and
East Asian of mid-1997, which after disturbing Russia and Latin America spread to almost all
developing countries. Brazil and Argentina also suffered economic shocks. All of these
occurrences, like the Great Recession, were caused by excessive risk-taking and the
exuberance of the financial markets (Stiglitz, 2010 cited in Ocampo et al., 2010b).
4.1 On the Great Depression
The Great Depression ended the faith in the market's ability to regulate the economy and
make the necessary adjustments to overcome cycles. The collapse of the stock market in
1929, economic stagnation, and the fall in demand made obvious the need to intervene.
Interventions were needed not only in relation to the euphemistically named externalities or
market imperfections, but also to maintain a minimum of economic activity and effective
demand, given the evident invalidity of Say's Law, according to which everything that is
offered for sale is sold. Keynes understood that. The crisis, Keynes argued, was more than an
isolated episode, and the capitalist system, to function in a satisfactory way, needs an
agency, the state, to protect the system, print money and invest to maintain employment and
sustain demand when crises demand it. He was especially critical of the financial sector, due
to its propensity for short-term speculation.
One of Keyness most important contributions was the rejection of the ergodic method of
classical economic theory, arguing that the axioms of this school are applicable only to
specific cases and not to contemporary economic conditions, from which it logically follows
that adverse outcomes can result from wrong conclusions (Davidson, 2012: 3) 9. Indeed, the
insistence on the validity of the ergodic axioms led to the qualification of the experiences of
9
Keynes also rejected the supposed neutrality of money and the substitutability of money and capital
goods.
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China, India and some countries of Latin America as temporary deviations from the normal
path of capitalism which, sooner or later, were bound to adjust themselves.
Some theoretical and empirical shortcomings also contributed to the advance of neoclassical
economic principles and the dismal of the Keynesian paradigms.
On the theoretical front, Keynes failed to explain why unemployed workers
would not offer to work for a lower wage, and why profit maximizing firms
would fail to hire them. On the empirical front, Keynesian economics failed to
explain stagflation (Farmer, 2012).
Therefore, economics returned to the business cycle theory of the 1920s, Farmer added.
Then, as now, there was no shortage of economists who saw the crisis as a great opportunity
for capitalism and, applying the parable of the broken glass, emphasized the benefits of
destruction, its constructive effects, and minimized or abstracted its economic and social
costs in order to emphasize that all countercyclical actions cause more damage than the
crisis itself. The resemblance to current austerity proposals with emphasis on fiscal discipline
and monetary control of inflation for Europe, the United States and Colombia, and generally in
Latin America, is no coincidence (Sarmiento, 2002; 2005). One lesson, now preferred to be
forgotten, is that by prematurely withdrawing the New Deal stimuli, the US economy again
began to decline, and only recovered with World War II military spending (Krugman, 2009b).
4.2 From the golden age of capitalism
Keynesian assumptions dominated economic theory and political action, at least from the end
of the war until the early 70s, during the phase known as the golden age of capitalism (Scott,
1991). During this time, all countries, developed and developing, grew at unprecedented
rates. 10 The rapid growth created pressure on natural resources and accelerated inflation.
The costs of depletion of natural resources appeared in the intellectual and political
landscape, with the Club of Rome, OPEC, the petro-dollars, the preamble to the debt crisis,
and the structural reforms.
The stagflation of the early 70s ended the golden age of capitalism and opened the way for
proposals that rejected Keynesian economic theory, in particular his recognition of lack of
demand as a cause of crises, and refuted the idea of implementing active employment
policies through public spending to maintain economic activity and domestic demand.
Starting in the 70s, many elements of classical economic theory gained traction again, this
time with less analytical complexity and more sophisticated instruments, focused on price and
product stability instead of growth, and also legitimized microeconomic fundamentals for
macroeconomic analysis.
The oil shocks and inflation of the late 60s prompted the general equilibrium models. The
assumptions of individual rationality and market efficiency were fully incorporated into the
econometric models: the representative individual became the lead actor. Due to the
10 Latin America recorded the highest growth rates and reduced the gap between its GDP per capita and
that of the United States. In this period (1945-1980), several Latin American countries, especially
Argentina, Brazil, Mxico, Peru, Venezuela, registered the highest rates of growth since the beginning of
the XX Century up to 2013.
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assumptions of perfect rationality and complete information, economic policy was labelled as
ineffective in reducing unemployment. Since individuals know how the market works, they
anticipate that any increase in public spending causes inflation and, in consequence, adjust
wages and prices accordingly, which prevents (even in the short term) increased
unemployment (Kaletsky, 2009). Unemployment became a voluntary decision of rational and
informed individuals (Friedman, 1968). Therefore, the mass unemployment of the 30s, or the
striking total unemployment in Spain (24.5%), and the dramatic unemployment amongst
young people (53% of the economically active population) would be a great collective
vacation (Krugman, 2009b).
The crisis of the 70s questioned the validity of the Phillips curve and the existence of the
indirect relationship between unemployment and inflation. The inflation of the 70s and the
debt crisis were followed by the economic and social costs of the lost decade, caused by the
severity of the adjustments. The bias of the structural reforms were not structural enough (M.
Lipton, 1991) since they only removed market restrictions resulting from the state's actions
and kept intact the suppression of transactions or exchanges, emerging from the
concentration of capital, production, knowledge and trade. As we shall see, in Latin America
the theoretical basis of the reforms and the macroeconomic policies adopted were
consistently applied: in Chile and Argentina during the 70s, and in other countries following
the debt crisis of the early 80s, and under the adjustment and structural reform programmes
of the International Monetary Fund, and the double conditionality established between the
IMF and the World Bank.
4.3 The great moderation, or the dangers of stability
The liberalization of the economy in response to the debt crisis and inflation that is to say,
the removal of the state from economic management set the course that would be followed
by economic theory, economic policy and the foundations of social organization. On the one
hand, the neoclassical ergodic axioms mentioned above were fully enthroned in theory and
macro-economic policy, and on the other, the market and individualism were held up as the
fundaments of all social action. Economic and political practice focused on the ultra-liberal
ideology summarized in the phrase of M. Thatcher (1987):
...there is no such thing as society. There are individual men and women,
and there are families.
Far from being a purely technical project, which exclusively affects the economy and seeks
only efficiency of public spending, the change of the development model disrupted the
structure of political power and the distribution of economic surplus, and transformed the
relations between state and society, between and within capital and labour, and between
social groups. By redefining the boundaries of the state, profitability was established as the
guiding principle of the economy. Efficiency, profitability and competitiveness were recognized
over equity as the guiding principles of public policy, and economists, it was said, needed not
to worry themselves about value judgments (Stigilitz, 1991). It deepened the separation
between positive economic theory and normative economic theory, and abandoned the
principle that efficiency and equity form a unit. This principle and the fact that market
imperfections permeate the whole economic system and do not guarantee the optimal use of
resources should be a topic of discussion between economists and politicians, as Stiglitz
put it:
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... these issues and not the issues of whether the market economy attains
the ideal of Pareto efficiency are or ought to be the focus of discussion in
democratic societies and not, as today, that the debate centres on whether
with democracy the market ensures Pareto efficiency or not (Ibid: 41).
Equity was relegated to residual measures, separated from economic policies, in order to
offset some of the damage caused by the exclusive preference for efficiency and capital
profitability. There is a greater tolerance for levels of poverty or degrees of inequality,
exclusion, unemployment and precarious employment, which were previously considered
morally unacceptable.
The liberal model ushered in the era of The Great Moderation, if some cases are ignored,
such as the crisis in the United States (mid-80s), the crises in Mexico (1986, 1994, 2009), and
the later crises in Southeast Asia, Colombia and Argentina. The liberal model plunged the
region into the lost decade, as a result of the severity of the adjustment and structural
reforms, as discussed below.
The Great Moderation, a term coined by James Stock (2003) and legitimized by Ben
Bernanke (2004), refers to the reduction in price and product volatility, and was brandished as
empirical confirmation of the success of liberalism and market power to establish the optimal
distribution of factors of production. Bernanke (2004) considers monetary restriction and
central bank independence as key among the various causes of stability. Bernanke
disregards as insignificant the political and structural causes: easy money, deregulated
markets, currency revaluations, cheap imports and less severe external shocks, among
others. The Great Moderation led Robert E. Lucas (2003: 1) to declare as solved, for many
decades to come, the great problem of macroeconomic theory: the management or
prevention of economic cycles. He limited the role of macroeconomic theory to the definition
of appropriate incentives to induce individuals to work and save: low taxes and moderate
public spending. For Lucas, the long-term welfare benefits deriving from better fiscal policies
far exceeded the short-term potential benefits of management of demand, however optimal it
may be (Lucas, 2003). In short, having tamed inflation and with available data and complex
models, risks have been eliminated. Thanks to complete information, the markets are efficient
and give the correct prices.
Efficient markets and correct prices were theoretical paradigms that endorsed the
deregulation of financial and commodity markets, and guided the privatization and mergers of
all types of businesses. All was well, or so it appeared, until the real estate bubble burst, in
2007-2008, ending the Great Moderation.
Several economists drew attention to the dangers that these axioms embodied, many using
simple but revealing statistics, such as those shown convincingly by Galbraith (2009). One of
the clearest perhaps was Minsky (2008). He argued that long periods of stability induce the
taking of greater risks with higher rates of return, which fatally lead to Ponzi schemes like
Madoff, Stanford, and the Colombian Creole version La Pirmide de La Hormiga (The Ants
Pyramid). 11 For Minsky, instability is intrinsic to the capitalist financial system, so it requires
better and more refined control, rather than less regulation. Thus Minsky dared to contradict
the opinion of Greenspan (1998), who assured us that:
11 A Ponzi scheme instrumented by David Murcia Guzmn. The name comes from the Putumayo city in
which the scheme was located (Palacios, 2014).
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information technologies have expanded markets to such an extent that

governments, even the unbelievers, have no alternative but to deregulate ...
The global financial markets are today, undoubtedly, more efficient than ever
(Greenspan, 1998: 1).
The crisis was foreseen and was avoidable, and only indifference and irresponsibility impeded
it, as concluded by the extensive report of the United States Congress Financial Crisis Inquiry
Commission (FCIC, 2010).
Clearly, the crisis that began at the end of 2007 has been long and deep by the standards of
post World War II, and full recovery is still not in sight (IMF, 2014). It is also not yet clear
which axioms have been permanently discredited, since, although several paradigms have
been challenged, resistance to change is strong, giving life to the words of W. Faulkner: The
past is not dead. Indeed, it is not even past. In Latin America, the crisis hit countries with
different intensities, and, as we shall see, the recovery has been slow if not fragile.
In his appearance before the US Congress to explain the financial crisis, Greenspan (2007)
stated that the intellectual foundations on which the macroeconomic policies of the Great
Moderation had been built (the hypotheses of efficient markets and correct prices) had
collapsed because the models did not sufficiently assess risk. However, 18 months later, in
his submission to the Financial Crisis Inquiry Commission (FCIC), while he did identify the
global proliferation of toxic credit securities as the immediate causes of the crisis, he
exonerated the policy of cheap money and mass deregulation by identifying the collapse of
communism as one of the root causes of the crisis. According to Greenspan, by establishing
the rule of capitalism and market economics throughout the world, the United States had
become exposed to competition from countries with lower costs, that save too much and
spend too little, especially China and other Asian nations (Greenspan, 2010). In the same
forum, Stiglitz (2009) provided a more objective assessment of the causes and actors
responsible for the crisis: banks, financial funds, controlling agencies, and governments failing
to fulfil their duty to protect citizens.
5 Are the physics metaphors dead?

At the end of 2014, nearly seven years after the onset of the crisis, we can ask if a new
economic model, or at least a new international financial architecture, is emerging as many
expected (Ocampo et al., 2010a), or if, as John Quiggin (2010) stated:
Some ideas are difficult to remove, even when they has been shown to be
erroneous and dangerous. They are neither living nor dead they are
undead, or zombie ideas.
The Great Moderation principles that lead to the actual crisis are still in force among
academics, politicians and public administrators, although their lack of explanatory power,
erroneous economic predictions and their toxic prescriptions have been consistently
demonstrated, as shown by the financial crisis of the Euro, most recently in Cyprus.
Only time will tell which ideas will prevail: those that conform to scientific rigour, or those that
ensure the elegance and parsimony of the models and satisfy vested interests.
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Some propose to bury the natural unemployment rate (NUR) and the non-accelerating
inflation rate of unemployment (NAIRU) which have been used to design monetary and fiscal
policies although their difficult or impossible demonstration makes both the NUR and the
NAIRU a dubious guide to economic policy. Both these assumptions have legitimized the high
rates of unemployment, or high informal and precarious employment of the strategies focused
on GDP growth with low inflation, and have undervalued active policies to counter the high
and prolonged unemployment that the crisis has generated. Today, more than ever, the
automatic return of the labour market to full employment is questioned, and the acceptance
as normal of high long term rates of unemployment, the so called jobless recovery and
jobless growth is staggering (Farmer, 2009). Accepting the validity of both the NUR and the
NAIRU would require the admission, on the one hand, that it has risen sharply in recent
decades, far above the 5% level considered normal, and on the other, of the futility of any
attempt to revive the labour market. Nothing has to interrupt the great vacation, however, in
Leckys words unemployment is nothing more than an irrational waste of productive resource.
A more comprehensive approach points to the efficient market hypothesis (EMH) 12 as another
axiom to lay to rest. The EMH credo supposes the rationality of investors and households,
and assumes that, given the necessary information about the future, they make correct
decisions about consumption or investment (Kaletsky, 2009; Greenspan, 1998: 1). Markets
give reliable signals for resource allocation according to Pareto optimality (Kay, 2009). The
EMH, applied to financial markets, implied the deregulation of hedge funds and derivatives
(Puyana, 2011; Thaler, 2009) and, for others, is the source of energy and natural resource
intensive GDP growth, deforestation, pollution, and climate change (Woodward and Sims,
2006).
A clear conception of the EMH is that the future is predetermined and revealed by the
information provided by the models, and, as described by Davidson (2012: 3), 13 it eliminates
the constant reflexive interaction that takes place between the actors involved in the markets,
especially the financial market, and ignores the effects of these interactions because
...what people think about today's market can affect and alter the future path
the market takes. The future is not predetermined (Davidson, 2012: 3).
Other critics (Shiller, 2005; Akerlof and Shiller, 2009) have described the EMH as one of the
most remarkable errors in the history of economic thought, since economic agents are not
perfectly rational, and often have moments of optimism that lead to irrational exuberance,
followed by pessimism and withdrawal from the market. The agents tend to act as a herd,
because in the markets both optimism and panic are contagious. While it is difficult to predict
prices, it does not necessarily follow that the prices dictated by the market are correct.
Greenspan, in his testimony before Congress in 2008, identified the EMH, the great
exuberance and the to-act-as-herd instinct as direct causes of the crisis.
The negligence of economists like Greenspan and Bernanke, managers of public policies that
affect us all, was in rejecting even the possibility that there was a housing bubble, or if it
12
Hypothesis proposed by Fama (1970) and criticized by Fox (2009), Thaler (2009), Bernstein (1996),
Roubini (2006), and Shiller (2007), among others. Another criticism comes from a conservative author,
who suggests that the current crisis proves that markets are not self-regulating and assigns the
responsibility not to the government but to a market failure that market forces were unable to solve.
Thus the deregulation of the financial market is responsible (Posner, 2009).
13 Davidson criticises Samuelson for his endorsement of the ergodic models, because they eliminate the
capacity for reflection and its effects.
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existed, that it could explode, since the market would promptly take care of its gradual
deflation (Greenspan, 2004, and Bernanke, 2005, cited in Krugman, 2011).
The crisis also challenged the assumption of complete information about products, prices and
risk. The mortgage crisis and speculative bubbles would not have been possible if all
investors were fully rational and had known the exact value of all investment options
(Ackerman, 2008). However, only beings with superpowers would be able to access the
hundreds of thousands of disperse data related to prices and profits that would be required to
make truly optimal decisions (Foyle, 2004).
Finally, another neoclassical paradigm under discussion as a result of the Great Recession is
the concept of Pareto optimality. The most serious criticism relates to public policies that
allocate public goods based on a narrow definition of social objectives which are distant from
reality.
That the market is not always efficient in allocating resources and frequently fails to ensure a
stable balance, is now a conclusion more generally accepted. There are goods that cannot
be put in the market, such as human life, and others in which trade would be morally
unacceptable (slavery, human trafficking). Justice, education and other public goods should
be available for all and the access to them cannot be price rationed. Moreover, public policies
always benefit some groups to the detriment of others, depending on the interests pursued by
the dominant groups (Ackerman, 2008). Hence the optimum is rarely achieved
(Stiglitz, 1991).
That not everyone benefited and many lost from the reforms leading to the prevailing
liberalized market is evident from the increase in concentration of wealth that has occurred in
the globe during the last three decades, disproving the macroeconomic neoclassical trickledown promises: the spill that would guarantee greater welfare for all if GDP grew. Something
did not work as expected and clogged pipes meant that 1% of Americans took ownership of
93% of the additional revenue generated in 2010, as compared to 2009. In addition, the
average income of a full-time worker is less than it was more than four decades ago
meanwhile, those at the top have never had it so good (Stiglitz, 2012: 1). The elite 1% of the
richest Americans concentrates the power to influence and direct the definition and enactment
of laws, regulations and policies that favour them, according to Stiglitz. For example, the
bailout of banks with public funds, the labour flexibility laws, corporate incentives and tax
policy, and the rejection of writing-off of mortgage debt or its renegotiation (Despain, 2012).
To resolve the crisis, monetary easing should be accompanied by debt forgiveness to
households, not banks. Ocampo et al. (2010a) and Ocampo and Stiglitz (2008) give clear
ideas and arguments as how to analyse the intrinsic problems of the functioning of the global
economy since the eighties, and proposes ways to reform and improve them. The ideal
solution to the financial system is to transform the Special Draw Rights (SDR) into the major
global reserve asset, creating a global fiduciary currency as the centre of the system
(Ocampo et al., 2010a: 24).
6 Social policies versus economic policies

The debate about the relationship between economic and social policies has been
strengthened by the facts shown in previous sections and the publication of Capital in the
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Twenty-First Century 14 and the myriad of notes on the authors theoretical limits, arguments
and statistical methods 15. In synthetic form, the definition of growth as the ultimate goal of any
economic policy subsumes all others. The definition of development and social policy typically
accepted since the 70s is clearly based on this subordination, and enshrines GDP growth as
the primary objective of economic theory and the central concern of economic policy (Lynn,
2003: 129). Growth has become, as revealed by the in-vogue definition of social
development, the basis for political advancement since the 80s:
We conceive of social development as the natural complement to economic
development, both for its intrinsic and instrumental value (World Bank,
2005:2).
Thus, social policy is reduced to no more than a complement to economic policy, which
cannot affect either its essence or nature. For example, poverty programmes must limit
themselves to relieving the more aggressive and harmful effects of the growth model
(increased inequality, resilient poverty and precarious employment), since these can lead to
disappointment with democracy, or globalization, or both; to social conflicts of varying
intensity; or to unexpected election results and undesirable populist governments (some from
South America) with, for orthodox economists, unacceptable redistributive programmes. The
desire to isolate and make social policy independent from economic policy has its origins in
the separation of positive and normative economic theory, and leads to the false question of
whether there are social and economic objectives that are independent and contradictory to
each other a meaningless distinction in economic reality. There are no economic objectives
without social effects and vice versa they form an indivisible unity. Exchange policy, for
example, has clear distributional effects (revaluation is a subsidy to imports, and affects the
production structure of importable and exportable goods and the labour market). It is also a
subsidy to those with debts and expenses in dollars, and a tax on remittances. It changes the
relative prices of importable, exportable and non-tradable goods. Curbing inflation has effects
on employment, labour income, investment in education and health; on the labour force, its
dynamic and productivity; and on economic growth.
Finally, the alleged scientific superiority of economic theory (Edward, 2000; Becker, 1996) has
ignited a debate about the relationship between economics and other social sciences. The
assumed scientific superiority has led to the emergence and acceptance of the imperialism of
economics in the social sciences, 16 and other social science disciplines are uncritically
adopting the economic axioms currently under question among economists from different
strands. Perfect markets and rational expectations invaded the study of voters rationality,
institutions, economic history, political uprisings and the drug trade. The study and
interpretation of the institutions also adopted them to propose the third wave of structural
reforms. It is also evident in social programmes, where the universal social rights of the
welfare state are being replaced by targeted and conditioned cash transfer programmes. In
these, it is assumed that the poor are rational beings and, as such, will respond correctly to
bureaucratically established economic stimuli and sanctions. Once equipped with basic health
and education, children from households in extreme poverty will be individuals with the skills
and knowledge necessary to compete and triumph in supposedly perfect markets, in
14
Piketty, T. (2014) Capital in the Twenty-First Century, Harvard UPl

For an exhaustive recount, see Real-world economics review special issue (no. 69) on Piketty's
Capital at: http://www.paecon.net/PAEReview/issue69/whole69.pdf
16 For a detailed analysis of the imperialism of the economy, the abundant literature of Fine Ben, such
as: Fine (2008) and Fine and Milonakis (2009a; 2009b).
15
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imaginary meritocratic societies. At this point society has done its duty, the responsibility now
rests with the individual.
7 The lessons from Latin America

Several reasons validate concluding this essay on the crisis of economic theory and
economic policies, with insights into the Latin American economic development, since the
1982 debt crisis, exemplified by the Mexican experience.
The first reason is that the process of reforms and structural adjustment that took place in
Latin America in the 70s, 80s and 90s, and which intensified after Mexico signed NAFTA,
have been repeatedly presented as examples of the successful implementation of economic
liberalization, macroeconomic adjustment and fiscal discipline. The entire world, especially
the countries now called peripheral Europe, has been advised to follow Latin American
reforms as an exemplary safe route to sustained growth. C. Lagarde spoke in this vein in
2008, in declarations before her visit to Mexico, Peru and Brazil. 17 The International Monetary
Fund chief prudently failed to mention that Latin America is the region with the most inequality
in the world, and that large numbers of the population have been and are being permanently
excluded from progress and civil rights, and have never enjoyed a welfare state. Under the
prevalent Latin American political conditions, it may be easier to establish cuts to basic social
spending than in more plural, less discriminatory and more democratic societies. The
International Monetary Fund chief, in her statements, neglected to mention that structural
reforms in Latin America were initiated in the 70s in Chile and Argentina, during the military
dictatorship of Pinochet and Videla, and subsequently in Mexico during the full power of the
PRI regime the perfect dictatorship according to Vargas Llosa. In these countries the
liberal reforms were earlier and more intensive and comprehensive than in other, less
dictatorial or more democratic, Latin American countries (LAC).
Second, liberalization of foreign trade and the North American Free-Trade Agreement
(NAFTA) were presented to the world, especially to developing countries, as the optimal
integration into the global economy, by linking Mexico and the United States in a process of
total and accelerated trade liberalization. Mexico and United States are highly contrasting
countries in terms of their resource endowments, productivity, technological development,
political might and military power. According to classical economic theory, this North-South
trade agreement, of the most classical Ricardian cut, would maximize Mexican trade benefits
and ensure higher economic growth rates than those Mexico had before NAFTA came into
force. After two decades under the rules agreed in NAFTA, not one of these effects has
emerged at the expected speed and intensity and the Mexican economy has not recovered
the rates of GDP, productivity and employment growth registered during the import
substitution period. Nevertheless, several Latin American countries, including Colombia and
Chile, ten years later signed NAFTA type agreements, possibly to avoid being left out of the
friends of the United States club. They followed the path initiated by NAFTA, without paying
attention to the effects that were already being observed in Mexico. It could be said that
leaders in Mexico, Colombia or Chile not only failed to read Linder (1961) Amsden (1986;
17 Ms Lagarde (2011) in an interview to iMFDirect, stated: ...the new Latin America can provide some
lessons to the developed countries about saving for a rainy day and controlling the financial system.
Argentina confronted the 2001 crisis devaluating the peso and defaulting on payments, measures that
Greece, Spain and Italy cannot adopt if they wish to stay in the monetary union.
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1989), Krugman or Rodrik, but also overlooked the real world lessons coming from Mexico
and other countries.
Third, Latin America seems to be specializing in primary commodities, rebuffing to deepen
industrialization, and ignoring the consequences of relying on the exports of natural resources
and subjecting their economies to the Dutch Disease symptoms and the natural course
syndrome. This reprimarization of Latin American Economies is a logical and expected
effect of the liberalization of the regions' economies and foreign trade policies (Frenkel and
Rapetti, 2011). All Latin American countries become engaged in a Ricardian exports pattern:
on one side, Mexico and other Central American and Caribbean countries as exporters of
manufactures inserted in global value chains, with low national value added and low labour
intensity at individual product level and; on the other Argentina, Brazil, Chile and Colombia
amongst them specializing in commodities and resource based manufactures.
Fourth, the growth spells Latin America experienced (2004-2006 and 2008-2013) coincided
with low inflation, rising commodity prices, a relaxation of the external constraints and the
reduction of income concentration. Most important, multilateral organizations argued that
these growth spells meant that the region had initiated an irreversible sustainable growth path
thanks to adjustment policies and liberalization. So Latin American governments need not be
worried any more about how to restore growth and control inflation (the problems which for
decades restricted the regions development), but rather about how to manage prosperity
with equity. 18 These assertions recall Lucass (2003) dictum on the death of economic cycles
mentioned above.
Fifth, the region succeeded in reducing poverty and inchoately lowering income
concentration, when in other countries, especially in the EU and the USA, the path was the
opposite. For considering the above points, we will discuss the path of trade liberalization and
its effects, since it was the central element of the reforms. Further, we present in more detail
the effects of economic liberalization, the reprimarization of exports and the reduction in
inequality.
The liberalization path after the debt crisis: The liberalization of Latin American countries has
been intensive and indisputable. For example, the external coefficient of Argentinean GDP
grew from 10.3 % in 1970 to 34% in 2011 and descended in the two years after. The change
observable in Chile and Mexico was from 14.5% to 65.8% and from 17.4% to 64.2%,
respectively (WB, 2014). Table No. 1 presents the trajectory of the liberalization of LAC
economies. Some patterns emerge: First Chile and Mexico, the upmost liberal economies
with an external coefficient that, in 2013, almost doubles the LAC average. Second,
Argentina, Brazil and Colombia, with the lowest external coefficient in 2013. Third, Colombia
and Chile had between 1960-1970, the highest external coefficient of all countries
represented in Table No. 1, and the liberalization of Colombia after 1990 was rather slow. In
general, larger economies tend to have a smaller external coefficient since their larger
domestic market and resource abundance permit it. But Mexico does not fit this argument. All
countries liberalized their economies and there is no clear ideological difference between the
left-leaning regimes (Left of the Centre, LOC) countries and the centre-right and right as in the
classification in Cornia (2012).
18 Augusto de la Torres (World Bank, Chief Economist for Latin American and the Caribbean),
comments at the OAS Forum on Prosperidad con Equidad: el Desafo de la Cooperacin en las
Amricas, Washington, October, 2014. The same opinion was defended by Bustillo, Director of ECLAC
office in Washington.
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Table No. 1 External Coefficient of the economies of selected Latin American Economies
1960-2013
EXTERNAL COEFFICIENT (EXPORTS+IMPORTS/DGP)100
GDP Trillons
US$ 2005)
1.17
Brasil
Mxico
1.04
Argentina
0.33
0.21
Colombia
0.19
Venezuela4
Chile
0.17
Per
0.12
Ecuador
0.06
0.03
Panam7
Costa Rica
0.03
4
0.03
Uruguay
5
0.02
El Salvador
Bolivia3
6
Paraguay
Honduras
Nicaragua
Values in % GDP
1960
1980
2013
14.2
20.4
27.6
20.1
23.7
64.2
15.2
11.5
29.3
30.4
31.8
37.4
G. Domestic Product
Annual growth rates

Annual growth rates2
1960-1980 1981-2013 1960-1980 1981-2013
4.8
1.6
7.3
2.6
1.0
3.8
6.8
2.5
-0.2
4.5
3.5
2.6
0.6
0.7
5.4
3.6
43.3
29.2
41.6
36.3
50.6
49.8
41.8
35.0
50.4
65.5
48.4
63.6
1.1
3.6
0.5
1.2
-2.0
1.0
2.6
2.3
3.9
3.6
4.5
5.5
2.3
4.8
3.3
3.2
ND
47.6
186.9
63.3
137.7
73.9
ND
1.7
-0.6
1.0
6.0
5.9
4.8
4.1
32.4
35.7
55.8
2.4
-1.0
2.2
2.5
55.2
67.4
72.2
1.6
0.7
3.1
2.1
0.01
48.9
46.8
85.1
0.0
-0.8
3.4
2.9
0.01
0.01
0.01
PROMEDIO
ND
44.4
49.8
ND
81.3
67.5
92.7
117.5
92.9
3.3
1.8
0.7
1.7
5.0
7.0
5.1
3.9
3.6
3.3
2.0
36.3
54.2
69.6
1.7
1.3
4.8
3.1
Source: Own elaboration based on WB, WDI, 2014
As to the speed of liberalization, Table No.1 suggests that in the period 1960-1980, several
countries in Latin America (Brazil, Chile, Uruguay, Honduras...) did open the economy,
reforming the Import Substitution model. In the second period, some countries, including the
ones with a lower coefficient in 2013, opened their economies to external competition in high
gear. Paradoxically, Chile, up to date the most liberal economy, opened its economy less
rapidly than Brazil and Argentina. And Colombia, considered to be a radical orthodox
economy, appears as moderate in exposing its economy to external competition.
And yet, the post liberalization growth path does not correspond with expectations, as Graph
No. 1 illustrates. Structural reforms and liberalization, both within the framework of the WTO
or in regional arrangements, were supposed to deliver a balanced macroeconomic
environment conducive to higher growth rates and move the economy towards a new process
of industrialization with higher levels of productivity, as well as stimulate private domestic and
foreign investment so as to raise the rate of capital formation. All these effects were to
improve employment and labour income. As we shall see, little of this has been achieved
despite the undisputed liberalization, which took place at a different pace and intensity in each
country.
Economic expansion after 1983, even the growth spells (2003/2008 and 2010/2013) have
been lower than before the crisis (two last columns in Table No. 1, and Table No. 2). A
similar course was followed by capital formation and labour productivity (Puyana, 2014). The
rates of Latin American GDP growth, presented in Table No. 2, show the lower pace since
1980.
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Graph No. 1 Latin American and Caribbean gross domestic product rates of growth (in
percentages) 1960-2013.
9.0
7.0
5.0
3.0
1.0
-1.0
-3.0
GDP growth (annual %)

Polinmica (GDP growth (annual %))
2013
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
1969
1967
1965
1963
1961
-5.0
GDP per capita growth (annual %)

Polinmica (GDP per capita growth (annual %))
From both Graph No. 1 and Table No. 2, it is clear than not even during the years of faster
growth, were the record levels of the decades before the crisis surpassed. It is clear as well
that instability, measured by the standard deviation of the growth rates seems to be higher
than before. So optimism has to be restrained.
Table No. 2 Latin American GDP Growth Rates, 1960-2013

Annual GDP Growth
Standard Desves.
Total
per head
Total
per head
1961-1980
5.83
3.20
2.13
2.02
1981-2000
2.41
0.65
2.01
1.99
2001-2008
3.41
0.27
1.65
1.60
2009- 2013
2.71
1.56
2.71
2.68
The impacts of liberalization of capital and trade accounts, plus the brunt of the protracted
appreciation of national currencies as a price anchor, were not made explicit. Under these
conditions, productive investments do not flow due to a lack of profitability, and the registered
growth of the economy has proved to be insufficient to boost job creation and prevent salary
deterioration.
The liberalization of foreign trade increased the trade imbalance as a proportion of GDP, an
indicator of the limits of foreign trade as a growth driver. Among the variables that explain the
growth of the region, and of each of the large and medium countries, trade liberalization has
very little explanatory power almost none although the relation is positive in some
countries (Colombia, Chile and Peru) and negative in others (Mexico, Argentina, Brazil)
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(Puyana, 2014). The changes in the tariff structure reduce the protection to domestic value
added, which, combined with currency appreciation, has generated another type of
substitution: that of national with imported labour. All in all, and despite significant trade
liberalization, the region has not recovered the proportion of world trade that was recorded in
1960 or 1970.
The reprimarization of Latin American Economies: Economic liberalization opened the door to
the reallocation of productive factors in accordance with competitive advantage and
abundance of natural resources, and the resurgence of specialization based on it in
accordance to the Heckscher-Ohlin model. Brazilian and Argentinean exports of commodities
and food products constitute 63-65% of total exports. This proportion is similar to that
registered in Costa Rica and Honduras, which export low technology final consumption
manufactures inserted in global value chains. Again, as with the external coefficient, nothing
clear-cut emerges between countries divided by political differences. Production and export
structures of countries with larger economies and territories tend be more diversified and in
commodities and food than small countries.
So, the Latin American neo-extractivism emerged and an interesting theoretical debate on
how to interpret it. There are two ways of looking at neo-extractivism: first, the increasing
participation of commodities in total exports; and second, the resulting deindustrialization of
open economies. Both processes are present in the trajectory of the regions economies
structures. Table No. 3 presents the structure of several Latin American Countries and
reveals the specialization in commodities and their manufacture. Mexico, Costa Rica, El
Salvador and Panama figure as exporters of hi-tech manufacturing, a misleading data since
even in Mexico the national value added of its exports is minimal and responds mainly to
ensemble activities.
Table No. 3 Export structure of Latin American countries. In percentage of total exports
Exports structure
Specialization of exports
Argentina
Materias primas (65%)
Alimentos (54%)
Bolivia3
Combustibles (55%)
Brasil
Chile
Colombia
Ecuador
Oro y metales (61%)

Combustibles (70%)
Combustibles (58%)
El Salvador5
Manufacturas (71%)
Manuf de alta tecnologa 4.7%
Costa Rica
Manufacturas (61%)
Honduras
Alimentos (56%)
Mxico
Manufacturas (74%)
Nicaragua
Alimentos (90%)
Alimentos (60%)
Panam7
Manufacturas (93%)*
Per
Venezuela4
Oro y metales (50%)
Materias primas (97%)*
Combustibles (97%)
Paraguay
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The debate intends to respond to two main questions: is neo-extractivism a new development
model, and are the governments pursuing it neo-developmental ones? Gudynas (2012)
describes neo-extractivism as a development path based on the commoditization of nature
with an enclave type of production mainly for exports. The model depends on foreign
investments and technology. Coinciding with Acosta A. (2012) he suggests that neodevelopmental states use commodity rents to pay for social expenditure, reduce poverty and
alleviate inequality, without taxing large capital earnings or changing the export lead model,
therefore, for Gudynas neo-extractivism is a new economic model, which he names post
neo-liberal. On the other side, Hans-Jrgen Burchardt and Kristina Dietzb suggest that the
political ecology of neo-structuralism has not been sufficiently analysed. For them, despite the
improvements in poverty and inequality, and in some cases in the labour market, neoextractivism is not a new model and the neo-extractivist states maintain several elements of
rentist states. The distribution of the rents could be one way to consolidate political support for
a model that has several negative effects on distribution, democracy, employment and the
environment. So, a conservative political consensus emerged based on sharing the spoils,
not on solidarity (Burchardt and Dietzb, 2014: 476).
The reduction in poverty and inequality registered in Latin America is one of the arguments in
favour of economic liberalization and structural reforms, although the reasons for the decline
are not without debate. Abundant literature on the reduction of poverty and inequality in the
region seems to confirm the gains even during and immediately after the 2008 crisis, and they
attribute it to the emergence of democratic left wing regimes, especially in South America
(Bolivia, Brazil, Chile, Ecuador, Uruguay and Venezuela).
Table No. 4 shows the long term trajectory of the GINI index of income concentration in
several Latin American Countries, grouped by political orientation as suggested by Cornia
(2012). Andrea Cornia (2012; 2014) provides a classification of countries according to their
political orientation. He puts countries in four groups (Radical Left, Social Democrat Left,
Centre, Centre Right and Right). For him, the biggest reductions are registered in countries at
the Left of the Centre (LOC) and explained it in terms of the change of regime in 15 countries.
Without commenting the problems related to such fine-tuned classification, we would like to
show that the progress in reducing Latin American inequality depends on the period
considered. To reckon with the trajectory after the reforms, a long term perspective is needed
and with it a different picture emerges. In several countries inequality was more intensive in
2010 than in 1960 or in 1980, and the reduction is minimal. During 1960-1980, almost all
countries reduced inequality, and the process reversed after the reforms in the 80s decade. In
the 2000-2010 period, the Radical Left and Social Democrat Left countries did manage to
reduce inequality quite substantially indeed, but it took place after 2005. Some of the causes
of this improvement cannot, however, be attributed to public policies, neither to an economic
model that promotes a growth path with better employment, higher productivity and higher
incomes,
and
progressive
fiscal
and
labour
policies.
34
Pas
45.1
43.6
48.5
54.9
43
59.13
50.9
47.5
37
50
66
61
54
60.6
50
Paraguay
Uruguay
Costa Rica
Honduras
Per
Colombia
Mxico
Panam
Centrists
Centreright and
right
53.1
54.2
48.4
57.1
57.9
44.7
47.2
1980
48.2
61
42.4
57
68.1
46.2
41.4
1960
SocialChile
demcraticEcuador
left
El Salvador
Brasil
Bolivia
Radical Left Nicaragua
Venezuela
Argentina
Political
regime
57
46.4
56.7
53.1
56.3
57
40.6
46
54.7
56
50.5
52.8
45.87
47
59.51
49.28
55.1
52.8
52.9
55.84
44.39
47.4
56.44
50.93
58.68
54.2
57.66
644
57.3
51.79
53.1
47.88
61.3
57.9
46.8
51.06
55.22
55.9
53.1
53.2
49
49.27
58.47
64.3
42.041
56.7
44
47.7
2005
ndice de Gini
1990
2000
0.2
56.7
45.8
55.7
48.1
51.9
53.3
42.2
49.2
-16.8
-29.5
9.5
-16.0
-5.0
17.8
-3.0
10.2
-11.1
14.2
57.62
522
49.5
45.4
-15.0
-3.2
14.0
-14.1
-24.9
3.1
-20.6
3.8
18.2
14.1
-1.6
8.3
-18.9
7.1
1.1
-29.8
-14.7
7.5
20.9
2.7
18.4
-0.8
6.5
21.4
23.7
1.8
-2.3
4.0
3.1
9.7
12.1
0.0
4.7
8.2
52.9
-10.0
-5.8
-11.4
-14.5
-4.5
-4.9
3.8
0.5
-10.1
-5.1
-11.3
-10.0
1.1
8.3
-18.9
7.1
18.2
14.1
-1.6
-14.1
-24.9
3.1
-20.6
3.8
-21.0
-17.4
-15.8
-12.8
20.9
-29.8
-14.7
7.5
-12.1
4.5
-3.8
2.3
39.3
-16.4
7.5
-9.1
4.5
-13.5
-1.3
-9.1
9.0
6.3
8.9
19.2
0.3
4.4
-0.2
1.1
-8.8
-1.9
-9.1
-18.1
GINI growth by periods

Gini Growth. Average country groups
1960-80 1960-10 1980-00 1960-10 2000-10 1960-80 1960-00 1960-101980-00 1980-10 2000-10
47.82
39.4
44.5
50.82
2010

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Table No. 4 Latin America. Gini Coefficient evolution from 1960 to 2010
35
1 Gini 1991 and 2009.
2 Gini 2009.
3 Gini 2001.
4 Gini 1999.
Source: Own elaboration
based on Cornia (2012),
WDI (2014), CEPAL
(2014) for index in green
and Prados de la
Escosura (2005) in red
index.

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Cornia lists external and internal causes for reductions in poverty and inequality among the
first. He mentions the terms of trade improvements, rising remittances from workers abroad
and larger access to international credit. The domestic causes of poverty and inequality
reduction are: first, decline of the rate of dependence and the increase in activity rates;
improvements in education levels and the reduction in higher education responding not to
increase of wages of low skilled labour resulting from increase in the demand of that labour,
but from the declining of real medium salaries of better educated workers; finally, but not
least, the effects of monetary conditioned cash transfers, fast economic growth and changes
in fiscal expenditure.
Some lessons from Mexico
The advancement of Mexican exports is the most notable amongst all Latin American
countries, a real miracle as some called it in early 90s. In fixed year 2000 dollars, they grew
from $24 billion in 1980 to $330 billion in 2013. Imports grew faster. Manufactured goods
account for 85 % of external sales, and a similar proportion of these are products originating
in maquila 19 and other temporary import programmes. Mexican exports of manufactured
items incorporate low national value added, have low technological intensity, are intensive in
imported inputs and despite its relative labour intensity, generate few jobs. In effect, while
manufacturing exports advanced from 10 to 85% of the total Mexican foreign sales, its
proportion of GDP and total employment stagnated (around 18% the first) or declined (to 10%
the second). Hence, sectoral productivity gains have been achieved, but mostly by reducing
employment rather than by increasing total production volume. These facts demonstrate the
effects generated by the combination of full trade liberalization, flexibilization of labour
regulation and exchange rate appreciation. In fact, the index of manufacturing openness is
around 93 % of the sectoral GDP, due to the high imported content of manufactured exports.
In contrast to what was proposed, in Mexico neither capital endowment per worker nor gross
formation of fixed capital have grown in relation to GDP, despite the increase in external
financial flows. The increase in investments in the late 80s and early 90s is primarily
explained by privatizations and acquisitions of existing companies, none of which raised
capital stock. In 2013, the capital endowment per Mexican worker in 2000 dollars was about
3% lower than in 1980. Investments are made by a limited number of companies linked to
either the export sector or activities that emerged during the import substitution
industrialization, such as the manufacture of automobiles, chemicals, plastics, electronics,
etc. When these activities and businesses are embedded in global production chains, they
are located in the fragments of the production process with the lowest technological content,
and the investments are not complex.
In corollary with the negative investment trajectory, the informal economy and informal
employment are rising, with the former representing about 27% of GDP, and the latter around
63% of the total employed population (Puyana and Romero, 2012). The advance of the
informal sector suggests, firstly, that the surplus of labour in agriculture has shifted to the
cities and taken refuge in the informal sector, and secondly, that the movement of factors has
not driven the growth of total productivity, neither labour nor a total of factors, as suggested in
Puyana and Romero (2009) and several authors cited in that work.
19
A manufacturing operation in a free-trade zone which imports material and equipment on a duty-free
and tariff-free basis for assembly, processing or manufacturing, and then exporting the finished
products.
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Both the reforms and the multilateral liberalizations (or NAFTA) seem to have failed to bring
about change in the structure of GDP and employment towards the tradeable sectors with
higher productivity in international terms. These have receded considerably and given way to
services and construction, sectors which combined have lower productivity than
manufacturing, although slightly more than agriculture. This composition of GDP and
employment is a symptom of the premature receding of tradeable sectors, in a process that
has intensified since 1981 and which also affects almost all Latin American countries,
Colombia, Argentina or Brazil.
This context displays the most important failures of the reforms: their inability to guarantee
sustained growth rates higher than those from the period of import substitution in Latin
America and those registered in developed countries, which, in the case of Mexico, explicitly
meant bridging the gap that separates it from the United States. It was said repeatedly that
the push that NAFTA would give to exports and investments would be of such magnitude that
Mexico would export goods and not people as the two economies converged. This has not
happened, given that the Mexican average annual growth per capita in GDP during 19802011 was the lowest since 1900, and far less than that recorded in 1945-1980, when
recorded growth rates of GDP per capita were higher than in the United States and the gap
between the countries narrowed. Since NAFTA, migration has multiplied, reaching over half a
million nett migrants per year and, pari passu, this has made remittances expand to over 24
billion pesos in 2008, with a strong effect on the earnings of at least four million poor
households. Only the crisis in the United States and the militarization of the border has
reduced migration and reversed the diaspora.
Besides the export success, low unemployment around 4.4% of the active labour force
since 1982 with inflation below 6% in the last year are presented as an example of the
strength of the Mexican economy. Hence, the traditional low unemployment rate does not
imply that the Mexican economy is in good health or approaching full employment, given the
accumulation of informal employment, low productivity and low incomes. During the crises,
the Mexican labour market adjusted itself in terms of income, wages, and changes in the
relationship between formal and informal employment. The long lasting effect of the
worsening of labour conditions is the fall of labours share in national income and the increase
of earnings accruing to capital. Labour share decreased from nearly 40% of income in 1975 to
just above 29% in 2012 (Figure No. 2).
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Figure No. 2 Share of labour and capital in national income 1960-2012.
70.0%
% of GDP
60.0%
50.0%
40.0%
30.0%
L/GDP
2011
2008
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
20.0%
RK/GDP
Source: From Puyana, A. 2014
The production of manufactured items presents a similar path: larger rates of growth of
income (g) and lower in wages (r). In effect, for the period 1990-1013, the value of r-g was 13.48, signaling a major expansion of g. In comparison, for the period 1995-2013 we found
gains in annual productivity which contrasts with declining in real annual wages per worker
(Figure 3).
Figure 3 Mexico: Annual productivity per worker and real annual average wages per worker.
1995-2013 (in thousand pesos 2010).
350
300
250
200
150
Productivity per worker
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
100
Wages per worker
Source: Puyana, A. 2014
According to Lewis (1954), under conditions of abundant labour, real incomes rise when an
economy moves from the earliest stage of classic development with abundance of labour, to
the second stage, that of neo-classical development, with scarce labour and increases in the
total labour income. Before reaching this stage, the benefits of growth accrue due to the
38

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absorption of surplus labour and not to the growth of incomes (Puyana and Romero, 2012) 20.
Our assumption is that the Mexican economy is still in the classical development stage, of
abundance of labour, at a pre-Lewisian turning point, as a result of the pattern and dynamic of
economic growth since the reforms. The surplus labour in agriculture has moved to the urban
informal sector, let it be, domestic labour, trade, street traders and so on, and not to modern
sector higher productivity activities such as manufactured goods and sophisticated services.
So, agriculture and rural emigration in Mexico have taken place at an intensive pace without
corresponding increases in labour productivity, and only with decreases in its share in total
GDP and labour. Mexico and other Latin American countries did not promote the agricultural
revolution, that is, accelerated increments in labour productivity and per hectare yields which
Kaldor (1967) presented as necessary requisite industrialization, which in turn is an
indispensable development factor. Others arrived at the same conclusion years later,
including authors such as Meier, G (1995 and 2000), Krugman (1997) and Rodrik (2013.
Industrialization is even more important for open economies intensively integrated in global
markets. What a country exports matters for economic growth and income distribution. As
Haque, suggested, it does matter whether a country exports potato-chips or micro-chips
(Haque Irfan et al., 1995). The failure to industrialize and to elevate agricultural productivity
has put Latin American countries in a track of low growth-low income-low demand. This is an
effect of the deindustrialization process resulting from depressed aggregate demand, spurred
by the interaction with international economy (Patnaik, 2003) in not full employment
conditions. In developing countries, even in the most dynamic emerging countries, full
employment was and is not the norm.
Mexico, and practically all of Latin America, fully liberalized their economies so the movement
of goods and capital is totally free, but labour is not and economic international migration is
very costly. This partial factor liberalization accelerated the mobility of capital and increased
the ratio capital/labour mobility. Therefore, capital is relatively more scarce, labour more
abundant and the relative profitability of capital higher. From 1980 to 2012, Mexican real
minimum collapsed and medium wages stagnated. Table No. 5 presents the index of real
minimum and medium wages during 1980-2013. The index of minimum wages in 2012 was
68.3% lower than in 1980.
Table No. 5 Index of minimum and medium real wages 1980-2013. Year 2000 = 0.
1980
1990
2000
2010
2013
Minimum Real wage

312
145
100
97
99
Medium Real wages

114
89
100
113
114
Source: Puyana, A. 2014
The problem is that in Mexico, as in other Latin American countries, there is evidence of an
asymmetric reduction of the income elasticity of employment, which means that if the
response of employment to falls in output is now less intense, the recuperation of employment
when the economy expands is even more subdued. In other words, if one accepts the notion
of a natural rate of unemployment, it appears to be rising. The liberalization of the economy
20In Puyana and Romero, 2012, the Lewis model is analysed in detail, and its econometric formulation is
developed and applied to the study of Mexican growth between 1940 and 2008.
39

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and the expansion of exports have not encouraged greater labour absorption, or its transfer to
the tradable sectors with higher productivity.
Another factor to consider is the declining labour intensity of GDP, observed between 1960
and 2011. In Mexico it fell 40%, while in Colombia, Argentina, Chile and Uruguay it fell by
more than 50%. This trend is the consequence of increasing productivity by substituting jobs
for capital and maintaining lean output growth. This situation is paradoxical since with
liberalization, the effective demand for the domestic product is global and, for small countries
such as Colombia, Chile, and even Mexico, demand is assumed to be infinite and, except for
a few products (such as Brazilian or Colombian coffee), their production and exports do not
affect world prices. The reduction of production cost by importing better inputs at lower than
domestic prices, or by the liberalization of labour and capital markets and tax cuts, have not
been translated into more investments and higher output and employment growth, but rather
into juicier profits and an elevation of the share of capital in income and decline in of that of
wages, very clearly so in Mexico, as illustrated in figures No. 1 and 2 and commented in
Puyana, A. (2014). That trend has translated into the fall of the index of real minimum and
average wages. While average wages recovered the loss between 1980 and 1990, the real
minimum wage index fell sharply, to represent by 2013 only 31% of the index in 1980. In
2013, the proportion of workers earning up to three minimum wages was 65%, an increase of
35% from 1980. This increase illustrates the downfall of labour incomes, since three minimum
2013 wages represented only one third of one the minimum wage of 1980. So the balance of
the Mexican liberalization is alarming: lower rates of economic growth, rather feeble
expansion of productivity and the fall in real incomes and, with it, faint domestic demand.
Conclusions
There are grave doubts about the possibility of an economic paradigm shift being the
outcome of the protracted global economic crisis. For a radical change to be feasible, a
political change is needed, deeper perhaps than that which occurred in France in the last
election or in those of other countries around the globe. I have in mind Argentina, Bolivia and
Ecuador, for instance. The power of large financial interests is great and in the United States
they have a legal license to promote the election of presidents, Congressmen and women,
and the discretion to relentlessly lobby them. Latin America seems divided into two welldefined camps, with two distinct ways of making policy and directing the economy. Which of
these will be predominant in the long term remains unclear. The changes in political power
and economic policies in some countries such as Argentina, Bolivia, Brazil, Ecuador or
Venezuela are interesting and important, but so far it is not clear whether they will last, or how
far they intend to change the liberal export lead model in a meaningful degree. There are also
doubts about the economic path the newly-elected Indian Prime Minister will take and where
the country will go.
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___________________________
SUGGESTED CITATION:
Alicia Puyana, A never ending recession? The vicissitudes of economics and economic policies from a Latin
American perspective, real-world economics review, issue no. 72, 30 September 2015, pp. 16-46,
http://www.paecon.net/PAEReview/issue72/Puyana72.pdf
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Capital accumulation: fiction and reality

Shimshon Bichler and Jonathan Nitzan 1
[Israel and York University, Canada]
Copyright: Shimshon Bichler and Jonathan Nitzan, 2015

1. The mismatch thesis

What do economists mean when they talk about capital accumulation? Surprisingly, the
answer to this question is anything but clear, and it seems the most unclear in times of
turmoil. Consider the financial crisis of the late 2000s. The very term already attests to the
presumed nature and causes of the crisis, which most observers indeed believe originated in
the financial sector and was amplified by pervasive financialization.
However, when theorists speak about a financial crisis, they dont speak about it in isolation.
They refer to finance not in and of itself, but in relation to the so-called real capital stock. The
recent crisis, they argue, happened not because of finance as such, but due to a mismatch
between financial and real capital. The world of finance, they complain, has deviated from and
distorted the real world of accumulation.
According to the conventional script, this mismatch commonly appears as a bubble, a
recurring disease that causes finance to inflate relative to reality. The bubble itself, much like
cancer, develops stealthily. It is extremely hard to detect, and as long as its growing, nobody
save a few prophets of doom seems able to see it. It is only after the market has crashed
and the dust has settled that, suddenly, everybody knows it had been a bubble all along.
Now, bubbles, like other deviations, distortions and mismatches, are born in sin. They begin
with the public being too greedy and policy makers too lax; they continue with irrational
exuberance that conjures up fictitious wealth out of thin air; and they end with a financial
crisis, followed by recession, mounting losses and rising unemployment a befitting
punishment for those who believed they could trick Milton Friedman into giving them a free
lunch.
This mismatch thesis the notion of a reality distorted by finance is broadly accepted. In
2009, The Economist of London accused its readers of confusing financial assets with real
ones, singling out their confusion as the root cause of the brewing crisis (Figure 1). Real
assets, or wealth, the magazine explained, consist of goods and products we wish to
consume or of things that give us the ability to produce more of what we want to consume.
Financial assets, by contrast, are not wealth; they are simply claims on real wealth. To
confuse the inflation of the latter for the expansion of the former is the surest recipe for
disaster.
This paper is an edited transcript of a March 2015 presentation by Jonathan Nitzan at UQAM,
organized by AESE UQAM (Association des tudiants en Sciences conomiques,
http://bnarchives.yorku.ca/436/). An earlier and somewhat different version of this article was published
in 2009 by Dollars & Sense (Contours of Crisis II: Fiction and Reality, April 28,
http://bnarchives.yorku.ca/258/). Shimshon Bichler teaches political economy at colleges and
universities in Israel. Jonathan Nitzan teaches political economy at York University in Canada. All of
their publications are available for free on The Bichler & Nitzan Archives (http://bnarchives.net). Work on
this paper was partly supported by the SSHRC.
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Figure 1: The classical dichotomy: real and financial
The division between real wealth and financial claims on real wealth is a fundamental premise
of political economy. This premise is accepted not only by liberal theorists, analysts and
policymakers, but also by Marxists of various persuasions. And as we shall show below, it is a
premise built on very shaky foundations. 2
When liberals and Marxists say that there is a mismatch between financial and real capital,
they are essentially making, explicitly or implicitly, three related claims: (1) that these are
indeed separate entities; (2) that these entities should correspond to each other; and (3) that,
in the actual world, they often do not.
In what follows, we explain why these claims dont hold water. To put it bluntly, neither liberals
nor Marxists know how to compare real and financial capital, and the main reason is simple:
they dont know how to determine the magnitude of real capital to start with. The common,
makeshift solution is to estimate this magnitude indirectly, by using the money price of capital
goods yet this doesnt solve the problem either, since capital goods can have many prices
and there is no way of knowing which of them, if any, is the true one. Last but not least,
even if we turn a blind eye and allow for these logical impossibilities and empirical travesties
to stand, the result is still highly embarrassing. As it turns out, financial accumulation not only
deviates from and distorts real accumulation (or so we are told), it also follows an opposite
trajectory. For more than two centuries, economists left and right have argued that capitalists
and therefore capitalism thrive on real investment and the growth of real capital. But as
we shall see, in reality, the best time for capitalists is when their real accumulation tanks! . . .
2 Not all political economists see themselves as either liberal or Marxist, but even the nonaligned tend to
accept the fundamental division between real capital and financial assets.
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2. The duality of real and nominal

The basic dualities of subject and object, idea and thing, nomos and physis have preoccupied
philosophers since antiquity. They have also provided an ideal leverage for organized
religions and other dogmas specializing in salvation from alienation. And more recently, they
have come to form the basic foundation of modern economics.
Following the classical dichotomy proposed by the British philosopher David Hume,
economists divide their economy into two parallel worlds: real and nominal. The more
important of the two realms, by far, is the real economy. This is the domain of scarcity, the
arena where demand and supply allocate limited resources among unlimited wants. It is
where production and consumption take place, where sweat and tears are shed and desires
fulfilled, where factors of production mix with technology, where capitalists invest for profit and
workers labour for wages. It is where conflict meets cooperation, the anonymous forces of the
market engage the visible hand of power, exploitation takes place and actual capital
accumulates. It is the raison d'tre of social reproduction, the locus of action, the means and
end of economics. In short, it is the real thing.
The nominal economy merely reflects this reality. Unlike the real economy, with its productive
efforts, tangible goods and useful services, the nominal sphere is entirely symbolic. Its various
entities fiat money and money prices, credit and debt, equities and securities are all
denominated in dollars and cents (or any other currency units). They are counted partly in
minted coins and printed notes, but mostly in electronic bits and bytes. This is a parallel
universe, a world of mirrors and echoes, a bare image of the real thing.
This real-nominal duality cuts through the whole of economics, including capital. For
economists, capital comes in two varieties: real capital (wealth) and financial capital
(capitalization). Real capital is made of capital goods. It comprises means of production,
including plant and equipment, infrastructure, work in progress and, according to many,
knowledge. Financial capital, or capitalization, represents a symbolic claim on this real capital.
Its quantity measures the present value of the earnings that the underlying capital goods are
expected to yield.
Both Marxists and neoclassicists accept the real/nominal bifurcation of the economy. They
also accept that there are two types of capital real and financial. And they also believe (in
the Marxist case) and concede (in the neoclassical case) that, usually, there is a mismatch
between them. The main difference between the two schools is the direction of the mismatch:
Marxists begin with a mismatch that they argue must turn into a match, whereas
neoclassicists begin with a match that, they reluctantly admit, often disintegrates into a
mismatch. So lets examine this difference a bit more closely, beginning with the Marxist
view. 3
2.1 The Marxist View
Marx wrote in the middle of the nineteenth century, roughly half a century before others
started to theorize capitalization in earnest and a full century before it became the central
A subtle distinction: most Marxists accept the real/nominal duality and the difference between real and
financial (or fictitious) capital. But only classical Marxists anchor their acceptance in Marxs labour theory
of value. Neo-Marxists tend to eschew value theory altogether and, in doing so, eliminate the
theoretical basis on which their notions of real and financial capital might otherwise stand.
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ritual of modern capitalism. Yet he was prescient enough to understand the importance of this
process and tried to sort out what it meant for his labour theory of value.
He started by stipulating two types of capital: actual and fictitious. Of these two, the key was
actual capital means of production and work in progress counted in labour time. This was
real capital. Fictitious capital or capitalization was the magnitude of expected future
income discounted to its present value. This later capital, counted in dollars and cents, was
deemed fictitious for three basic reasons: (1) often there is no principal to call on (as in the
case of government debt, where the creditor owns not actual capital, but merely a claim on
government revenues); (2) capitalization is based on changing income expectations that may
or may not materialize; and (3) even if the expected income is given, its capitalized value
varies with the discount rate.
The existence of two types of capital created a dilemma for Marx. Theoretically, actual and
fictitious capital are totally different creatures with totally different magnitudes. But the
capitalist reality is denominated in prices, which means that, in practice, real and fictitious
capital are deeply intertwined. This latter fusion, says Marx, leads to massive distortions,
particularly during a boom, often to the point of making the entire process of accumulation
unintelligible:
All connection with the actual process of self expansion of capital is thus lost
to the last vestige, and the conception of capital as something which expands
itself automatically is thereby strengthened. . . . The accumulation of the
wealth of this class [the large moneyed capitalists] may proceed in a direction
very different from actual accumulation. . . . Moreover, everything appears
turned upside down here, since no real prices and their real basis appear in
this paper world, but only bullion, metal coin, notes, bills of exchange,
securities. Particularly in the centers, in which the whole money business of
the country is crowded together, like London, this reversion becomes
apparent; the entire process becomes unintelligible. (Marx, Karl. 1894.
Capital. A Critique of Political Economy. Vol. 3: The Process of Capitalist
Production as a Whole. Edited by Friedrich Engels. New York: International
Publishers, pp. 549, 561, 576, emphasis added)
Marxs followers solved this problem by assuming that, over the long run, the labour theory of
value prevails (with prices proportionate to labour values) and therefore that, at some point,
there must be a financial crisis to bring the price of fictitious capital back in line with the
labour values of real capital:
In order for the price system to work, financial forces should cause fictitious
capitals to move in directions that parallel changes in reproduction values. . . .
By losing any relationship to the underlying system of values, strains
eventually build up in the sphere of production until a crisis is required to
bring the system back into a balance, whereby prices reflect the real cost of
production. The fiction of fictitious value cannot be maintained indefinitely. At
some unknown time in the future, prices will have to return to a rough
conformity with values. . . . (Perelman, Michael. 1990. The Phenomenology of
Constant Capital and Fictitious Capital. Review of Radical Political
Economics, Vol. 22, Nos. 2-3, p. 83),
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2.2 Fishers House of Mirrors

On the neoclassical side, the duality of real and financial capital was articulated a century ago
by the American economist Irving Fisher. This was the beginning of a process that
contemporary commentators refer to as financialization, and whose logical structure Fisher
was one of the first theorists to systematize. Table 1 and the quote below it outline his
framework:
Table 1: Fishers House of Mirrors
PRESENT CAPITAL
QUANTITIES (REAL)
capital wealth
FUTURE INCOME
income services
VALUES (FINANCIAL)
capital value
income value
The statement that capital produces income is true only in the physical
sense; it is not true in the value sense. That is to say, capital-value does not
produce income-value. On the contrary, income-value produces capitalvalue. . . . [W]hen capital and income are measured in value, their causal
connection is the reverse of that which holds true when they are measured in
quantity. The orchard produces the apples; but the value of the apples
produces the value of the orchard. . . . We see, then, that present capitalwealth produces future income-services, but future income-value produces
present capital-value. (Irving Fisher, The Rate of Interest, 1907, NY: The
Macmillan Company, pp. 13-14, original emphases)
In this quote, Fisher draws three basic links: (1) the stock of capital goods, which economists
consider as wealth, generates future income services; (2) future income services generate
corresponding future income values; and (3) future income values, capitalized in the here and
now, give capital its financial value.
And so the ancient alienation of the thing from its idea is hereby resolved. The real capital on
the asset side of the balance sheet is made equal to the financial capital on the liabilities side.
The machines, structures, inventories and knowledge, taken as an aggregate magnitude, are
equivalent to the sum total of the corporations equity and debt obligations. The nominal
mirrors the real. The nomos and physis are finally made one and the same.
Now, admittedly, this is merely the ideal state, the ultimate equilibrium a free, rational
economy is bound to achieve. Sadly, though and as neoclassicists are at great pain to
admit we are not there yet. In practice, the here-and-now economy is constantly upset by
shocks, imperfections and distortions that, regrettably, cause finance to deviate from its
proper, real value and equilibrium to remain a distant goal.
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3. The quantity of wealth

To sum up, then, Marxists and neoclassicists approach the real/nominal duality from opposite
directions. In the Marxist case, the duality starts as a mismatch that is eventually forced into a
match, whereas in the neoclassical case it begins as a match and gets distorted into a
mismatch.
However, in both cases and this is the key point the benchmark is real or actual capital.
This is the yardstick, the underlying quantity that finance supposedly matches or mismatches.
At some point, be it at the beginning or the end of the process, the capitalized value of finance
must equal the quantity of wealth over which it constitutes a claim. In other words, the entire
exercise is built upon the material quantity of capital goods. The only problem is that nobody
knows what this quantity is or how to measure it.
3.1 Utils and SNALT
During the 1960s, there was a very important controversy in economics, pitting heterodox
professors from Cambridge University in England against some of their orthodox counterparts
at MIT in Cambridge, Massachusetts. The U.K. economists claimed that orthodox economics
was built on a basic fallacy: it treated capital as having a definite quantity while, in fact, such a
quantity cannot be shown to exist. Capital, they demonstrated, can rarely if ever be measured
in its own natural material units. And their U.S. counterparts eventually agreed. Reluctantly,
they conceded that real capital was merely a parable. Like the ever elusive God, you can
speak about it, but, generally, you cannot quantify it.
This Cambridge Controversy, as it later came to be known, has since been buried and
forgotten. The textbooks dont mention it, most professors havent heard about it and certainly
dont teach it, and the unexposed students remain blissfully ignorant of it. 4 The reason for the
hush-hush is not hard to understand: to accept that real capital has no definite quantity is to
terminate modern economics as we know it. In order to avoid this fate, the dismal scientists
have taken the anti-scientific route of keeping their skeletons in the closet. They have ignored
their own conclusions, gradually erased the very debate from their curricula and syllabi and
fortified the walls surrounding their academic religion to ward off the infidels.
But the problem remains, and, given its devastating consequences, it is worth considering, if
only briefly. The basic reason that real capital cannot be measured is aggregation.
Considered as a productive economic entity, capital consists of qualitatively different objects:
tractors are different from trucks, ships are different from airplanes and automobile factories
are different from oil rigs. This heterogeneity explains why the heterodox Cambridge
economists claimed that capital has no natural unit: there is no simply way to compare and
add up its components, and that inability makes it difficult to decide how big or how small
it is. 5
The common solution in such cases is reduction i.e., going one step lower to devise a
fundamental quantity common to all entities in question. Perhaps the first to employ this
method was the Greek philosopher Thales, when he claimed that everything in the world was
4
In his UQAM presentation of this paper, Nitzan asked the audience how many had heard of the
Cambridge Controversy. Out of about 50 people, consisting mostly of economics students, only one
raised his hand. He had heard about it in a sociology class.
5 Apparently unbeknown to the Cambridge controversialists, this argument was articulated already at the
turn of twentieth century by the American political economist Thorstein Veblen.
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made of water. The same principle is used by physicists when they argue that every quantity
in the universe can be expressed in terms of mass, distance, time, electrical charge or heat
(so velocity = distance time; acceleration = rate of change of velocity; force = mass
acceleration, etc.).
Economists mimic this reductionism with their own fundamental quantities. For the
neoclassicists, this quantity is the util, a measure denoting the hedonic pleasure generated
by commodities. 6 Like any other commodity, every capital good has its own util-generating
capacity, and if we add the individual util-generating capacities of different capital goods we
get their aggregate measure as real capital. For instance, if one Toyota factory can produce 1
million utils and a BP oil rig can produce 2 million utils, their combined real capital is 3 million
utils.
Classical Marxists do the very same thing with labour time. Every commodity, they say, can
be measured by the socially necessary abstract labour time (SNALT) it takes to produce; and
by adding up these times, we can calculate the aggregate real quantity of the capital in
question. If a Toyota factory takes 100 million socially necessary abstract labour hours to
produce and a BP oil rig takes 200 million hours, their total quantity is 300 million hours.
So far so good but then here there arises a small but nasty problem: unlike the physicists,
economists have never managed to actually measure their fundamental quantities. As far as
we know, no liberal has ever observed a util, and no Marxist has ever identified a unit of
SNALT. As they stand, these so-called real quantities are, in fact, entirely fictitious.
But the economists havent given up. Instead of measuring utils and SNALT directly, they go
in reverse. God is revealed to us through his miracles, and the same, argue the economists,
holds true for the fundamental quantities of economics: they reveal themselves to us through
their prices. For a neoclassicist, a 1:2 price ratio between a Toyota factory and a BP oil rig
means that the first entity has half the util quantity of the second, while for a classical Marxist
this same price ratio is evidence that the SNALT quantity of the first entity is half that of the
second.
This reverse solution is the bread and butter of all practical economics. It is a common
procedure that all economists use and few, if any, question, let alone critique. It is employed
by everyone, from official statisticians and government economists to Wall Street analysts
and corporate strategists. And as our reader might by now suspect, it doesnt work at least
not in the way it is supposed to.
3.2 Equilibrating the capital stock
To see why the reserve solution doesnt work, consider Table 2 and Figure 2, which present
the same information first numerically and then graphically. The table and figure pertain to a
hypothetical company, Energy User-Producer Inc., which owns two assets automobile
factories that use energy and oil rigs that produce it. To make the example simple, we
assume that there is only one type of automobile factory and that all oil rigs are identical. In
6
Hard-core neoclassicists might object to this description, saying that utils are unique to the individual
and therefore impossible to add across individuals to start with. However, since following this objection
to the letter would make comparison and aggregation and therefore practical economics impossible,
most neoclassical economists tend to ignore it. To bypass their own liberal-individualistic logic, they
assume that all individuals are the same, that they are therefore perfectly comparable, and that their
utilities can be aggregated after all. . . .
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order to know how much capital of each type there is, all we need to do is count. Table 2
shows the number of each of these real assets: Column 1 shows the number of automobile
factories as they change over time, and Column 2 shows the corresponding number of oil
rigs. These same numbers are shown by the two series at the bottom of Figure 2. The next
two columns in the table 3 and 4 display, for each year, the unit price of each type of
asset, counted in millions of dollars.
Now, since automobile factories and oil rigs are different entities, they cannot be added in
their own natural units. And since we dont know their util or SNALT contents, we cannot
add those numbers either. But we can follow the economic recipe of revealed preferences to
backpedal from prices to utils or SNALT.
Consider the neoclassical inversion. 7 In order to tease utils out of prices, all we need to do is
identify a year of perfectly competitive equilibrium (PCE). So for arguments sake, assume
that this year happened to be 1970. This is a convenient assumption to make, because, in
PCE, buyers and sellers are said to exchange commodities at prices proportionate to their
util-denominated (marginal) preferences. 8 In our case here, the shaded/bold numbers in
Table 2 show that, in 1970, an automobile factory cost $200 million and an oil rig cost $100
million (both hypothetical numbers). And since these are assumed to be PCE prices, their
ratio presumably reveals that the util-generating capacity of an auto factory is twice that of
an oil rig.
Now remember that in order to keep things simple, we also assumed that all automobile
factories and oil rigs are the same, and that they remain unchanged over time. This
assumption, together with our knowledge that 1970 was a year of PCE, allows us to easily
calculate the overall quantity of capital owned by Energy User-Producer. All we need to do for
every year is, first, multiply the number of automobile factories by 200 and the number of oil
rigs by 100, and then sum up the two products. This calculation would then give us the utilgenerating capacity of the company, year in, year out, as shown in Column 5.
There is a nasty catch here, though.
Note that our calculations are premised on the assumption that PCE occurred in 1970 but
what if this assumption is wrong? What if PCE occurred not in 1970, but in 1974, when the
price of oil was three times higher and inflation was running amok?
The Marxist inversion would be the same, only that, instead of utils, it would generate SNALT.
Neoclassical economists insist on distinguishing between average and marginal utility. But since utils
are forever invisible, and given that, in the interest of aggregation, neoclassical individuals are reduced
to identical drones with homothetic preferences anyhow, this distinction need not distract us.
8
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Table 2: The Many Quantities of Energy User-Producer Inc.
Year
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Number
(1)
(2)
Auto
Oil
Factories
Rigs
33
20
32
20
31
20
28
20
28
21
28
21
28
21
28
24
28
30
28
31
28
32
28
33
28
33
28
33
28
30
27
30
27
29
27
29
27
30
27
31
26
32
26
33
25
33
25
33
25
36
24
36
23
36
22
37
17
38
17
40
17
41
17
40
17
42
18
43
18
44
19
45
17
46
15
47
14
51
13
52
13
51
14
54
12
52
11
55
12
55
10
57
Price ($ million)
(3)
(4)
Auto
Oil
Factories
Rigs
200
100
220
120
218
220
270
280
300
300
345
400
350
450
410
600
390
700
400
800
415
810
432
820
445
850
450
900
432
850
450
870
460
800
473
790
470
690
460
650
500
680
502
700
510
720
500
705
480
730
511
780
520
785
510
800
530
750
535
760
540
755
560
730
550
780
530
800
580
850
550
900
590
950
600
1000
610
800
590
700
580
750
530
700
510
800
520
820
500
800
515
700
Quantity of Capital (utils)

by year of equilibrium
(5)
(6)
(7)
Eq. in
Eq. in
Eq. in
1970
1974
1979
8,600
15,900
29,200
8,400
15,600
28,800
8,200
15,300
28,400
7,600
14,400
27,200
7,700
14,700
28,000
7,700
14,700
28,000
7,700
14,700
28,000
8,000
15,600
30,400
8,600
17,400
35,200
8,700
17,700
36,000
8,800
18,000
36,800
8,900
18,300
37,600
8,900
18,300
37,600
8,900
18,300
37,600
8,600
17,400
35,200
8,400
17,100
34,800
8,300
16,800
34,000
8,300
16,800
34,000
8,400
17,100
34,800
8,500
17,400
35,600
8,400
17,400
36,000
8,500
17,700
36,800
8,300
17,400
36,400
8,300
17,400
36,400
8,600
18,300
38,800
8,400
18,000
38,400
8,200
17,700
38,000
8,100
17,700
38,400
7,200
16,500
37,200
7,400
17,100
38,800
7,500
17,400
39,600
7,400
17,100
38,800
7,600
17,700
40,400
7,900
18,300
41,600
8,000
18,600
42,400
8,300
19,200
43,600
8,000
18,900
43,600
7,700
18,600
43,600
7,900
19,500
46,400
7,800
19,500
46,800
7,700
19,200
46,000
8,200
20,400
48,800
7,600
19,200
46,400
7,700
19,800
48,400
7,900
20,100
48,800
7,700
20,100
49,600
Normalized Quantity of
Capital (utils)
by year of equilibrium
(8)
(9)
(10)
Eq. in
Eq. in
Eq. in
1970
1974
1979
100.0
100.0
100.0
97.7
98.1
98.6
95.3
96.2
97.3
88.4
90.6
93.2
89.5
92.5
95.9
89.5
92.5
95.9
89.5
92.5
95.9
93.0
98.1
104.1
100.0
109.4
120.5
101.2
111.3
123.3
102.3
113.2
126.0
103.5
115.1
128.8
103.5
115.1
128.8
103.5
115.1
128.8
100.0
109.4
120.5
97.7
107.5
119.2
96.5
105.7
116.4
96.5
105.7
116.4
97.7
107.5
119.2
98.8
109.4
121.9
97.7
109.4
123.3
98.8
111.3
126.0
96.5
109.4
124.7
96.5
109.4
124.7
100.0
115.1
132.9
97.7
113.2
131.5
95.3
111.3
130.1
94.2
111.3
131.5
83.7
103.8
127.4
86.0
107.5
132.9
87.2
109.4
135.6
86.0
107.5
132.9
88.4
111.3
138.4
91.9
115.1
142.5
93.0
117.0
145.2
96.5
120.8
149.3
93.0
118.9
149.3
89.5
117.0
149.3
91.9
122.6
158.9
90.7
122.6
160.3
89.5
120.7
157.5
95.3
128.3
167.1
88.4
120.7
158.9
89.5
124.5
165.7
91.9
126.4
167.1
89.5
126.4
169.9
NOTES TO TABLE 2:
The numbers of auto factories (Column 1) and oil rigs (Column 2) are hypothetical.
Column 5 = value of Column 3 in 1970 * Column 1 + value of Column 4 in 1970 * Column 2
Column 8 = Column 5 / value of Column 5 in 1970 * 100
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Figure 2: The Many Quantities of Energy User-Producer Inc.

180
200
number
utils
190
170
"Quantity" of Capital
(1979 equilibrium, left)
180
160
170
150
160
150
140
130
140
130
120
120
110
110
1970=100
100
100
90
90
80
80
70
Number of
Oil Rigs
(right)
70
60
60
50
40
50
30
Number of
Automotive
Factories
(right)
40
20
30
10
www.bnarchivs.net
20
0
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
2020
NOTE: The number of auto factories and oil rigs is hypothetical. The annual quantity of capital (in utils)
is computed first by multiplying the number of auto factories and oil rigs by their respective equilibrium
price; and second by adding the two products. The quantity of capital with a 1970 equilibrium assumes
that the util-generating capacities of an auto factory and an oil rig have a ratio of 2:1 (based on
respective prices of $200 mn and $100 mn); the quantity of capital with a 1974 equilibrium assumes
that the ratio is 1:1 (based on respective prices of $300 mn and $300 mn); and the quantity of capital
with a 1979 equilibrium assumes that the ratio is 1:2 (based on respective prices of $400 mn and
$800 mn). For presentation purposes, all three quantity-of-capital series are normalized with the year
1970=100.
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According to Table 2, in 1974 the price of automobile factories was $300 million apiece 50
per cent higher than in 1970 and the price of oil rigs was 200 per cent higher, at $300
million. Now, if we take these as our PCE prices and therefore as revealing the true utilgenerating capacity of the underlying assets, the quantity of capital would be very different
than in the first scenario. Unlike before, the price ratio now is not 2:1, but 1:1, and that
difference changes everything. The new results are shown in Column 6.
And the same question can be raised again: what if PCE occurred not in 1974, but in 1979,
when inflation accelerated further and the price of oil rigs shot through the roof? According to
Table 2, the price ratio now is 1:2, and that change, documented in Column 7, makes the
quantities of capital different than in both previous scenarios.
In order to better compare the evolution of the capital stock under our three PCE settings, it is
convenient to normalize Columns 5-7, as we do in Columns 8-10. For each of the Columns 57, we divide the quantity of capital by its value in 1970 and multiply the result by 100. This
computation recalibrates the three series, bringing them all to a single common denominator,
so that their respective values in 1970=100. Note that, because each observation in this
transformation is divided and multiplied by the same numbers, the relative temporal changes
of Columns 8-10 (although not the absolute numbers) are identical to those of Columns 5-7,
respectively.
The top part of Figure 2 shows the three normalized quantities of capital (Columns 8-10),
each corresponding to a different PCE year. And as you can see, the trajectories of the series
differ markedly from each other: if PCE occurred in 1970, the quantity of capital is shown to
have declined by about 10 per cent over the entire period; if PCE occurred in 1974, though,
the quantity of capital is shown to have increased by over 20 per cent; and if PCE occurred in
1979, the quantity of capital is seen to have risen by nearly 90 per cent.
3.3 So what is there to mismatch
Now, these are only three examples, and as our reader by now can imagine, we can give
many others in fact, as many as we wish each based on a different PCE point and each
yielding a different quantitative series. The crucial point here is that these different series all
pertain to the same capital stock, so obviously only one of them, if any, can be correct but
which one is it?
Sadly, nobody knows.
As far as we can tell, nobody not even top-of-the-line winners of the Nobel Memorial Prize
in Economic Sciences can identify PCE when they see it (assuming this is a meaningful
social state to start with). And as long as PCE remains invisible, there is no way to decide
which series, if any, shows the true magnitude of capital.
Similar problems haunt the Marxists. Given that SNALT is not directly observable, let alone
measurable, Marxists, just like neoclassicists, are often forced to go in reverse. They deduce
the labour-time magnitude of capital from the (PCE?) market prices of capital goods or
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worse still, simply use the neoclassical, util-based measures provided by the national
accounts. 9
And so weve come full circle. The mismatch thesis claims that the quantity of financial capital
deviates from and distorts the quantity of real capital. But as it turns out, the quantity of real
capital the thing that finance supposedly mismatches and distorts in the first place is in
fact totally nominal. Moreover, since this nominal quantity can be anything and everything
(depending on our arbitrary choice of PCE), the economists are left with no unique (money)
measure of real capital, let alone one they can all agree on. Caught in Platos cave, they try to
glean reality from its reflection in their self-made mirror only to discover that this mirror
projects not one but an infinite number of images and that they have no idea how to choose
between them. They end up with no real benchmark to match and therefore nothing to
mismatch.
3.4 Flowing with the delusional crowd
In every other science, this inability to measure the key category of the theory would be
devastating (think of measuring Newtons gravitation without mass or distance). But not in the
science of economics. 10
Here, everything continues to flow smoothly. The national statistical services instruct their
statisticians to come up with real numbers for the capital stock (as well as for every other
economic entity). In order to comply, the statisticians have to identify instances of PCE; but
since they too are clueless about the subject, they pretend. They designate an arbitrary year
as their PCE, go through the hoops of Table 2, and churn out the required numbers. And
although these official numbers are entirely fictitious, the economists, neoclassical as well as
heterodox, dont seem to care. They use them, usually without a second thought, as if they
were the real thing.
So lets not spoil the parade and, for the moment, continue to flow with the delusional crowd.
For the sake of argument, lets assume, along with the average economist, that, at any point
in time, the dollar value of capital goods or wealth, as Irving Fisher called them is
proportionate to the their real quantity, and then use this (pseudo) real measure as our basic
benchmark.
With this assumption, we can now run a pragmatic test: we can take the financial magnitude
of any capital (market capitalization) and compare it to its (fabricated) real benchmark (the
aggregate money price of the underlying capital goods). According to Fishers neoclassical
scriptures summarized in Table 1 and assuming we are using the true PCE benchmark
the two quantities must equal. If they differ, reality must have been distorted.
For more on the classical Marxist treatment of capital, see Chapters 6-8 in our book Capital as Power:
A Study of Order and Creorder (Routledge, 2009, http://bnarchives.yorku.ca/259/). It is important to
mention here that, in their empirical research, most Marxists have thrown in the methodological towel.
Instead of relying on labour time and the dialectical method, they use real neoclassical data, liberal
classifications and equilibrium-based econometrics. This wholesale surrender is akin to physicists
reverting back to astrology and chemists back to alchemy. Moreover, most Marxists rarely acknowledge,
let alone assess, the implications of this surrender and the handful who do often end up defending it!
10 A note to the uninitiated: the term economics was coined at the end of the nineteenth century by
Alfred Marshall, who thought that political economy was insufficiently scientific, and that a suffix of ics
would make it sound much more respectable, like mathematics and physics.
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4. Microsoft versus General Motors

The remainder of the paper draws its empirical illustrations from the United States. This focus,
dictated largely by data availability, is of course limiting. But given that the U.S. was the
leading engine of capitalism throughout much of the twentieth century and remains pivotal to
contemporary global accumulation, its experience can still tell us plenty.
Figure 3 illustrates a simple case of reality distorted by finance. The chart, focusing on the
year 2005, compares the so-called real and financial sides of two leading U.S. firms
Microsoft and General Motors. Seen from the real side, General Motors is a giant and
Microsoft is a dwarf. In 2005, General Motors had 335,000 workers 5.5 times more than
Microsoft and it had plant and equipment with a book value of 78 billion dollars 33 times
greater than Microsofts.
Figure 3: General Motors versus Microsoft, 2005
500
GM
Microsoft
400
64%
2,583%
300
200
100
18%
www.bnarchives.net
3%
0
Employees (000)
Plant and
Equipment ($bn)
Market Value
($bn)
Market Value and

Debt ($bn)
NOTE: The per cent figures indicate, for any given measure, the size of Microsoft relative to GM.
SOURCE: Compustat through WRDS (series codes: data29 for employees; data8 for net plant and
equipment; data24 for price; data54 for common shares outstanding; data 181 for total liabilities).
But when we examine the two companies through the financial lens of capitalization, the
pecking order is reversed: Microsoft becomes the giant and General Motors the dwarf. In
2005, Microsoft had a market capitalization nearly 26 times that of General Motors. Indeed,
even if we take the sum of debt and market value, General Motors is still only 55 per cent
bigger than Microsoft a far cry from its relatively huge workforce and massive quantity of
plant and equipment.
So, obviously, there must be some distortion here for otherwise, how could a dwarf be a
giant and a giant a dwarf?
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Most economists, though, would shrug off the question. The problem, they would say, is that
the chart shows only part of the picture. It measures real capital by looking at plant and
equipment and the number of employees yet neither of these magnitudes captures the
importance of technology. This is a crucial omission, they would continue, for, as we all
know, Microsoft is a high-tech company and therefore possesses much more technology than
General Motors. And since technical knowhow affects market capitalization but rarely if ever
gets counted as plant and equipment and has no bearing on the size of the companies
workforce, our comparison is inherently lopsided. It demonstrates not a distortion but a simple
mismeasurement.
And perhaps there is a mismeasurement here but then, how can we be sure? Note that
economists know the magnitude of technology here not by observing it directly (which
nobody really can), but only indirectly, through its reflection in the mirror: they deduce it as the
residual between market capitalization and the dollar value of plant and equipment.
Most economists encounter the technological residual in their study of production functions.
These functions are intended to explain the level of output by the level of productive inputs
and are notoriously bad at doing so. Usually, they leave out a large unexplained variation in
output the infamous residual whose existence the economists customarily blame on their
inability to quantify knowledge (calling it a measure of our ignorance).
This inability has devastating consequences. To illustrate, consider two hypothetical
production functions, with physical inputs augmented by technology: (1) Q = 2N + 3L + 5K + T
and (2) Q = 4N + 2L + 10K + T, where Q denotes output, N labour, L land, K capital, and T
technology. Now, suppose Q is 100, N is 10, L is 5 and K is 4. The implication is that T must
be 45 in function (1) and 10 in function (2). Yet, since technology cannot be measured, we
cant know which production function is correct, so both and, by extension, any technologyaugmented function can claim incontrovertible validity. But then, if production cannot be
objectively described, what is left of the supply function, equilibrium and the entire edifice
called economics?
The production-function residual is related to but different from the residual between
capitalization and the real capital stock: the former supposedly measures the contribution of
technology to output, whereas the latter presumably quantifies the actual magnitude of
technology. However, both residuals share the property of being conveniently invisible and
therefore irrefutable.
Now, what if the mirror of capitalization lies and the residual gives us a false reading? For
example, what if it were in fact General Motors that possessed the bigger technology and
the asset market simply mispriced the two stocks to erroneously suggest the opposite? And
then there is the possibility which we have graciously assumed way, though only as a
freebie that 2005 was a not a year of PCE, and therefore that our (nominal) measures of the
real capital stock of the two companies are in fact distorted to start with. How do we know that
the know-all market didnt misprice these assets as well? And if there is no way of knowing,
how can we say anything meaningful, let alone definitive, on the presumed size of
technology?
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5. Tobins Q: Adding Intangibles

The same question, though on a much grander scale, arises from Figure 4. Whereas our
comparison of Microsoft and General Motors is restricted to two firms at a point in time, in
Figure 4 we look at all U.S. corporations from the 1930s to the present. The chart shows two
series. The thick line is our (pseudo) real benchmark. It shows the current, or replacement,
cost of corporate fixed assets (i.e., what they would cost to produce, every year, at prevailing
rather than historical prices). The thin line is the corresponding magnitude of finance. It
measures the total capitalization of corporate equities and bonds, an aggregate that
constitutes a claim on and presumably mirrors the underlying sum total of real assets.
Figure 4: The Quantity of U.S. Capital
NOTE: The market value of equities and bonds is net of foreign holdings by U.S. residents.
SOURCE: U.S. Bureau of Economic Analysis through Global Insight (series codes: FAPNREZ for
current cost of corporate fixed assets). The market value of corporate equities & bonds splices series
from the following two sources. 1932-1951: Global Financial Data (market value of corporate stocks and
market value of bonds on the NYSE). 1952-2014: Federal Reserve Board through Global Insight (series
codes: FL893064105 for market value of corporate equities; FL263164103 for market value of foreign
equities held by U.S. residents, including ADRs; FL893163005 for market value of corporate and foreign
bonds; FL263063005 for market value of foreign bonds held by U.S. residents).
Note that we plot the two series against a log scale, so the discrepancies between them,
although they look small on the graph, could be very large. These discrepancies are
calibrated in Figure 5. The chart shows the Tobins Q index, named after the late economist
James Tobin. For our purpose here, Tobins Q offers a sweeping measure of the financial-real
mismatch. It computes, for every year, the ratio between the market value of corporations in
the numerator and the replacement cost of their plant and equipment in the denominator. If
finance matches reality, the two magnitudes are the same and Tobins Q will equal 1. If there
is a mismatch, Tobins Q will exceed or fall short of 1.
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Figure 5 has two notable features. First, it shows that the historical mean value of Tobins Q
isnt 1, but slightly above 1.2. Second, it demonstrates marked variations in Q, ranging from a
low of 0.6 to a high of 2.5. These variations are not random, but rather cyclical and persistent.
Lets examine these two features more closely.
Figure 5: Tobins Q in the United States
NOTE: The market value of equities and bonds is net of foreign holdings by U.S. residents. The last
data point is for 2014 (based on the measured value of corporate equities and bonds and the estimated
current cost of corporate fixed assets).
SOURCE: See Figure 4.
First, why is the historical average of Tobins Q greater than 1? The conventional answer, just
like in the Microsoft-General Motors case, is mismeasurement. When physicists were unable
to square their computations regarding the structure and expansion of the universe, they
didnt rush to change their theory; instead, they solved the problem, at least provisionally, by
hypothesizing the existence of invisible dark matter whose assumed mass, when added to
the mass of observed matter, would make their calculations consistent. Economists do the
very same thing with the real-financial mismatch. The reason that capitalization tends to be
larger than real capital, they say, is that fixed assets are only part of the picture. The other
part is made of equally productive intangible assets. Unfortunately, most of these intangibles,
like the physicists dark matter, are invisible. And it is this invisibility that explains why finance
often mismatches reality and why Tobins Q averages more than 1.
Intangibles, many economists argue, have become more important since the 1980s onset of
the information revolution and knowledge economy exactly when Tobins Q started to
soar. According to this view, corporations have accumulated more and more invisible assets
in the form of improved technology, better organization, high-tech, synergy and other such
knowledge-related blessings. These intangibles have in turn augmented the quantity of
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capital, and have therefore led to larger capitalization. Accountants, though, remain
conservative, so most intangibles dont get recorded as fixed assets on the balance sheet.
And since the capitalized numerator of Tobins Q takes account of these intangibles while the
fixed-asset denominator usually does not, we end up with a growing mismatch. By the mid2000s, some guestimates suggested that intangibles have come to account for 80 per cent of
all corporate assets up from less than 20 per cent 30 years earlier.
Although popular, these claims are highly dubious. Just like in the Microsoft-General Motors
case, here, too, intangible capital is computed as a residual, deduced by subtracting from
market capitalization the value of fixed assets. Now if we accept this method as most
economists do we must also accept that intangible capital is a highly flexible creature,
capable of expanding rapidly (as it did during the 1980s and 1990s, when Tobins Q rose on a
soaring market) as well as contracting rapidly (as it did during the major bear market of the
2000s, when Tobins Q tanked). But does this flexibility make any sense?
Given that technical knowhow tends to change very gradually and rarely contracts, how could
its magnitude jump several-fold in a short decade, only to drop precipitately in the next? And
thats not all. To accept the residual method here is to concede that intangible capital can
become negative for otherwise, how could we account for Tobins Q falling below 1?
6. Boom and bust: irrationality

So what do the economists do to bypass these implausibilities? They add irrationality. The
textbooks portray economic agents as rational and markets as efficient but when pressed to
the wall, even the fundamentalists admit that reality is rarely that pristine. In practice,
economic agents are plagued by emotions, often misinformed and occasionally delusional.
Moreover, and regrettably, the market, which the textbooks like to describe as perfect, is
heavily contaminated and distorted by public officials and policymakers, oligopolies and
insiders, labour unions and NGOs (and, more recently, also by a host of non-economic actors
from religious sects to terrorist organizations). This toxic cocktail means that, unlike in theory,
actual market outcomes can be irrational and occasionally unpredictable.
Irrational, unpredicted markets certainly have their downsides. They caused Isaac Newton to
lose a fortune when the eighteenth-century South Sea Bubble burst and Irving Fisher to lose
a much greater sum $100 million in todays prices when the U.S. stock market crashed in
1929. Humiliated, Newton observed that he could calculate the movement of the stars, but
not the madness of men. Fisher, by contrast, remained upbeat. Instead of throwing his hands
up in despair, he went on to found the Cowles Commission, Econometrica and other such
startups, all in the hope of putting the art of making money on a truly scientific footing.
Whether or not these initiatives have facilitated moneymaking remains an open question, but
they have certainly loosened the grip of strictly rational neoclassical economics over matters
financial. Nowadays, market capitalization is said to consist not of two components, but three:
tangible assets, intangible assets and the irrational optimism and pessimism of investors.
And it is this last component, many now believe, that explains why Tobins Q is so volatile.
How is this volatility manifested? A typical financial analyst might describe the process as
follows. During good times that is, when real accumulation is high and rising investors get
excessively optimistic. Their exuberance causes them to bid up the prices of financial assets
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over and above the true value of the underlying real capital. Such overshooting can serve to
explain, for example, the Asian boom of the mid-1990s, the high-tech boom of the late 1990s
and the sub-prime boom of the mid-2000s. In this scenario, real capital soars, but financial
capital, boosted by hyped optimism, soars even faster.
The same pattern, only in reverse, is said to unfold on the way down. Decelerating real
accumulation causes investors to become excessively pessimistic, and that pessimism leads
them to push down the value of financial assets faster than the decline of real accumulation.
Instead of overshooting, we now have undershooting. And that undershooting, goes the
argument, can explain why, during the Great Depression, when fixed assets contracted by
only 20 per cent, the stock market fell by 70 per cent, and why, during the late 2000s, the
stock market fell by over 50 per cent while the accumulation of fixed assets merely
decelerated.
Figure 6: The World According to the Scriptures
* Computed annually by adding to the historical average of the growth rate of current corporate fixed
assets 2.5 times the deviation of the annual growth rate from its historical average.
NOTE: Series are smoothed as 10-year trailing averages. The last data points are for 2013.
SOURCE: U.S. Bureau of Economic Analysis through Global Insight (series codes: FAPNREZ for
current cost of corporate fixed assets).
This pattern of irrationality is illustrated in Figure 6. The thick line in the chart measures the
actual rate of change of fixed assets priced at replacement cost and smoothed as a 10-year
trailing average. 11 Unlike the thick line, the thin line is hypothetical. It simulates what the ups
and downs of capitalization might look like if investors were excessively optimistic on the
upswing and excessively pessimistic on the downswing (the exact computation of the series
is explained in the footnotes to the chart).
11 Note that this series excludes intangibles, but since we are displaying here not levels but rates of
change, we can conveniently assume that the sum of tangible and intangible assets would follow a
growth pattern similar to that of the tangible assets only.
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Such simulations help market analysts tease order from the chaos. They show that investors
irrationality however embarrassing, regrettable and inconvenient is bounded and therefore
manageable and predictable. The build-up of excessive investors optimism during the boom
is reversed during a bust, when these very investors become excessively pessimistic. The
boom-driven euphoria that gives rise to a bubble of fake wealth and a soaring Tobins Q is
eventually replaced by fear, causing wealth to appear smaller than it really is and Tobins Q to
crash-land.
7. A house of cards
So now everything finally falls into place. (1) Real capital cannot be measured and probably
doesnt have a unique quantity to begin with, but thats OK if we can pretend that its
magnitude is proportionate to the current price of fixed assets. (2) Tobins Q averages more
than 1 but thats OK too, since the larger value can be attributed to the existence of highly
productive intangible assets that, unfortunately, nobody can really see. And (3) Tobins Q
fluctuates heavily admittedly because the asset market is imperfect and humans are not
always rational but that, too, is fine, since the asset markets oscillations are safely
bounded, pretty predicable and, most importantly, move broadly together with real
accumulation.
Or do they?
Notice that the capitalization series in Figure 6 is entirely imaginary. As it stands, it reflects not
the reality of the market, but the assumptions of the theory and in particular, the assumption
that the growth rate of capitalization amplifies yet moves together with that of real capital. But
is this a correct assumption to make?
According to Figure 7, the answer is a resounding no.
The thick line here is the same as in Figure 6. It measures the rate of change of the
replacement cost of fixed assets. The thin line, though, is no longer hypothetical: it measures
the actual rate of change of the value of corporate stocks and bonds. And it is here that the
real/nominal duality and its associated mismatch thesis run into a brick wall. Unlike in
Figure 6, where the ups and downs of the capitalization series amplify those of fixed assets,
here they seem to move in exactly the opposite direction.
Note that these are not short-term fluctuations. The history of the process shows a very longterm wave pattern, with a cyclical peak-to-peak duration of 15-40 years. Furthermore the
countercyclical movement of the two series seems highly systematic.
Now, unlike our previous findings in the paper, which we have agreed to overlook for
arguments sake, the inverse pattern evident in Figure 7 is patently inconsistent with the
fundamental duality of real and financial capital. We can perhaps concede that real capital
does not have a material quantum, and then pretend that this quantum is proportionate to the
market price of the underlying capital goods. We can perhaps accept that there are invisible
assets that nobody can observe, yet believe that the know-all asset market can indirectly
measure them for us, as a residual. And we can perhaps allow economic agents to be
irrational, and then assume that their imperfect asset pricing is nonetheless bounded,
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oscillating around the true price of real capital. But it taxes credulity to observe that the
accumulation of real and financial assets move in opposite directions, yet maintain that the
latter movement derives from and reflects the former.
Figure 7: U.S. Capital Accumulation: Fiction vs. Reality
NOTE: The market value of equities and bonds is net of foreign holdings by U.S. residents. Series are
shown as 10-year trailing averages. The last data points are 2014 for the market value of corporate
equities and bonds and 2013 for the current cost of corporate fixed assets.
SOURCE: See Figure 4.
Present-day capitalists or investors, as they are now known dont really care about real
capital. They are indifferent to means of production, labour and knowledge. They do not lose
sleep over individual rationality and market efficiency. And they can live with both free
markets and government intervention. The only thing they do care about is their financial
capitalization. This is their Moses and the prophets. The rest is just means to an end.
The promise of classical political economy, and later of economics, was to explain and justify
the rule of capital: to show how capitalists, while pursuing their own pecuniary interests,
propel the rest of society forward. The accumulation of capital values, the economists
explained, goes hand in hand with the amassment of real means of production, and
therefore with the growth of production, employment, knowledge, rationality, efficiency and
laissez faire. But, then, if the U.S. case is representative and the growth rates of capitalization
and real capital move not together but inversely, the interests of the capitalist rulers are
pitted against those of society. And if that is indeed the case, whats the use of economics?
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8. Endgame
When capital first emerged in the European burgs of the late Middle Ages, it seemed like a
highly promising startup: it counteracted the stagnation and violence of the ancien rgime with
the promise of dynamism, enlightenment and prosperity, and it replaced the theological sorcery
of the church with an open, transparent and easy-to-understand logic. But once capital took
over the commanding heights of society, this stark difference began to blur. The inner workings
of capital became increasingly opaque: its ups and downs appeared difficult to decipher, its
crises seemed mysterious, menacing and hard to manage, and its very nature and definition
grew more slippery and harder to grasp.
Political economy the first science of society attempted to articulate the new order of
capital. In this sense, it was the science of capital. The rule of capital emerged and
consolidated together with modern science, and the methods of political economy developed
hand in hand with those of physics, chemistry, mathematics and statistics. During the
seventeenth century, the scientific revolution, along with the processes of urbanization, the
shifting of production from agriculture to manufacturing and the development of new
technologies, gave rise to a mechanical worldview, a novel secular cosmology whose
intellectual architects promoted as the harbinger of freedom and progress. And it was this
new mechanical cosmology itself partly the outgrowth of capitalism that political
economists were trying to fit capital into.
Their attempts to marry the logic of accumulation with the mechanized laws of the cosmos are
imprinted all over classical political economy and the social sciences it later gave birth to, and
they are particularly evident in the various theories of capital. Quantitative reasoning and
compact equations, Newtonian calculus and forces, the conservation of matter and energy,
the imposition of probability and statistics on uncertainty these and similar methods have all
been incorporated, metaphorically or directly, into the study of capitalism and accumulation.
But as we have seen in this paper, over the past century the marriage has fallen apart. The
modern disciplines of economics and finance overflow with highly complex models, complete
with the most up-to-date statistical methods, computer software and loads of data yet their
ability to explain, let alone justify, the world of capital is now limited at best. Their basic
categories are often logically unsound and empirically unworkable, and even after being
massively patched up with ad hoc assumptions and circular inversions, they still manage to
generate huge residuals and unobservable measures of ignorance.
In this sense, humanity today finds itself in a situation not unlike the one prevailing in
sixteenth-century Europe, when feudalism was finally giving way to capitalism and the closed,
geocentric world of the Church was just about to succumb to the secular, open-ended
universe of science. The contemporary doctrine of capitalism, increasingly out of tune with
reality, is now risking a fate similar to that of its feudal-Christian predecessor. Mounting global
challenges from overpopulation and environmental destruction, through climate change and
peak energy, to the loss of autonomy and the risk of social disintegration cannot be handled
by a pseudo-science that cannot define its main categories and whose principal explanatory
tool is distortions. You cannot build an entire social cosmology on the assumptions of
individual rationality, equilibrium and perfect markets and then blame the failures of this
cosmology on irrationality, disequilibrium and imperfections. In science, these excuses and
blame-shifting are tantamount to self-refutation.
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What we need now are not better tools, more accurate modelling and improved data, but a
different way of thinking altogether, a totally new cosmology for the post-capitalist age.

___________________________
SUGGESTED CITATION:
Shimshon Bichler and Jonathan Nitzan, Capital accumulation: fiction and reality, real-world economics review, issue
no. 72, 30 September 2015, pp. 47-68,
http://www.paecon.net/PAEReview/issue72/BichlerNitzan72.pdf
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Amartya Sen and the media

John Jeffrey Zink
[Morningside College, USA]

Copyright: John Jeffrey Zink, 2015

Abstract
Amartya Sen has correctly sought to correct some shortcomings within neoclassical
economic theory. Nonetheless, there still exists a tension in his work. His overall
frame of analysis is still congruent with much of the neoclassical tradition. However,
his critiques seem to imply that a sharp break with neoclassical theory is necessary.
This conflict is examined in light of the connections between the press and the media,
its impact on capabilities and functionings in Sens framework, politics, and basic
ideas about justice. Sens individualist focus on capabilities and functionings seems to
reflect the individualist orientation derived from neoclassical theory, but his use of
other categories calls for a new kind of analysis that better examines the connections
that enable people to shape and be shaped by their institutional environment.
JEL codes B3, B5, K00, L82
Section I: Introduction
Almost everyone recognizes that the media plays a crucial role in real democracies. One
must examine the media to understand its role in how democracies work, including how it
both enhances and detracts from how well any democratic society works. Amartya Sen
recognizes this basic truth in the realms of capabilities, functionings, economics, and
freedom. However, there is a tension between this recognition and the fact that Sen does not
deeply develop the structural and institutional aspects of the role of the media and of
democratic society.
In many of his works, Amartya Sen has correctly pointed out the links that exist between
many kinds of freedom. One of the most important is the connection between democratic
participation, political freedom, and the structure of the media. This is important because Sen
argues that direct or representative democracy prevents catastrophic famine. (Sen 1999,
2009) He has also forcefully argued that political participation is important in its own right.
In order to reap the full benefits of democracy, Sen has argued that it is crucial have a free
press that allows for the free flow of ideas. The free press helps a society decide which
policies to pursue, since these discussions lead to the direct consideration of the goals that
society thinks are worthwhile. These discussions also shape a society, because they inform
citizens how it might be best to pursue goals that are already settled on. On this point, I agree
with Sen.
However, there is a problem. Authors like Robert McChesney have argued that the ownership
structure of media companies limits debate over economic and political policy. In the U.S., the
primary concern seems to be the potential for corporate censorship, while in other parts of the
world the main problem appears to be government censorship.
For the U.S., the argument goes like this. Media companies such as Disney, Fox, and Turner
have direct economic interests. Large media companies are large corporations, and they sell
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advertising to other large corporations. Management of these large corporations has the
responsibility to run the firms as profitably as they can. This is both a competitive requirement,
and in some ways a legal one. One could argue that these firms have to please two masters,
their shareholders and their audience. Management is often legally bound to serve
shareholders first in case of a conflict between shareholder interests and other competing
interests, such as those of employees or the audience. The corporate structure of these firms
gives them an economic incentive to consider the financial consequences to the corporation
of any particular story, regardless of its truth or potential social importance even if they
maintain a strict separation between the news division and other divisions. Important aspects
of any debate over social, political, and economic policy may be sidestepped because of
corporate organization and the accompanying incentives. For example, Stromberg (2004)
developed a model that describes the links between the mass media, political competition,
and the resulting public policy. The emergence of the mass media may introduce a bias in
favor of groups that are valuable to advertisers, which might introduce a bias against the poor
and the old. (Stromberg 2004, 281)
This may limit the range of acceptable discourse and debate in major media outlets. The
internet could be a different story, but the evolving debate and actions of the government
regarding net neutrality is a debate about who controls this important information gateway,
and how that control will be used. It would also be important to consider the worldwide
aspects of this debate. While Sen has placed many of his arguments within the context of a
national debate over some policy, many of todays media companies have a worldwide reach.
Policies that affect a media outlet in one country often require the company to make
adjustments in other areas, thus influencing a wide area of activity. Benjamin Compaine
(1999) believed that the internet could broaden the discussion. In a way it has made a much
more diverse views available to just about anyone, but the problem remains that it is very
expensive to provide content. Easy duplication and dissemination of content has reinforced
the market power of the big players. (Foster and McChesney 2011, Hindman 2009,
McChesney 2001, 2004, McChesney and Nichols 2010) So while there are many more voices
available, they continue to be drowned out by the large established players.
If policy makers uncritically accept constraints on which views are deemed acceptable, they
could limit the discussion to alternatives that are pre-approved. This preapproval is implicit,
and understood by all players in the game except for fringe elements. This needs only to
become widely accepted in policy circles, not throughout the society. This has happened in
the United States, and the result is a lack of information for people causing a poor political
culture and a lack of civic engagement.
Section II: Sen and Democracy

Sen directly discusses the importance of democracy in such works as Hunger and Public
Action (co-authored with Jean Drze), Development as Freedom, and Inequality Reexamined.
Sens emphasis of personal differences in Inequality Reexamined points to the importance of
democratic discussion. Democratic discussion is important because people differ in many
ways. Thus, Sen writes If every person were much the same as every other, a major cause
of these disharmonies would disappear (Sen 1992, 2). He points out that equality in one area
does not automatically correspond to equality in another area. Differences in wealth can be
associated with equal incomes. Equal incomes can be associated with unequal happiness,
and equal opportunities can lead to unequal incomes (Sen 1992). Sen has forcefully argued
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that there are direct causal links between different freedoms, such as between political
participation and famine prevention (Sen 1983, 1999, Drze and Sen 1989).
In order to address these differences, Sen argues that . . . the intensity of economic needs
adds torather than subtracts fromthe urgency of political freedoms (Sen 1999, 148). He
feels that this is important for three reasons. Basic political and liberal rights are intrinsically
important, because they enable people to lead more fulfilling lives. Sen believes that political
and social participation are important parts of a truly fulfilling life. Second, these political rights
and freedoms are instrumentally important, because they empower people to tell others about
problems that need attention. Third, these freedoms play a constructive role in the discussion
and formation of the ideas of economic need within a society. In other words, the fact that
there is discussion influences or alters the conceptions of needs that arise within a particular
society.
So far so good, but how does democracy actually work? Does it work well, poorly, or not at
all, and why? Obviously, this is a question that would require a book length treatment, and
probably more than one! To his credit, Sen is aware of this problem, so he supplements his
discussion of the importance of political rights and democracy with the admission that the
effectiveness of such political rights depends crucially on how they are used. He writes:
However, in presenting these arguments on the advantages if democracies,
there is a danger of overselling their effectiveness. As was mentioned earlier,
political freedoms and liberties are permissive advantages, and their
effectiveness would depend on the how they are exercised (Sen 1999, 154).
Sen steps directly into the discussion of how political rights are used and what influences the
use of those rights.
This is a crucial point. Taking India as an example of a functioning democracy, Sen points out
that democracy in India has been able to prevent catastrophic famine since independence in
1947. At the same time, it has been much less successful in eliminating chronic hunger,
gender inequalities, or widespread and persistent illiteracy (Sen 1999). He also points out that
there are similar failings in more well developed democracies, such as the Unites States. He
cites the deprivation of African Americans in the United States in areas such as social
environment, education, and health care. A symptom of this is the mortality rates for African
Americans, which are much higher than the average for the rest of the population. He writes:
Democracy has to be seen as creating a set of opportunities and the use of
these opportunities calls for an analysis of a different kind, dealing with the
practice of democratic and political rights. In this respect, the low percentage
of voting in American elections, especially by African Americans, and other
signs of apathy and alienation, cannot be ignored. Democracy does not serve
as an automatic remedy of ailments as quinine works to remedy malaria. The
opportunity it opens up has to be positively grabbed in order to achieve the
desired effects (Sen 1999, 155 emphasis in original).
Sen is aware of the difficulties that this involves, and the examples of hunger in India and
mortality of African Americans are prime examples. But there are additional problems.
First there are problems recognizing patent injustices, aside from the obvious catastrophes
such as famines and disease. Sen notes that:
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. . .no matter how inescapable it may look in terms of foundational ethical

arguments, the emergence of a shared recognition of that injustice may be
dependent in practice on open discussion of issues and feasibilities. Extreme
inequalities in matters of race, gender and class often survive on the implicit
understanding . . . that there is no alternative (Sen 1999, 287).
It will be difficult to remove discrimination against women and girls in societies that have a
long history of sex discrimination against women and girls. Getting these societies to
recognize that sexism is not inevitable will be a long struggle. People may not believe that
non-sexist arrangements are possible, even when they believe that they are desirable.
This discussion is pitched at the national level. Aiming this discussion at the national level
makes sense for several reasons. Many discussions of democracy have implied that the
national government should be a democratic government. National governments have the
most resources and are more able to prevent catastrophes such as famines. They are also
the most influential when it comes to enacting policies that affect everyone, such as health
care and education. State and local governments act within that context. They may not be
allowed to have their own policies in some areas. They also will not have the resources to
respond to some problems.
Even though it makes sense to have this discussion at the national level, there is an
international dimension to consider. The practice of democracy in the United States has
worldwide implications. For example, U.S. trade policy affects virtually every other nation and
their citizens. From the point of view of democracy most writers consider it desirable for
people to have a voice in those affairs that affect them most. If the policies of the United
States affect the citizens of Gambia to a great degree, how are government, businesses, and
other institutions in the U.S. supposed to take into account the views of Gambians?
Gambians do not vote in U.S. elections. Democracy can work to unite a nation behind a set of
policies that benefits its citizens at the expense of the citizens of another nation. Dissident
citizens can try to make other people aware of this, with varying degrees of success. Often
these implications are brought to light only after the fact.
Sen is also aware of the problems of the reach and effectiveness of public discussion. Open
public discussion has played a key role in reducing fertility rates in some areas of the world,
but a proper understanding of economic and other needs depends crucially heavily on public
discussion and debate:
Public debates and discussions, permitted by political freedoms and civil
rights can also play a major part in the formation of values. Indeed, even the
identification of needs cannot but be influenced by the nature of public
participation and dialogue (Sen 1999, 158).
Public discussion helps society determine what a need is and what is not. The cultivation of
this kind of public discussion helps democracy work well. According to Sen, a more informed
and less marginalized public discussion of environmental issues would help both the planet
and democratic practice.
Sen captures some of this international concern in a recent article on John Rawls. Rawls
aimed his idea of the original position and the construction of a just society at the national
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level. When Rawls first proposed the idea of the original position, the veil of ignorance was
supposed to remove individual bias from the contractual exercise of setting up a just society.
In the original position, people would not know what positions they would hold in the society
they constructed. They would also be ignorant of the comprehensive doctrine or ideology
they would hold in the society they constructed. Rawls defines a comprehensive doctrine as
a religious, moral, or philosophical outlook that generates a particular conception of the good,
which is expressed by the people who believe in it. Rawls argues that the fact that one person
occupies a certain social position is not a good reason for others to accept a conception of
justice that favors those that occupy that position. If one person holds a particular
comprehensive doctrine, this is not a good reason to propose a social structure that favors
that doctrine, nor is it a good reason to get others to accept a social structure that favors that
doctrine (Rawls 1993, 24). Rawls original position is pitched at the national level, a closed
society having no relations with other societies (Rawls 1993, 12). Rawls justifies this on
grounds that it enables us to examine important questions free from distracting details. Rawls
says that a political conception of justice will need to address the just relations between the
peoples of different societies. He terms this the law of peoples (Rawls 1993). However, he
sticks to the national level in Political Liberalism.
Sen brings in the problem of international relations, or the relations between societies in his
paper Open and Closed Impartiality which appeared in the Journal of Philosophy in 2002.
Sen asks whether the impartial assessment of a state of affairs or a proposed state of affairs,
is limited to a fixed group. Rawls clearly answers yes it is, and the fixed group is a group of
national citizens. Rawls recognizes the importance of international relations but leaves it
aside until problems at the national level can be worked out. Sen points out that limiting the
group in this way is not always successful. Thus when the group is limited, this reflects closed
impartiality. Sen shows that for closed impartiality, the procedure of making impartial
judgments invokes only the members of the focal group itself (Sen 2002, 445). Rawls
original position is one example of closed impartiality. No outsider is involved in deliberations
or construction of the just society. While Sen admits that this is useful for eliminating
individual biases within the focal group, he points out:
But even under the veil of ignorance, a person does not know that she
belongs to the focal group (and is not someone outside it), and there is no
insistence at all that perspectives from outside the focal group be invoked. As
a device of structured political analysis, the procedure is not geared to
addressing the need to overcome group prejudices.
In contrast, the case of open impartiality, the procedure for making impartial
judgments can (and in some cases must) invoke judgments inter alia from
outside the focal group (Sen 2002, 445-446).
According to Sen, a new device is needed, and for this Sen turns to Adam Smiths impartial
spectator who is not necessarily part of the focal group. Open impartiality requires that the
views of others receive adequate consideration whether or not they are members of the focal
group. The advantage of this is that it can take into account views that reveal group prejudice
and bias (Sen 2002, 446).
Sen strengthens his case by arguing that there are three basic weaknesses of closed
impartiality. These are procedural parochialism, inclusionary incoherence, and exclusionary
neglect. Procedural parochialism is the idea that closed impartiality can eliminate individual
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biases within the group itself, but does not address the limitations of partiality toward the
shared prejudices or biases of the group itself (Sen 2002, 447). Inclusionary incoherence is
the idea that decision by the focal group in the original position under closed impartiality can
influence the size or composition of the group. Sen sees the choice of population policy in the
original position as an example. Finally, there is also exclusionary neglect, where people
whose lives are affected by the decisions of the focal group are not included in the focal
group. Sen believes that this problem is not adequately addressed through multistage
procedures such as Rawls law of peoples. In other words, this would not be a problem if the
decision of the focal group affected only those within the focal group.
This discussion begs the question, What does the group consist of? If it consists only of
individuals behind the veil of ignorance, and you take the methodological stance that the
group consists only of the people or individuals within it, then by implication if you eliminate all
individual bias behind the veil of ignorance, then you must also eliminate group bias behind
the veil of ignorance. Put another way, can the group be prejudiced without prejudice on the
part of each member? In other words, if the veil of ignorance prevents people from knowing
anything about their personal characteristics and social and historical circumstances,
presumably this would include personal biases and prejudice. There is an emergent
properties problem here, for if Sen wants to advocate open impartiality as a remedy for
exclusionary neglect, we are left wondering where group biases would come from. Is this
something out of nothing? This distinction may be untenable; you are either impartial or not.
Sen seems to be suggesting an incomplete impartiality in this argument.
There is another problem. The discussion of inclusionary incoherence breaks down as well.
As I understand it, the membership of the group placed in the original position is fixed. They
debate and decide the form of society they would like to have, come to some form of
agreement (through some unspecified procedure such as majority rule or consensus), then
the veil of ignorance is lifted and they proceed to live their lives in accordance with the
agreement. It seems to me that by construction, the group behind the veil of ignorance is
fixed, so that decisions by the group will not affect the size of the group. This cant hold in real
societies, since government policy affects economic and population growth though areas
such as health care and immigration policy.
These contractual exercises rest on the ability to justify decisions to other people. The focal
group accepts or rejects proposals made by its members. Sen sums it up by writing:
Judgments of justice cannot be an entirely private affair unfathomable to
others and the Rawlsian invoking of a public framework of thought which
does not in itself demand a contract is a critically important move (Sen
2002, 456).
There is a great deal of openness left here. Agreements may not cover all situations, and
certain principles can be accepted in such a public framework if these are judged to be
plausibly just or at least not manifestly unjust.
The question is whether an agreement that arises from a public framework of thought can
cross national or political boundaries. Sen believed that it can, and argues that there is no
reason that communication and public engagement can be sought and found only inside
these boundaries. The impartial spectator may draw on any perspective. This is critically
important for Sen especially in light of terrorism. It becomes imperative that nations strive to
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understand one another in order to address this international problem. This requires
communication and public engagement which highlights the role of the media and the press.
These are the institutions that present information to the citizens, so the structure of these
institutions plays a key role in decisions about the amount and kind of information that is
presented to citizens, and then used to make decisions.
If these difficulties beset idealized exercises, imagine the same problems in democratic
practice in the real world. Procedural parochialism and exclusionary neglect will be hard to
separate. Inclusionary incoherence will affect population and its composition directly, and
through the structure of the media. It will shape the structure of the media, which will in turn
shape the structure of the discussion of any problem, including media structure.
Section III: Methodology

As admirable as Sen is for broadening the discussion of economics to include ethics and a
more realistic conception of the person, something is still a bit off. His focus on individuals
prevents him from paying adequate attention to other forces at work. As shown above, he
does not ignore many of these issues. There is a question of whether Sen can really be
classified as a methodological individualist. It certainly seems that way given his focus on
capabilities and functionings. However, it could be argued that Sen uses capabilities and
functionings as the most important evaluative space to measure how well policies and
decisions work. This is conceptually distinct from using methodological individualism as a
basis for investigating society and economics. If this is true, it seems that Sen himself has not
been all that clear about issue himself, which has led to some confusion for his readers,
including me.
Nonetheless looking at other forces is warranted and useful. According to Nuno Martins
(2006; 2007) Sen has engaged in explicitly ontological theorizing, with his main focus on the
nature of capabilities and functionings themselves and their usefulness as an evaluative
space. People exercise these capabilities and functionings with varying degrees of success.
This success depends on many factors which Sen has described, particularly in Development
as Freedom (1999).
These capabilities and functionings take the role of causal powers, according to Martins
(2006). Martins argues that the capabilities approach uses an open system characterization of
the social world, so that these causal powers do not have direct and obvious links with
observed outcomes. Capabilities are potential causal powers that may or may not be realized
or achieved. If achieved, they become functionings. These functionings arise as a result of
underlying biological, psychological, or social structures. Specifically, Martins writes:
Capabilities, like causal powers in general, are not actualities they are
potentials that may or may not be exercised and / or actualized. And similarly
to causal powers, capabilities arise by virtue of underlying biological,
psychological, or social structures which facilitate or constrain a particular
achievement or functioning (Martins 2006, 678).
This is a specific instance of invoking a structure to explain an outcome. The structure
facilitates a persons ability to learn to read, so over time we observe that Jim is literate. The
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structure may affect people differently because of their location within it. Positions on the
ladder of the distribution of wealth and income come to mind.
What seems to be missing from Sen is a specific description of the influence of structures of
any kind on capabilities and functionings, with two huge exceptions: famines and the
treatment of women. But with respect to democracy we have generalities. We are given
warnings that democracy is effective only insofar as people make good use of it. The ability to
make good use of democracy depends in turn on the institution of the press and the media
and its position between the people and the government. What might lead people to make
better use of democracy, assuming its existence? This is a specific question that might be
answerable using Sens methods.
However, Sen may be under elaborated here. According to Martins, Sen uses several
ontological categories. These are freedom as measured by capabilities and functionings,
structure, process, interconnectedness and diversity (Martins 2007). However, Martins argues
that people do not exist in a steady state. People grow, develop, and change. This process
cannot be explained in terms of static categories like capabilities and functionings. We need
institutions to help explain process. Most people do not learn to read on their own. That takes
schools, which themselves evolve over time as people act on and within them, which in turn
affects how well people can makes use of democracy.
Sen has stressed the intrinsic and instrumental importance of democracy. He views
democracy as absolutely essential for maintaining personal freedom. He has also stressed
that political freedom is important once it has been achieved, since it contributes directly to
freedom and indirectly to the achievement of other goals. The effective use of political
freedom can vary. How does democracy actually work, and what is the role of the press and
free expression in how democracy works? These concrete questions demand concrete
answers. These answers will differ over time because societies change.
What are the issues that confront a democratic government? Start with the idea that
democracy is the idea that the power of the government flows from the people. According to
Steven J. Wayne, there are three criteria used to measure how well democracy works. First is
the problem of how the government represents and responds to the public. Second is the
problem of the rules of how the government operates and makes policy decisions. Third is the
problem of actual policy and its impact on society (Wayne 2004, 3). A government is
considered to be more effective if it is more representative of the population, and if social
needs, public inputs, and policy responses mesh together well (Ibid.)
Wayne also points out that democratic governments exist to protect certain core, basic
values. The first set of values is life, liberty, and self-fulfillment. The second core value is
political equality. This includes equal treatment under the law and equal opportunity to
express their view through words, actions and votes. Wayne recognizes a practical problem
here, writing:
Citizens with greater resources have a better chance of being heard and
getting their way. The freedom to spend ones resources to influence who is
elected to government and the policy decisions made by that government run
counter to the principle that everyone should exercise equal influence
because everyone is of equal worth (Ibid., 4).
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Thus tension exists between liberty and equality, and Wayne argues that it should be
resolved in a way that benefits society as a whole. Wayne terms this the collective good and
for him it represents the third pillar of democratic government.
In light of these concerns, Sen discusses the role of the press and media in his 2009 work,
The Idea of Justice. He candidly acknowledges that for democracy to work, a free and
independent press is crucial for several different reasons. These are not necessarily unique to
Sen, but they are important. Sen notes that free speech in general and a free press in
particular directly improves the quality of life. Primarily this involves the exchange of
information. Sen is concerned with government suppression of information here. He argues
that diminished press and media freedom directly erodes the quality of life even if
. . . the authoritarian country that imposes such suppression happens to be
very rich in terms of gross national product (Sen 2009, 336).
He further acknowledges the informational role played by the press through specialized
reporting such as on cultural or business affairs. It is important because it keeps people
informed about what is happening in their communities and around the world. He says:
investigative journalism can unearth information that would have
otherwise gone unnoticed or even unknown (Ibid.).
Sen also values the protective function of the press. He lists the ability to give voice to the
neglected and disadvantaged. The rulers of a country he writes, are often insulated, in
their own lives from the misery of the common people. They can live through a national
calamity, such as a famine or some other disaster, without sharing the fate of its victims
(Ibid.). Yet if they have to face public scrutiny through the combination of valid elections with
a free and uncensored press, the rulers can be held accountable, or be forced to pay a price
too in Sens words. The idea is to subject the government to some kind of accountability to
either prevent such things or to insure a more adequate response.
Sens discussion of the actions of Ian Stephens in October of 1943, editor of the then British
owned Statesman of Calcutta is revealing here. It shows both the limits and the promise of a
journalism structured in a particular way. According to Sen, during the famine of 1943:
The Bengali Newspapers in Calcutta protested as loudly as government
censorship permitted it could not be very loud, allegedly, for reasons of the
war and fighting morale. Certainly there was little echo of these native
criticisms in London. Responsible public discussion on what to do began in
the circles that mattered, in London, only in October 1943, after Ian
Stephens, the courageous editor of the Statesman of Calcutta (then British
owned) decided to break ranks by departing from the voluntary policy of
silence and publishing graphic accounts and stinging editorials on 14 and 16
October (Sen 2009, 341).
Public relief began in Bengal in November of that same year and the famine officially ended in
December, both because of a new crop and the relief that was now more widely available
(Sen 2009, 341). The press is often not as free as we might like to think even if official
government restraints do not exist. In this instance, Mr Stephens was under intense pressure
not to publish. That pressure may have prevented Mr Stephens from acting before he actually
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did. Had those pressures not existed, such as NOT being in the midst of WWII, Mr Stephens
(and other journalists) would have been freer to publish those accounts sooner than they did,
and saved more lives.
Fourth, open discussion leads to the formation, acceptance, and possible change of values.
He writes:
New standards and priorities (such as the norm of smaller families with less
frequent child bearing, or greater recognition of the need for gender equity)
emerge through public discourse and it is public discussion, again, that
spreads new norms across different regions (Sen 2009, 336).
The give and take between majority and minority rights in this context is correctly highlighted
by Sen, reflecting the emergence of relatively tolerant values and practices (Sen 2009, 337).
The formation and acceptance of values will depend crucially on the structure of the press
and the media itself. This is tremendously important, and I will return to this idea below.
The fifth reason is the general idea that the press and media have an important role to play in
facilitating public reasoning in general. Many scholars view the pursuit and assessment of
justice as involving discussion among different people, with different interest and points of
view. Though Sen views individual capabilities and functionings as the proper space for
evaluation, Sen acknowledges the importance of institutions in a sense, writing:
The many sided relevance of the media connection also brings out the way
institutional modifications can change the practice of public reason. The
immediacy and strength of public reasoning depends not only on historically
inherited traditions and beliefs, but also on the opportunities for discussion
and interaction that the institutions and public practice provide (Sen 2009,
337).
Such traditions and beliefs are often invoked to explain the poor quality of public discussion
and press freedom in some areas, but Sen argues that authoritarian censorship of the press,
suppression of dissent, and banning and jailing opposition parties and candidates provides a
better explanation (Sen 2009, 337). Not surprisingly, Sen thinks that removing these barriers
is a crucial contribution of democracy to the attainment and assessment of justice.
The press and the media can fulfill its important role with respect to Waynes three aims and
Sens five reasons supporting a free press to a greater or lesser extent. Consider the first, the
way the government responds to and represents the public. Obviously the press plays a key
role here. The press and the broader media are institutions that occupy a place between the
people and the government. The government itself is obviously an institution. Hamilton writes:
The social framework, within which economic activity takes place, shapes
and molds economic activity. In other words, economic behavior is looked
upon as institutionally conditioned behavior. But the most important common
point of agreement of all these intuitionalists is that institutions are modes of
social organization. They represent a way of order. These models of
organization are subject to change as man faces new problems and new
needs (Hamilton, 2004 [1970], 76).
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What becomes obvious is that we now have a society in which people organize their affairs
and develop institutions to help them. These institutions both shape what people think and
how they act, and this in turn can lead people to makes changes in these institutions. This of
course depends on the values that a society and its people hold, and press and media
discussions can shape and change those values.
Section IV: Media ownership

In the previous section, I have summarized the three basic core functions of government
according to Wayne, and the five important reasons to support a free and independent press
according to Sen. It is possible to categorize both as being in the public interest in some
sense. However, the difficulty is that the press and the media in general can play a key role in
actually defining the public interest. since this falls under the ability to formulate and
advocate for the acceptance of values. The public interest is likely to be multidimensional.
Lawyer and Economist Howard Shelanski divides the public interest into two possible
aspects. The first is a so called efficiency model. Here the media is structured so that the
media can better satisfy consumer (reader?) preferences. However, the democracy model of
the public interest implies that the media should be structured so as to allow the public access
to diverse points of view and to allow informed discussion of public issues.
We already run into problems here. One, these goals are not always mutually compatible.
Two, if the press and the media have a role in the formation of the preferences and the values
of people and a society, then preferences and values can change so that efficiency in the
efficiency model becomes a moving target. Three, the ownership structure of the media and
the press becomes a vital public issue about which the public ought to be informed under the
protective function and open discussion function. Robert McChesney writes that the
problem of the media is really two problems. One is the content of the media itself. The
second is the policies, structures, subsidies, and regulations that are responsible for the
nature of the media system as it exists today (McChesney 2004, p. 16). He points out that the
media in the U.S. today is the result of an evolutionary process, which narrowly resulted in the
medias current commercial structure (McChesney 2004, Chapter 1).
The possible influence of the ownership structure at this point is best illustrated by example.
Legal scholar Edwin Baker argues that the press clause of the Constitution is vital to
maintaining democratic discourse in the U.S. He remarks that a theory of democracy will be
needed, and that this will entail a corresponding structure for the media and the press, which
has implications for the freedom of the press. If there are failures, are these caused by
inadequate training of journalists and editors, or are there deeper structural problems that
have to be addressed at a different level? Which means, according to Baker:
These questions implicate central issues of First Amendment theory.
Agreement on two abstractions-that democracy requires a free press and that
the First Amendment protects a free press-is relatively easy. But what
constitutes freedom of the press? That question cannot be answered without
understanding the role or purpose of the constitutional guarantee (Baker
1998, 318).
Baker goes on to outline four theories of democracy. These are elitist democracy, liberal
pluralism or interest group democracy, republican democracy, and complex democracy. In the
elitist model, government tackles complex problems that require expert guidance. Most
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people have neither the time nor the talent to be involved in every aspect of governmental
decision making, so electing representatives to do this for them seems to be a practical
solution (Baker 1998, 320-322).
Baker views liberal pluralism or interest group democracy as one version of popular
participation. Here, theorists view politics largely as conflict and partial resolution between
different groups that have different interests. There needs to be a way for government to
respond fairly to the different concerns of each group. Institutions should be designed to help
create fair bargains or compromises between each group (Baker 1998, 323-331).
Republican ideas of democracy accept some of the premises and concepts of the liberal
pluralist theorists, but differ in important respects. For one, where liberal pluralists seem to be
arguing from the premise that interest groups cannot put aside their differences and act for
the common good, republican theorists argue that they can. People and groups can have a
conception of the common good and be concerned with the welfare of others. Second, group
and individual interests emerge from their own efforts to formulate values and act on them.
People and groups have to gather information to be able to do this, so that their political
concerns and actions are or believed to be much more public spirited and community oriented
than in the liberal pluralist view.
Bakers idea of complex democracy incorporates ideas from each of the other three
theories. Baker agrees with the elitist tradition in that government often addresses very
complex problems that require expert guidance to address properly. Problems and their
potential solutions will be advocated by different groups, which will make bargaining and
compromise necessary a liberal pluralist idea. Each person and group gathers information
and acts on the values they from and embrace, but they can set these aside in the public
interest if this if they choose, which reflects the republican idea of a public realm that is used
for the formulation and pursuit of the common good (Baker 1998, 325-339).
Clearly, the protective function of the press is key to all of these theories of democracy. Each
one has particular implication for media regulation by the government. Note the feedback loop
here. Government has some responsibility for media regulation, which can enhance or impair
the flow of information which can enhance or impair the protective function of the press, which
can enhance or impair the responsiveness of government to political pressure on issues like
wait for it - media reform. Adherents of complex democracy fear that the watchdog/protective
function could be undermined by either government or private power. (For fears about
government power, see Compaine 2002, and Djankov, McLeish, Nenova, and Schleifer 2003.
For fears about private power, see McChesney 2004, Clark, Thrift, and Tickell 2004, and
Miller 2002. For an article that incorporates both fears, see Motta, Polo, Rey, and Roller
1997). People fear that market segmentation or monopolization will undercut effective
discussion. People also fear that a pluralist media will be strongly biased toward propaganda
and mobilization, so much so that it will not add to the thoughtful discussion and informed
debate about the issues.
All of this implies a particular structure for the media and the press. Policy in the media realm
will have several functions for adherents of complex democracy. One, the strongest media
order will not depend only on a single form of organization. Two, the media will perform
different functions so it cannot possibly be organized in a uniform way. Think about the
difference between the broadcast, cable news, and major daily newspapers on the one hand,
and newsletters for particular groups like the National Rifle Association or the Union for
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Radical Political Economists on the other. Three, government policy should seek to support
other types of media organization that would operate alongside the private, market oriented
sector. Four, the amount of government support, if any, should depend on how distorted or
underdeveloped a particular sector is. Five, the nature of government support should depend
on the function of the media type being subsidized. All of this with a view toward establishing
a mixed media that is partially market driven, partially not, so that the media will be able to
better perform the watchdog function better than a purely market oriented structure (Baker
1998, 386).
Bakers discussion of market failure through public externalities in the provision of information
makes this kind of reform all the more important. It is a remedy to the under-provision of
information that the media would provide in a purely private market setting. He cites the
presence of advertising as a potential corruptor of public discourse. This is not a universally
held belief, and Daniel Sutter 2002 provides a fairly well thought out contrasting view.
Second, Baker argues that the public discourse or common discourse products will have a
competitive advantage over smaller, pluralistic outlets mainly because of high initial costs of
production, and relative ease of duplication. The implication is that:
Both economic and democratic theory however, predict that pluralistic
media, especially those designed for comparatively impoverished groups, are
likely to be especially underdeveloped and ought to receive special public
support. Still, as a practical matter, the key principle for complex democracy
is to pursue an opportunity to further government support for new, noncommercial forms of media discourse. Secondarily, it should support policies
that reduce advertisings corrupting effects (Baker 1998, 387).
One need only note the tension between this view as described by Baker, Rawls original
position and Sens identification of group bias in that context as detailed in a previous section.
Another illustrative example is provided by the American Journalism Review that highlights
the possibility of advertisings corrupting effects. Shepard 1994 details an instance of the
influence of advertising on the news. According to Shepard, in May of 1993, the San Jose
Mercury news printed a guide showing how to read an auto dealers invoice and negotiation.
Local car dealers were not happy and about 40 dealers pulled their display ads, costing the
newspaper about $1 million in revenue (Shepard 1994). The reporter, Mark Schwanhausser
offered tips such as relying on the dealers invoice and not just what the salesperson said, and
he quoted the author of a book on negotiating who suggested that one reason God gave you
feet was so you could use then to walk away from car salesmen (Shepard 1994). The paper
issued an apology, but the ad. boycott continued and did not end until the paper began
running a full page house ad. that described 10 reasons why you should buy or lease your
nest new car from a factory authorized dealer. That soothed many, but a few did not return
(Shepard 1994).
However, the problem may be deeper, and this points to the structural issues that Baker
alludes to above. Shepard talked to Ronald Collins, a George Washington university
professor of law who studied advertiser attempts to shape media coverage, who said he was
surprised the story ran in the first place: Usually, the editor will kill that kind of story or the
reporter knows certain areas are no nos. Schwanhausser highlights the same idea from the
reporters point of view, saying:
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The publisher has ideas about how he would have done the story differently,
and I have ideas about how I would respond to this boycott differently. But the
boycott isnt really over my story. Thats tunnel vision. Larger financial and
journalistic issue are at the heart of this (Shepard, 1994, my italics).
Miller 2002 adds some additional insight. He notes that there will be ethical dilemmas in
journalism as the media concentrates. Miller contends that ethics must be modeled and
practiced by those at the top of media conglomerates. Miller acknowledges that the process
of conglomeration can have either positive or negative impacts on the ethical practice of these
new media giants and other corporations. As a result, practicing journalists increasingly find
that they occupy the bottom rung of the corporate hierarchy, and increasingly have to balance
the ethics of journalism with the pressures that arise when news organizations are part of a
media or other conglomerate.
Benjamin Compaine 2002 makes some further points that need to be considered. One is that
many current media critics and reformers are wedded to an ideal vision of the media and the
press that never has existed and never will. With respect to the idea that corporate ownership
is killing, or has killed, hard hitting journalism, Compaine writes:
A bright red herring. When exactly was this golden age of hard-hitting
journalism? One might call to mind brief periods: the muckrakers in the early
20th century or Watergate reporting in the 1970s. But across countries and
centuries, journalism typically has not been hard-hitting (Compaine 2002,
22).
Compaine further argues that ownership may not matter now the way it once did, such as in
the case of William Randolph Hearst, William Loeb, and Robert McCormick, each of whom
had political agendas that then permeated their papers (Compaine 2002, 22). Corporate
ownership may have driven out family or personal partisanship in the U.S. a while ago, and
Compaine claims that that shift is doing so now in Latin America, at least as of 2002. Again,
Compaine:
As Latin American media shift from family owned, partisan media to
corporations, observes Latin America Media Scholar Silvio Waisbord, the
media become less the public avenues for the many ambitions of their
owners, and their coverage of government corruption is more likely to be
informed by marketing calculations and the professional aspirations of
reporters. This trade-off may not be bad (Compaine 2002, 22).
And it may not change anything. A shift from family ownership to corporate ownership would
likely still largely reflect the concerns of the upper classes of that society. Think marketing
calculations and professional aspirations of reporters. Since Compaine mentions Brazil, we
could look at what Reporters Without Borders has to say about that country with respect to
their index of press freedom. In 2002, Reporters Without Borders ranked Brazil at #54 out of
154 countries. It fell to 84th of 164 countries by 2007, but this was not a steady decline. Brazil
jumped to 82nd of 168 countries in 2008, then climbed steadily to #58 of 173. There was a
large fall to 108th of 178 countries by 2012, a fall to #111 of 180 countries by 2014, and a
climb to 99th of 180 countries in 2015. But media ownership and legal protections of
journalists continue to be a problem, despite the enactment of an Internet Civil Framework
Law:
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The safety of journalists and the concentration of media ownership in few

hands nonetheless continue to be major problems. Many acts of violence
against journalists occurred during a wave of protests in Brazil. A human
rights secretariat report in March 2014 on violence against journalists
emphasized the involvement of local authorities and condemned the role of
impunity in its constant recurrence (Reporters Without Borders,
https://index.rsf.org/#!/index-details/BRA).
Media ownership and structure is a vital concern for a free press and media. Reporters
Without Borders is correct to be concerned with government ownership and interference with
the press and the media overall, as are most scholars. Overt censorship becomes a
paramount concern in these cases. However, the ownership structure matters for privately
oriented and commercial media structures as well. If advertising continues to be a big source
of revenue for press and media outlets, there will be continuing tensions like that faced by the
San Jose Mercury News in the early 1990s. This tension is well captured by McChesney and
Nichols, who write in the preface of The Death and Life of American Journalism:
We demonstrate in this book that the entire press system of the United
States was built on a foundation of massive federal postal and printing
subsidies that were provided to newspapers during the many decades that
forged the American experiment. The first generations of Americans
understood that that it was entirely unrealistic to expect the profit-motive to
provide for anywhere near the level of journalism necessary for an informed
citizenry, and by extension self-government, to survive (McChesney and
Nichols 2010, xiii).
Media and press ownership matter. Private ownership and the organization of the press as a
for-profit business will shape the news in an indirect manner, through ethics (as highlighted by
Miller 2002), and framing.
Section V: Frames
Framing is at best a difficult idea to pin down. Obviously that presents a problem if it is going
to be used as an analytical category. That said, the use of the terms frame and framing have
found wide use in the social sciences literature. Entman 1993 offers a very useful synthesis of
the term. He starts with a basic definition:
Whatever its specific use, the concept of framing offers a way to describe the
power of a communicating text. Analysis of frames illuminates the precise
way in which influence over a human consciousness is exerted by the
transfer (or communication) of information from one location such as a
speech, utterance, news report, or novel to that consciousness (Entman
1993, 51-2).
If it is not already apparent, people need to be aware that a frame in this sense can exist in
the mind of the author of the text and can be reflected or captured in that text, and a frame will
also exist in the mind of the receiver of the information. These do not necessarily have to be
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consistent with one another. Entman identifies a fourth location for a frame the culture, from
which the communicator, the receiver and the text may draw. More specifically:
Framing essentially involves selection and salience. To frame is to select
some aspects of a perceived reality, and make them more salient in a
communicating text, in such a way as to promote a particular problem
definition, causal interpretation, moral evaluation, and or treatment
recommendation for the item described (Entman 1993, 52, emphasis in
original).
Entman further notes that frames perform four functions. They define problems, diagnose
causes, make moral judgments and suggest remedies. He uses the Cold war as an example
of a frame used by the press in foreign policy reporting up until around the time of the fall of
the Berlin Wall. For a cold war frame the press highlights certain events as problems, like
civil wars, then identified the source as communist rebels. Further, the press made moral
judgments that rebels are atheist aggressors and a threat to the American way of life, for
which the solution is American intervention in support of the other side (Entman 1993, 52).
Entman is using culture in a unique way. It is the stock of commonly invoked frames, which
for him leads to the definition of culture as the empirically demonstrable set of common
frames exhibited in the discourse and thinking of most people in a social grouping (Entman
1993, 53). After having defined culture thusly, one can ask the obvious question about how
those frames come to be, come to be shared, and how they come to be accepted.
Communication conveys information, but usually the communicator and receiver have some
form of common referent starting with language. Since humans also have tendency to
understand things through the use of narrative, people need to make choices about how to
present the information they wish to convey. Less obvious are the choices they make when
they receive information. The importance of the media and press grows once we recognize
the ability of the press and media to both present information and select the frame in which it
is conveyed to citizens, and the ability of citizens to interpret this information in light of their
own frames.
Frames may operate on at least two different levels. One is captured by Entman. The other
is captured by the idea that question wording changes survey responses. A recent work that
examines the impact of money on politics by Martin Gilens reveals both. He makes two points
with respect to surveys. First it is possible that different wordings do not really capture
identical concepts, so that the people in the survey cannot be said to have changed their mind
only based on the way the questions are phrased. Gilens points out that in numerous surveys
of U.S. citizens the phrase assistance to the poor elicits responses much more sympathetic
to the poor than does the phrase welfare. Gilens raises the idea that respondents typically
understand welfare as cash assistance to the able bodied working adult. By contrast,
assistance to the poor can include subsidized medical care, housing subsidies legal aid, job
training and a number of other programs. If this is the case, the negative impact of welfare
as opposed to assistance to the poor should be understood as:
. . . not as a superficial response to an emotionally laden term, but as a
sophisticated differentiation between kinds of government antipoverty
programs (Gilens 2012, 33).
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Different wordings for a question at the specific level may reveal different understandings at
the contextual or cultural level.
As Entman points out, frames affect the salience of information presented in any piece of
communication. But:
The word salience itself needs to be defined: It means making a piece of
information more noticeable, meaningful, or memorable to audiences. An
increase in salience enhances the probability that receivers will perceive the
information, discern meaning and thus process it, and store it in memory
(Entman 1993, 53).
Since we are talking about interactions here, a choice to highlight certain information by
repetition or placement may not make this information salient to the reader, if it seems to
conflict with the readers own frame(s). Conversely, an idea that is buried in part of a text or
other communication can be received as highly salient if it happens to be consistent with the
frame(s) used by the audience.
There are very important implications for political reporting:
Frames call attention to some aspects of reality while obscuring other
elements, which might lead audiences to have different reactions. Politicians
seeking support are thus compelled to compete with each other and with
journalists over news fames (Entman 1989, 55).
Entman describes four implications for both political reporting and wider communications
issues. One is audience autonomy and dominant meaning. By dominant meaning Entman
means that it comprises the problem, the cause(s), the ethical judgment or evaluation, and
solutions that are the most likely to be noticed and accepted by the most people. In other
words, if a text or piece includes mutually reinforcing elements that suggest that a glass is half
full, it is very unlikely that the audience will reframe the information to construct for
themselves the message that the glass is half empty (Entman 1989, 56). Two, even though
working journalists may follow the established rules to maintain objectivity, they may still
convey a dominant framing of the news or information that prevents most of the audience
from assessing a situation in a balanced way. Because reporters have no common
knowledge of framing, they are susceptible to very skillful media manipulators who impose
their dominant frames on the news (Entman 1989, 56-57). Reporters would need to be
educated on the existence and effects of framing to enable them to report and construct news
that makes two or more interpretations salient to the audience. This is much more than
reporters are now called on to do, but according to Entman it would result in a far more
balanced reporting than the current norm of objectivity. Three, content analysis would
become focused on identifying frames, which would then avoid treating all positive or negative
messages as equally important. Without framing, Entman reasons that analysts wont pick up
on the differences between the audience frames and the authors. Four, political elites may
control the framing of issues, in which case the ability to frame and have that frame accepted
would become a central power in a democratic country. The implication is that if the frame
can be manipulated, true public opinion could be impossible to find. At the very least, Entman
contends that considering the idea of framing allows a critical examination of the frames used
by politicians, audiences, and reporters. Thus, frames are an avenue by which the public can
influence the government, BUT the government could also influence the public. It is this
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symbiotic relationship between the media, the government, and the public that Sen does not
consider as much as he should.
The link between ownership structure and framing now begins to emerge. A government
owned or dominant media would frame issues differently from a private one. So much so that
Djankov et. al (2003) argue that a purely government owned media will not frame issues so
as to fulfill a public choice framework that cures market failure. Instead, they find that
government ownership tends to undermine political and economic freedom. This suggests
that the frame for government owned media might be The government is good, and
anything the opposition does to hinder the government is bad. However, the San Jose
Mercury News example discussed above suggests that there are market failures in the
provision of information, which Djankov et.al. acknowledge, but which neither a government
owned nor privately owned media might cure. The San Jose example is suggestive both the
newspaper and the dealerships were operating as businesses, and both accept the overall
idea that business is a morally laudable institution. At the risk of reading too much into the
example, the fact that the paper published a guide on negotiating with dealerships implies a
judgment about both the audience and the dealerships. The dealers picked up on the idea
that when the paper did this, it was implicitly endorsing the idea that car dealerships were
untrustworthy (Shepard, 1994). It also implies that the paper made a judgment that its readers
could benefit from the guide.
Murray Edelman, in pieces spaced roughly thirty years apart, suggests an idea that could be
used to explain the pattern of information in both a private and government system. Edelman
in his book The Symbolic uses of Politics (1964), explores the idea of politics as a symbol that
confers intangible benefits to groups of people as opposed to a rational exercise of resource
allocation and problem solving. It is clear that governments do engage in resource allocation
and problem solving, so that Edelman is not saying that the symbolic and the resource
allocation functions are mutually exclusive. For his idea to be coherent, these ideas have to
coexist. An important theme in this work is that there is a disconnect between what
governments are reported to do both legislatively and administratively in the press, and what
governments are actually doing.
Edelmans conception stands in direct contrast to the idea that the press and the media
adequately fulfill the informative and protective functions necessary for a working democracy.
In this, Edelman highlights the crucial aspect of the audience of the press and media, and
thus why ownership forms become a central consideration. In most ideal models, the press
supplies information to a public that will analyze those ideas and make considered political
judgments about the best policy to address some problem. But, Edelman writes:
The mass public does not study and analyze detailed data about secondary
boycotts, provision for stock ownership and control in a proposed space
communications corporation, or missile installations in Cuba. It ignores these
things until political actions and speeches make them symbolically
threatening or reassuring, and then it responds to the cues furnished by the
actions and the speeches, not to direct knowledge of the facts (Edelman
1964, 172).
He concludes that widely reported government actions can often serve as a symbol that
quiets a perceived threat, so that the public becomes quiescent even if the problem has not
been addressed. The symbolic role of government action is to provide reassurance. This
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occurs through several avenues. Edelman points out that what people actually get from the
government is what administrators and legislators do, rather than the promises of the law,
oratory, or constitutions. Further, people assume or believe that what administrators do is
actually specified by laws reflecting the public will so that these actions are acceptable to the
public. In addition, since people cant really know what effect a law or policy will have in the
future, they will substitute personal meaning for impersonal, or intersubjective, or objective
meaning. They believe that officials have wider leeway to deal with problems than they
actually have. People will ally themselves with those who symbolically show that they can
deal with the problems, even apart from the actual result. Fourth, the achievement of a
political goal by some group leads to demands for more of the same kinds of benefits, rather
than contentment. Fifth, speeches gestures, and settings serve to limit peoples political
claims and maintain public order (Edelman 1964, 193-194).
In 1993, Edelman follows up with his article Contestable Categories and Public Opinion
which appeared the journal Political Communication. Here he points out that the choice of
analytical category by a news organization has far reaching consequences that are not often
analyzed. Those categories become broad frames which highlight some information and
exclude other information. Edelman analyzes several of these contestable categories such
as crime. He claims that most crime reporting is based on the prior belief or frame that crime
is driven by evil people who thrive on murder, mugging, and robbery. Thus, widespread public
support for tough crime control measures is widely reported and helps candidates who are
perceived to be tough on crime win public office to enact these measures. But Edelman
points out some problems with this. First:
At the same time it helps office holders win reelection and helps
conservatives defeat social programs. The facile evocation of inherently
criminal types conceals the link between an economic and social system that
denies large numbers of people the means to support themselves and their
families and their resort to illegal action. To break the law is in part a way of
surviving and in part a form of social protest, usually the only effective way for
people who lack money and status to express their anger at a social and
political system that keeps them poor and dependent (Edelman 1993, 234).
Edelman then shows how this becomes a self-fulfilling prophecy. Labeling large numbers of
people as innate criminals ensures that breaking the law will remain almost the only viable
option for survival. Further, this will remain the only avenue for political expression, . . .
reinforcing the controversial categorization and constructing an ever more vicious cycle of
cause and effect (Edelman 1993, 235). If reports of crime appeal to the audience and
increase circulation, subscriptions or viewership, the media outlet becomes a more attractive
place for advertising, based on the characteristics of the readers or viewers. Note also that
the innate criminal frame likely appeals to businesspeople who control advertising budgets.
The existence of crime as the product of innately criminal people is very simple to understand
and easy to use. It fits in one sentence that has direct emotional appeal to both audience and
potential advertisers. The idea of crime arising from social, political and economic conditions
is harder to convey and understand, especially if a sizable portion of the public think it
excludes the possibility of the innately criminal or evil. Again, audience considerations pay a
role in framing considerations.
Finally, Edelman points out that the framing for a contestable category often serves to
benefit the top layers of society at the expense of the bottom. If the press and media and the
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advertisers are both classified as businesses, they will share a common outlook on a number
of issues, though not all. I cannot summarize it any better than Edelman:
Each such label highlights some immediate, surface aspect of a
governmental policy while obscuring the close links among related policies
and related categories. The classification therefore misleads opinion about
the origins of problems, their effects, their scope, and effective remedies. At
the same time the conventional categories are effective in winning and
maintaining public support for established hierarchies and inequalities, as
discussed below (Edelman 1964, 233).
Gilens (1996) asks why the face of poverty in the U.S. is usually that of African Americas in
urban areas. According to Gilens surveys show that that the American public largely
overestimates the proportion African-Americans among the poor, and that these perceptions
result in greater opposition to welfare programs among the general public (Gilens 1996, 537).
The media routinely underrepresent segments of the poor, such as children and the elderly,
that might engender more sympathy from the general public, whereas working age adults that
happen to be unemployed are overrepresented. Gilens concludes:
But current misunderstandings may pose a greater danger: that whites will
continue to harbor negative stereotypes of blacks as mired in poverty and
unwilling to make the effort needed to work their way out. By implicitly
identifying poverty with race, the news media perpetuate stereotypes that
work against the interests of both poor people and African Americans (Gilens
1996, 538).
In another case, Ervand Abrahamian in 2003 sought to examine the way the U.S. news media
reported on the September 11, 2001 attacks on the World Trade Center and the Pentagon.
His basic claim is that the media by and large accepted the framing put forth by Samuel
Huntington in his book Clash of Civilizations. The result was that the media failed to discuss
the political issues of Palestine and general Arab Nationalism. Huntington has been criticized
for his idea of culture as a fixed rather than fluid concept by anthropologists and social
historians, but this did not prevent the mainstream U.S. media from adopting a clash of
civilizations framing of the issues surrounding the September 11 attacks. Abrahamian writes
that a cursory glance at the US media after September 11 leaves no doubt as to:
Huntington's triumph. The media framed the whole crisis within the context
of Islam, of cultural conflicts, and of Western civilisation threatened by the
Other. Even the liberal New York Times adopted this framework, and then
tried every so often to distinguish between good and bad Muslims, between
the correct and incorrect interpretations of Islam, and between peaceful and
violent understandings of the Koran. No doubt its editors would reassure us
that some of their friends-nay, even some of their op-ed writers-are Muslim.
Such nuances, however, are lost within the larger picture portraying the main
threat as coming from the Muslim world (Abrahamian 2003, 531).
In a later paragraph, Abrahamian details the fact that the political demands of Muhammad
Atta and the other hijackers were not released by the FBI nor discussed in mainstream media
outlets. This is important because, as Abrahamian explains, Al-Qaida had been
incorporating into its recruitment tapes highly charged scenes from Palestine (Abrahamian
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2003, 536). Scholars and commentators who raised the issue of Palestine, as opposed to the
Huntington frame, found that they were ridiculed and punished for raising the issue of
Palestine. Abrahamian gives three examples an unnamed Georgia congresswoman, an
unnamed Saudi prince, and British Prime Minister Tony Blair. By contrast, a number of British
and European outlets made explicit reference to the Palestinian problem in their reporting
regarding September 11 and its aftermath. Abrahamian quotes a few examples; here is a
sample:
David Hirst of the Guardian reported that Palestine was central to the crisis.
He added that, by citing Palestine, bin Laden had struck a resonating chord
with much of Arab opinion; and that even the resolutely pro-American King
Abdullah of Jordan had told the US he doubted New York would ever have
happened had it addressed the Arab-Israel conflict in a more serious, less
partisan, way' (Abrahamian 2003, 537).
Eric Rouleau, travelling through the Gulf, reported for Le Monde that the
consensus in the region was remarkable, and that all, from head of state to
the man in the street, insisted the issue of terrorism could not be addressed
without first dealing with the Palestinian-Israeli conflict (Abrahamian 2003,
537).
Fred Halliday argued in the Guardian that the crisis could be explained by
political tensions, especially over Palestine, rather than by nonsense talk of
clash of civilisations (Ibid., 538).
Abrahamian also raises the issue of conformity/acceptance of the views of the government.
He points out that where the U.S. media diverged from the European, it conformed to the
views of the U.S. administration. A number of scholars have decried the press reliance on
official sources for news reporting. Among the most prominent have been Robert
McChesney and Robert M. Entman (Entman 1989, McChesney 2004). The reliance on official
sources can potentially undermine the protective function of the press and the media which
almost everyone agrees is tremendously important.
Along these same lines, Herring and Robinson (2003) use Noam Chomsky as an example of
a scholar whose work is routinely ignored by mainstream media outlets. Chomsky has argued
that institutional filters exist both in the press and in academia to filter out non-elite
perspectives. Herring and Robinson conclude that Chomsky is largely ignored because the
institutional filters screen out people who focus on corporate power, who have a principled
opposition to U.S. foreign policy and the role of the academy in supporting corporate power
(Herring and Robinson 2003 553, 568).
Stories and events that challenge the accepted classifications and narratives will receive little
play in the mainstream press and media. They will instead be marginalized to fringe outlets.
Often, if these stories and issues and their authors do appear in mainstream outlets, it could
be to give the appearance of balance, or to expose dissenting viewpoints to ridicule couched
as serious discussion of the issues. If one accepts the idea made popular in the 1980s and
continuing today by Reagan and Thatcher (among others) that government is the problem
you now have a frame, or a prior belief, that since too much government regulation hinders
the operations of business and hinders economic growth you then have a justification for
deregulation in all policy areas. Proposals for government regulation in many areas will be
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dismissed out of hand because of the presumed efficiency of business and ineptitude of
government. Or because government is presumed to be inept, proposals to privatize many
public services will get wider play.
Section VI: Conclusion

For a functioning democracy people need transparent discussion of polices that affect them,
such as labor and capital market policy and media regulation. This is what the press and the
media is supposed to provide. But if the media is structured in such a way that certain
discussions are off-limits, people cant make informed judgments about the workings of the
labor market, the capital market, or the structure of the media and the press. If such limits
exist, then this conflicts with the ideal of democracy.
Policies that affect the labor and capital markets are critically important because these
markets determine the distribution of income. Thus, they heavily influence the kinds of
freedoms that people enjoy. Sens main focus has been on capabilities and functionings as a
space for the evaluation of well-being. Sen admits that caste and class can influence a
persons capabilities and functionings, thus their well-being. Martins (2006) characterizes
much of what Sen has done as a philosophical under laboring exercise, an ontological
clearing of the decks, trying to find out what exists, what is important and why. Sen selects
capabilities and functionings as the primary units of analysis. But the focus on capabilities and
functionings as situated within the individual has diverted attention away from some of the
social and irreducible, less individualistic, yet important aspects such as structure, process,
interconnectedness, and diversity. All of these social aspects are important to Sen, but his
discussion makes it easy to miss. They seem secondary to capabilities and functionings.
Sens ontological structure may be insufficiently developed in this regard. It also means that
Sen and many of his readers (including me) have failed to distinguish the evaluative space
that Sen uses, individual capabilities and functionings, from a more methodological concern
about the basis for investigating society and economics, which is where questions about
methodological individualism reside. If Sen is a methodological individualist, writers will have
to carefully distinguish the evaluative space from the methodological concerns. Sen argues
that freedom is tremendously important, and that freedom should be measured in the space
of capabilities and functionings. Process, diversity, structure, and interconnectedness emerge
as secondary elements of analysis. Sen discusses them because they have important effects
on the capabilities and functionings of individual people. This reflects a problem, in that while
Sen can be seen in some ways as a methodological individualist given his focus on
capabilities and functionings as part of a single person, Hodgson (2007) has pointed out that
the definition of methodological individualism is not at all clear. Some writers have taken
methodological individualism to mean that the proper focus of study is individuals and the
relations among them. For Sen, the choice to focus on capabilities an functionings which
enable individual people to live the lives they value, would seem to place Sen in the camp of
methodological individualism. But there is a difference methodological individualism is
typically regarded by its defenders as a scientific method by which the phenomena of a
society are explained in terms of the laws that govern the nature of an individual human
being. There is a difference between taking people as a focus of study with respect to ethics
and justice as Sen does, and taking them as the proper focus of study for a scientific inquiry
regarding the laws that govern both individual behavior and outcomes, and social behavior
and outcomes. At the very least, this ambiguity plays out in Sen since the ideas of process,
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structure, interconnectedness, and diversity might fall under the idea of the relations among
individuals.
A broader construction would allow capabilities and functionings to influence process,
diversity, interconnectedness and structure, and vice versa. Sen seems to be trying to
improve neoclassical analysis from within the tradition, since he still uses many of the same
tools such as constrained optimization, an individualist orientation, and the use of a welfare
framework that is largely inspired by classical and neoclassical economic doctrine. The
tension between the individualism of neoclassical economics and the framework of process,
diversity, interconnectedness, and structure still remains.
The process of the development of the media and the press in the United States reveals the
interconnectedness between the audience and the media. Depending on the perceived
success of the press and media in conveying the information necessary for citizens to have a
functioning democracy or for the press and media to make a profit leads to attempts to
change the structure of the media and the press. Often this involves government action,
revealing yet another connection between the audience, the press and the media, and the
government. Now the press and media convey ideas that affect the debate over the structure
of the press and media, and other institutions, like banks and the financial industry. The idea
of the structure of the media and the press has very important implications for diversity of
points of view. Almost everyone rightly acknowledges the danger of a purely government
owned press, but this is a tacit admission of the idea that the structure of the press and media
influence the flow of information which can either enhance or subvert democratic governance.
In practice this means that having a media structured as a private business which can be very
large presents its own dangers. For example, Robert McChesney writes:
Most dominant media firms exist because of government granted and
government enforced monopoly broadcasting licenses, telecommunications
franchises, and rights to content (a.k.a. copyright). Competitive markets in the
classic sense are rare; they were established or strongly shaped by the
government. So the real struggle is over whose interests the regulation will
represent (McChesney 2004, p. 19).
Deregulation in this context will mean government regulation that often enhances the interests
of dominant corporate players (McChesney 2004, 20). McChesney and other writers such as
Isaacs (1986) detail the historical emergence of a professional journalism and the constant
barrage of criticism that followed. The press and the media in the U.S. emerged through a
process of historical struggle, the outcome of which was not certain at the time. However,
McChesney notes that there are three planks that inform media debate to this day that
emerged early on in this struggle in the United States. First, the American Newspaper
Publishers Association (ANPA) took steps to ensure that coverage of the debates between
the press and its often socialist and union based critics in the 1920s were either not reported,
or slanted in such a way that it favorably portrayed the interests of the owners. Second, the
owners used the First Amendment freedom of speech clause to blunt regulatory proposals
that might interfere with commercial interests. Third, the ANPA called for self-regulation as the
appropriate response to big, concentrated private control of communication (McChesney
2004, p. 63). The ultimate result of the struggle is ably summarized by Entman (1989) in the
introduction to his book Democracy without Citizens:
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In essence, the dilemma is this. To become sophisticated citizens,

Americans would need high quality, independent journalism; but news
organizations, to stay in business while producing such journalism, would
need an audience of sophisticated citizens. Understanding this vicious circle
of interdependence reveals that the inadequacies of journalism and
democracy are the fault of neither the media nor of the public. Rather, they
are the product of a process, of a close and indissoluble interrelationship
among the media, their messages, their elite news sources, and the mass
audience (Entman 1989, p. 10).
We are confronted with a world that is in many ways open and complex. We build theories to
describe and explain what we observe in that world that are closed, since our minds are finite,
and we limit our theories and models to include only what we judge to be relevant information.
I am not sure that questions of open systems have implications for ideas of justice, but it
seems Sen may be sending out feelers in this direction. It is possible that ideas of justice
have evolved as societies have evolved, while we typically think of justice as a fixed ideal.
Although Sen explicitly discusses democracy, he neglects process, structure, diversity, and
interconnectedness when it comes to the media and the press. That means that there is also
an ontological shortcoming in Sen. Sen does discuss interconnectedness, diversity,
individuals, and process in some places, but do we have social class and institutions explicitly
considered? Or time? These are important questions since social class and institutions both
reflect and influence the ongoing interplay of people and their surroundings. It seems that Sen
is trying to reconcile an equilibrium framework with an evolutionary process, and I do not think
that this is possible. If complex systems have properties that cant be reduced to individual
components, then Sen could further modify his own framework to engage in substantive
theorizing along these lines.
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SUGGESTED CITATION:
John Jeffrey Zink, Amartya Sen and the media, real-world economics review, issue no. 72, 30 September 2015, pp.
69-95, http://www.paecon.net/PAEReview/issue72/Zink72.pdf
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A critique of Keen on effective demand and changes

in debt 1
Severin Reissl
[Kingston University, UK]

Copyright: Severin Reissl, 2015

Abstract
In a paper for the Review of Keynesian Economics, Steve Keen recently provided a
restatement of his claim that effective demand equals income plus the change in
debt. The aim of the present article is to provide a detailed critique of Keens
argument using an analytical framework pioneered by Wolfgang Sttzel which has
recently been developed further. Using this framework, it is shown that there is no
strictly necessary relationship whatsoever between effective demand and changes in
the level of gross debt. Keens proposed relation is shown not to hold under all
circumstances, and it is demonstrated that where it does hold this is due to variations
in the velocity of debt-variable he introduces. This variable, however, lacks
theoretical underpinning. The article also comments on Keens proposal that trade in
financial assets should be included in effective demand, arguing that this undermines
the concept of effective demand itself. It is also shown that many weaknesses in
Keens argument stem from a lack of terminological clarity which originates in his
interpretation of the works of Hyman Minsky.
JEL codes E12, E20, E44, E51
Keywords effective demand, endogenous money, debt, balance mechanics
1. Introduction
For a few years, Steve Keen has been advancing the hypothesis that effective demand
equals income plus the change in debt, and has provided various formulations of this
argument. This article focuses on his most recent restatement thereof in the Review of
Keynesian Economics (ROKE) (Keen, 2014a) as part of a symposium on the matter. The aim
is to provide a detailed critique of Keens argument. An analytical framework balance
mechanics - adapted from a paper co-written by the present author is used to examine Keens
claims. Two general objections will be raised against the argument in his original paper.
Firstly, his velocity of debt is a variable lacking theoretical underpinning which, whilst
necessary for the argument, is essentially left undetermined to pick up all the contingencies
Keen does not take into account. It will be formally shown that there is no strictly necessary
relationship between effective demand and changes in debt. Secondly, Keen introduces a
questionable redefinition of key terms and his argument suffers from a lack of definitional
clarity partly carried over from the work of Minsky.
We will also refer to three critiques that have appeared alongside Keens article, one by
Palley (2014), one by Lavoie (2014a), and one by Fiebiger (2014). This critique will contribute
to the debate through the original application of the balance mechanics framework to Keens
hypothesis. The framework is used to show that the proposed relation in Keen (2014a) does
not hold under all circumstances, which is a novel point as well as the main conclusion. It will
also be shown that where the equation does hold, this is due to variations in the velocity
variable. However, Keen provides no theory of what governs changes in this variable. While
1
I would like to thank Marc Lavoie, Engelbert Stockhammer, Fabian Lindner, Johannes Schmidt, and
Jeanette Findlay for their helpful comments on various drafts of this paper.
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arguments similar to this point have been made by others, our analytical framework allows us
to establish this result in a formal manner.
This article is structured as follows: section 2 distinguishes Keens hypothesis from other
contributions in the post-Keynesian literature. Section 3 summarises Keens original article,
his rejoinder, and the main points raised in the three previous critiques. Section 4 presents
the analytical framework that will be used to examine Keens claims. Section 5 applies the
balance mechanics framework to Keens argument and discusses his interpretation of
Minskys work. Section 6 concludes.
2. Keen and the post-Keynesians

The role of credit in capitalist economies is, of course, central to post-Keynesian economics.
A distinctive feature of this paradigm is that analyses are set in the context of a monetary
production economy (see Keynes, 1973; Wray, 1999, p. 180), which forms the basis for the
long-run non-neutrality of money. Money is seen as having evolved from early credit
relationships (e.g. Tymoigne and Wray, 2006) while the money supply is held to be
endogenously determined by the demand for bank credit (e.g. Lavoie, 2006; Dow, 2006), with
the latter view gaining increasing acceptance outwith the post-Keynesian school (McLeay,
Radia, and Ryland, 2014). It is important, however, as Palley (1992) notes, not to conflate too
closely the issue of money supply endogeneity and the importance of financing relationships
at large, since this may lead to a misplaced focus on the money supply in macroeconomic
analysis. Palley (ibid.) proposes the term endogenous finance to reflect the view that
attention must be paid to bank as well as non-bank credit to appreciate the potentially
enormous elasticity in the economic systems capacity to finance transactions (ibid., p. 2)
which is generated by the financial system at large. This view is also expressed by Lindner
(2015).
The notion of credit-driven business cycles, of booms fuelled by credit followed by financial
crises and recessions caused and prolonged by excessive indebtedness is an essential
component of the post-Keynesian literature, with much of it being built on the contributions of
Minsky (1986/2008) (see e.g. Lavoie, 2009; Kapeller and Schtz, 2012; Stockhammer and
Michell, 2014). The most widely used modelling approach in post-Keynesian economics,
stock-flow consistent (SFC) modelling, is inherently well-suited for such analyses (Godley and
Lavoie, 2012). The claim investigated in this article, however, has to be clearly distinguished
from such arguments. The question at issue is not whether levels of (private 2) debt or
changes therein can have an impact on effective demand and consequently national income,
or on macroeconomic stability. On this proposition there appears to be universal agreement in
the post-Keynesian literature. Whether such a connection exists in a given context is then an
empirical question. For instance, Stockhammer and Wildauer (2015) find a positive effect of
household debt on consumption, but a negative one upon investment (including residential
investment).
Keens hypothesis is more fundamental and bold, namely that capitalist economies are
always and everywhere credit-driven, that there is an immutable link between changes in
aggregate (i.e. all types of) debt and changes in effective demand which can be expressed in
a simple relation much like the equation of exchange (M*V = P*Y). Apart from the papers we
2 Keens argument applies equally to both private and public debt qualitatively (Keen, 2014a, pp. 284285), although he appears to focus on the role of private debt.
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shall examine here, earlier statements of Keens argument can be found in Keen (2009a,
2009b, 2009c, 2011a, 2011b, 2012b, 2012c, 2013, & 2014c). In addition, a significant part of
the debate has taken place on blogs (see Keen, 2011d, 2012a & 2014b; Mason, 2012; V.
Ramanan, 2012 & 2014; Edmonds, 2014a & 2014b).
The next section will provide a summary of Keens article and present the most substantial
points from the three critiques which appeared alongside it.
3. Keens argument and previous critiques

Using the example of an increase in effective demand, which is the one he appears to focus
on, Keens argument can be summarised thus: If there is a positive difference between the
present periods effective demand and the previous periods realised aggregate income, this
difference has to be financed by an increase in debt. Effective demand is then equal to the
previous periods income plus the change in total debt multiplied by a velocity of circulation
variable (a discussion of this variable is provided below). Keens theory can be neatly
summed up in an equation used by both Lavoie (2014a, p. 322) and Palley (2014, pp. 313314) in their critiques and also presented by Fiebiger (2014, p. 300):
Where AD is aggregate or effective demand 3, Y is aggregate income, v is the velocity of debt

and D is the total change in the stock of all debt in the economy during the period under
examination. Keen additionally divides the variable _D into different components according to
the purpose for which the debt is incurred (Keen, 2014a, pp.284-285). However, equation (1)
can be seen as an adequate shorthand representation of the relations presented in Keen
(2014a), since Keen himself presents an almost identical relation at one point in his paper
(Keen, 2014a, p. 283), the only difference being notational, and has used it in other works
(e.g. Keen 2014c, pp. 12-13). All statements about equation (1) made below are valid for the
more detailed relations presented in Keen (2014a), since all these relations incorporate the
basic hypothesis summarised in equation (1). He further argues that since monetary
expenditure is on both goods and services and assets (Keen, 2014a, p. 284), debt that is
incurred to purchase financial assets must be included in the equation and hence be a part of
effective demand.
Keen cites Pigou, Schumpeter and Minsky as antecedents to his argument. He provides a
discussion of the velocity variable, a description of endogenous money creation, and a
section arguing that his approach is consistent with what he views as the identity of
expenditures and income. He concludes his argument by presenting some empirical data.
Palley (2014) notes that Keens equation is deficient in assuming that agents invariably have
expenditures equal to the previous periods aggregate income (Yt-1), unless there is a change
in the amount of debt (i.e. Dt 0). As such, changes in the amount of debt become the sole
3 For a textbook treatment of the principle of effective demand, see Lavoie (2014b, Ch. 5). Keens article
does not contain a definition of effective demand. As far as can be deduced, effective demand in period
t is simply taken to be equal to total expenditures in period t. We shall adopt a slightly more nuanced
definition in section 5.
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factor driving changes in effective demand, to the exclusion of other typical Keynesian factors
such as the distribution of income.
Fiebiger (2014) criticises Keen for a lack of definitional clarity as well as an inconsistent use of
time-subscripts in his period-analysis. These deficiencies, according to Fiebiger, lead Keen to
proclaim trivial statements as novel insights and serve to obscure his argument. Fiebiger
laments that Keen insufficiently distinguishes between endogenous money creation through
private bank credit and the impact of private sector debt at large, often appearing to identify
the one with the other. Fiebiger shows that most private sector debt is non-bank credit. On
this basis, he questions Keens empirical analysis.
Lavoie (2014a) 4 points out that if vt in equation (1) is not treated as constant, then the
equation becomes a truism, a tautology, where v becomes identified after the fact, as a
residual (ibid. p. 323), a point closely related to our discussion below. Lavoie also notes that
Keen performs a considerable leap from arguing that changes in debt can have a
considerable influence on effective demand to claiming that effective demand equals income
plus the change in debt a distinction we also pointed to above.
The next section introduces the analytical framework we shall utilise for our critique.
4. Balance mechanics
The balance mechanics method of analysis was devised by Wolfgang Sttzel in his two
major works (Sttzel, 1978 & 1979) and bears resemblance to Godleys sectoral balances
approach (see e.g. Godley, 1999) as well as to SFC modelling (Godley and Lavoie, 2012).
While Sttzels work is not well-known today, it has maintained a number of advocates (see
e.g. Schmidt, 2009 & 2012; Flassbeck, 2001 & 2011) and has attracted renewed interest in
the wake of the financial crisis, which led to Sttzel (1978) being reprinted. The formalisation
of the balance mechanics framework as utilised here was initially undertaken by Lindner (see
Horn & Lindner, 2011; Lindner, 2012, 2014 & 2015). The most recent version was developed
in a manuscript by Lindner and the present author (Lindner and Reissl, 2015). The content of
this section is an abbreviated version of section 1 in Lindner and Reissl, (2015), and a very
similar section can be found in Lindner (2015). The balance mechanics approach is
characterised by two elements. The first consists of simple accounting relationships:
The balance sheet of any economic unit (an individual, a household, a firm, etc.) consists of
its assets, its liabilities and its net worth, nw. Assets can be divided into tangible assets, ta,
and gross financial assets, gfa. Liabilities, l, are debts and equity 5:
Net financial assets, nfa, are the difference between gross financial assets and liabilities:
Some of the points made by Lavoie can also be found in his recently published textbook, in which a
subsection is dedicated to the debate (Lavoie, 2014b, pp. 271-273).
5 Stocks are here treated as liabilities for the issuer (and thus as financial assets for the holder) in line
with common accounting conventions (Eurostat, 2013; Lindner, 2015).
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Gross financial assets can be further split into means of payment m and all other financial
assets, ofa 6:
A units net worth hence consists of the value of their net financial assets plus the value of
their tangible assets. It changes if the sum of these alters:
In the absence of asset price changes, nfa, ta and nw can only change if the quantities of
financial assets and/or liabilities and/or tangible assets held changes 7.
4.1 Flows
We shall clearly distinguish three classes of flows which affect the balance sheet variables
discussed above.
Income, y, and consumption, c, are flows that change a units net worth:
Saving s here denotes the difference between all additions and all reductions in net worth
during a period. Investment (that is, by definition, a change in the quantity of tangible assets)
is hence only a subcategory of saving for any subset of economic actors.
Revenues, r, and expenditures, e, are flows that change a units net financial assets
This equation represents a units balance of payments, with the current account on the left
hand side and the financial account on the right hand side 8.
Payments and receipts are flows that change a units stock of money:
As noted in Lindner and Reissl (2015), the distinction between m and ofa will of course be subject to
change and context-dependent (for instance, demand deposits are a means of payment in transactions
between non-banks but not in transactions between banks). The distinction nevertheless exists and lies
at the heart of any liquidity crisis.
7 Lindner and Reissl (2015) provide a version of the balance mechanics framework incorporating asset
price changes. Since this is not required for the argument presented here, we limit ourselves to a
simpler version. This is hence closer to the one used by Lindner (2015).
8 nfa, as indicated above, can also change if the price of financial assets changes. As noted, we abstract
from changes in asset prices here.
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Although these terms are often used interchangeably, it is important to make this distinction. It
is possible, for example, for a transaction to give rise to income but no revenue, or a revenue
but no receipt, or a receipt but no revenue. For instance, the sale of a financial asset gives
rise to a receipt for the seller, but does not generate revenue since net financial assets do not
change. This can hence be termed a purely financial transaction. Similarly, if a unit receives a
loan, it realises a receipt but its net financial assets are not altered (although they will be
altered by interest payments, which is why these, despite the common designation as
payments, are classified as expenditures). The production of a good generates income, but
does not give rise to a revenue until the good is sold. Lindner (2015) and Lindner and Reissl
(2015) provide more detailed examples.
4.2 Groups and the aggregate economy
The second element of balance mechanics is the division of the aggregate economy, that is,
either a closed or the world economy, into a group and a complementary group. A group can
be a single firm, a particular sector such as households, or any other genuine subset of
economic agents as required for the problem at hand. Once a group is defined, its
complementary group is the rest of the aggregate economy. It is then possible to formulate
sets of statements about relations between groups, complementary groups, and the
aggregate economy derived from accounting relations, using a terminology introduced by
Sttzel (1978):
Partial statements are valid for groups, while global statements are valid for the aggregate
economy. The application of a partial statement to the aggregate economy is very often only
possible through the addition of highly restrictive assumptions; otherwise it is an outright
fallacy of composition. Relational statements describe the behaviour of the complementary
group required for a partial statement to be valid for the group considered. In this way, one
can avoid the possible pitfalls of drawing conclusions about the aggregate economy from
partial relationships.
This approach can be illustrated by considering that, following the above equations, the
income during a period t of any genuine subset (i.e. group) of economic actors is given by:
The revenues and expenditures of any group j during a period can obviously differ from each
other. For the aggregate economy, however, realised revenues and expenditures (but not
necessarily payments and receipts, see Lindner (2015, p. 10)) are always exactly equal 9:
Similarly, to every financial asset fak there is a corresponding liability lk, so that the aggregate
economys net financial assets as well as changes therein are always necessarily equal to
zero:
9 Throughout this article, lower case symbols denote variables pertaining to groups whilst upper case
symbols denote variables pertaining to the aggregate economy.
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Thus, while any group can save financially (partial statement) to the extent that the
complementary group dissaves financially (relational statement), the aggregate economy
cannot save financially (global statement), i.e. in the form of financial assets 10.
Using our definition of income for subsets derived above (equation 9) and aggregating, the
aggregate economys income is hence equal to its production during the period under
examination:
Having introduced and illustrated the basic features of the balance mechanics approach, we
now begin with an examination of Keens article and develop the framework further as
required for this.
5. Endogenous money and effective demand

Keen (2014a) begins the substantive part of his argument by constructing a set of equations
describing the aggregate consumption expenditures of workers and those of capitalists, as
well as investment expenditures. The volume of each of these aggregates is taken to be
determined by the sum of the previous periods income (divided into wages, distributed
profits, and retained profits) plus the turnover (Keen, 2014a, p. 277) of newly created debt to
the banking sector 11. For instance, the consumption expenditure of workers is here equal to
the previous periods wages plus the sum of their newly incurred bank debt used for
consumption expenditures times a turnover or velocity variable. Beyond the problem already
noted by Palley (i.e. all sectors always spend the same amount unless debt changes), there is
a more fundamental issue arising here. The velocity variables are introduced by Keen since
after any sum borrowed is spent it continues to circulate and therefore can be spent again
(ibid.).
However, any means of payment corresponding to wages (or distributed profits, or retained
earnings) are apparently, in addition to being invariably spent in their entirety, only spent once
(since there is no separate velocity variable attached to them). This is so since, according to
Keen, changes in the velocity of pre-existing money balances are a second-order process
(ibid.). In what way money balances newly created by bank lending are fundamentally
different from pre-existing ones in this respect does not become clear.
10
This argument is presented at greater length and expanded upon in Lindners (2015) critique of the
loanable funds model.
11 Hence, the velocity variable may be defined as giving the amount of additional expenditure generated
by an increase of the stock of bank debt by one currency unit.
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In fact, Keen claims in section 9 of his paper that the velocity of debt variable is identical to
the velocity of money. He argues that this follows from endogenous money theory, according
to which in a pure credit economy, the amount of money [...] is the initial amount (created by
fiat) plus the current level of debt (ibid. p. 283). Endogenous money theory implies no such
proposition. While it indeed argues that all money is debt, it does not argue that all debt is
money (Gardiner, 2004). The confusion arises since Keen appears to treat the terms debt
and bank debt as equivalent. When a commercial bank extends a loan, it simultaneously
creates a deposit, which is a liability of the bank to the non-bank sector. This becomes part of
the money supply and thus increases the stock of means of payment. In this sense, then,
bank debt is indeed money. However, there clearly are types of debt, even in a pure credit
economy, which are not monetised, i.e. not generally accepted as means of payment
(corporate bonds being one example). Keen even appears to recognise this at an earlier point
in his paper (ibid., p. 278) but makes the argument here regardless.
Although the two variables are claimed to be identical, the velocity of existing money balances
is dropped from his equation whilst the velocity of newly created money balances (debt) is
taken to determine changes in demand. This consequently entails the implicit assumptions
that a) all pre-existing money balances are spent precisely once per period and are neither
saved nor lent out and that b) therefore all newly created debt must be to the banking sector.
These assumptions enable Keen to derive the proposition that any change in effective
demand is equal to the turnover of new [bank] debt (ibid.). This reveals a more general
problem with Keens endeavours, namely that the need to make behavioural assumptions
contradicts his previously stated intention to derive a law or accounting identity 12. An identity
must hold regardless of which assumptions are made about the behaviour of agents. Of
course, Keen not only wishes to construct an identity, but also wants to show that within this
relation, causality runs in a particular direction, with this being implied by the time-subscripts
in equation (1). This may explain why Keen appears to be going back and forth between
building models using behavioural assumptions and redefining accounting concepts (see
section 5.2). It will be shown below that there are cases in which Keens equation does not
hold.
5.1 Balance Mechanics and changes in gross debt
We now draw upon the accounting relationships developed above to show why equation (1 or
any version of it appearing in Keen (2014a)) is problematic. We shall extend the balance
mechanics framework and use it to construct two sample cases which show that Keens
equation does not hold under all circumstances and that where it does hold, this is due to
variations in the velocity variable. While the velocity variable often, but not always, saves the
equation from returning an incorrect result, it is a theoretically empty concept which renders
the relation devoid of informational content. If its value can only be identified in a tautological
fashion (Lavoie, 2014b), it is difficult to see what the purpose of the theory should be, since it
then can be neither prediction nor the explanation of observed phenomena 13.
12
For instance, in the abstract to the ROKE paper, Keen writes that he aims to replace the accounting
truism that ex post expenditure equals ex post income with the endogenous money insight that ex post
expenditure equals ex ante income plus the ex post turnover of new debt (Keen, 2014a, p. 271). In
other works, this proposition has been termed the Walras-Schumpeter-Minsky Law (e.g. in Keen,
2011b, 2012a,b), suggesting that Keen does not merely wish to show that it is possible for economies to
be debt-driven, but rather that his proposition will hold good under all circumstances.
13 To simply state ex-post that the velocity has changed does not constitute a satisfactory explanation of
changes in effective demand since Keen does not provide a theory of what governs changes in velocity.
Changes therein could thus always be invoked in order to immunise the theory from criticism (Albert,
2012).
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5.1.1 Plans and Expectations

To illustrate the problems with Keens equation, we first extend the analytical framework
presented in section 4. The content of this section is adapted from Lindner and Reissl (2015).
An earlier version can be found in Lindner (2015). Section 4 above introduced the division of
the aggregate economy into a group and a complementary group. To analyse various
phenomena pertaining to the relationship between a group, its complementary group, and the
aggregate economy, an excess notional demand/supply framework can be used. This is
inspired by Myrdals work on monetary equilibrium (see e.g. Myrdal, 2005) as well as
Shackles discussion of Keynesian kaleido-statics (Shackle, 1965) and bears resemblance
to Patinkins (1958) excess demand/supply framework.
Abstracting from taxes and transfers, revenues and expenditures during a period consist of
spending on goods and services, including the purchase and sale of pre-existing stocks of
goods, that is, tangible assets, such as inventories or real estate, P*Q & PTA*QTA, labour
services, measured (for example) in hours of employment EMP, where W is the wage,
W*EMP, as well as interest payments on pre-existing financial assets and liabilities, INT*FV ,
where FV stands for face value and INT is the interest rate. While realised aggregate
expenditures are necessarily equal to realised aggregate revenues, planned aggregate
expenditures can obviously differ from expected aggregate revenues. With Rexp and Epl
denoting expected aggregate revenues and planned aggregate expenditures respectively, we
can write:
The above equation shows aggregated planned/expected current account transactions. A

is equal to
similar equation can be formulated for financial account transactions.
the sum of the planned/expected change in the stock of means of payment held and the
difference between the planned/expected change in the quantity of other financial assets and
liabilities:
Equation 14 contains all planned/expected financial account transactions, including those

required to finance planned/expected current account transactions. The excess notional
demand functions in the financial and current account can then be combined as follows:
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While this equation refers to the aggregate economy, a similar one can be formulated for any
group. However, while any group can actually realise, ex-post, a planned/ expected change in
its net financial assets (partial statement), provided that the complementary group incurs an
opposite change of equal absolute magnitude (relational statement), this is not the case for
the aggregate economy (global statement). If the plans and expectations expressed in
equation (15) are consistent with each other when aggregated in that there is no aggregate
planned/expected current account deficit/surplus, the economy is in a condition of what
Sttzel (1979, pp. 153-159) called circular flow equilibrium, akin to Keynesian expectational
equilibrium as described by Shackle (1965). It can prevail only if and as long as agents
expectations are congruent. To analyse the possible reactions to incongruities between
plans/expectations, behavioural assumptions are required, meaning that we must go beyond
pure balance mechanics. Using this framework we can then examine the movements of
effective demand and the aggregate level of debt in various possible scenarios.
5.1.2 Effective demand and changes in debt
One of the most important characteristics of money from a balance mechanical perspective is
that it is a medium allowing groups to run expenditure or revenue surpluses (Sttzel, 1979,
p.181) 14. Consequently, if a group plans to make expenditures exceeding its expected
revenues 15, either existing stocks of money in the groups possession have to be earmarked
for this purpose, or the group will have to go into debt to a third party to acquire the necessary
m. For the purpose of illustrating the problem with Keens equation, we shall assume that our
economy can be divided into two groups; one which holds an existing stock of means of
payment sufficient to finance any planned expenditure surpluses (group 1) 16, and one which,
ex-ante, would have to borrow from a banking sector (in keeping with Keen), which for this
purpose can be part of either group, to acquire m (group 2).
Consider a case in which one of the groups a) expects its revenues from the sale of currently
produced goods and services during the period under examination to be constant relative to
the previous period and b) plans to make expenditures on such goods and services in excess
of these expected revenues and also in excess of expenditures thereon realised during the
previous period. The other group plans expenditures on current output equal to its revenues
realised on current output in the previous period and expects its revenues on current output to
be constant relative to the previous period.
It is necessary to focus on expenditures on and revenues from goods and services produced
(or, even more precisely, value added) during the period under examination since we wish to
14
Of course, it is not the only medium capable of so doing. One can also run an expenditure surplus if
the counterparty/counterparties in the respective transaction(s) are prepared to grant some form of trade
credit.
15 Under the assumption that the amount of direct trade credit available is negligible.
16 In a fiat money system, there will of course be a stock of liabilities somewhere in the system
corresponding to this amount.
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examine links between changes in debt and effective demand. A definition of effective
demand should only include expenditures upon items contributing to current aggregate
income. Aggregate income would not arise, for instance, from sales of pre-existing goods
(tangible assets) since, strictly speaking, the aggregate income is generated by production
rather than exchange. Since Keen only focuses on the determination of the magnitude of
effective demand itself, and not on how precisely changes therein translate into changes in
aggregate income, we can largely avoid this issue, a detailed discussion of which would go
beyond the scope of this article 17. Hence, when we speak of expenditures, revenues,
expenditure surpluses or revenue surpluses in this section these terms should be taken to
mean expenditures on/revenues from currently produced goods and services. Aggregate
expenditures on such goods and services may be termed effective demand for our
purposes 18. Yt-1 in equation (1) is taken to be equal to the previous periods effective demand
thus defined.
We can then write for one group (regardless of whether it is group 1 or 2):
and for the other group:
This means that in the aggregate, plans to reduce nfa outweigh plans to increase nfa, leading
to an aggregate planned current account deficit:
If the group holding means of payment (group 1) is the one planning a current account deficit,
it plans to finance this by reducing its stock of m. If the other group (group 2) is the one
planning to run a deficit, it plans a change in liabilities by the amount of borrowing expected to
be required, while the change in its stock of money arising therefrom and the planned change
in m for running its current account deficit cancel out.
As established above, the aggregate economy cannot realise a current account deficit and
hence the realised NFA must always be zero. While it is clear that the individual
units/groups plans as set out above are incongruent in the aggregate (since NFApl/exp 0),
without additional assumptions, the framework does not allow one to predict what the
17
For some views on this matter see Hartwig (2002) and Allain et al. (2013).
Strictly speaking, the examples which follow assume that no revenue or expenditure surpluses on
non-effective demand items are realised. While this assumption is undoubtedly highly unrealistic, it
allows us to pinpoint very precisely the problem with Keens hypothesis
18
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consequences of this will be. The framework does, however, give the possibility of examining
various possible outcomes. We shall consider two simple cases.
Case 1
Consider the case in which group 1 successfully realises an expenditure surplus 19 (as well as,
by assumption, current expenditures in excess of previous expenditures), which implies that
group 2 necessarily realises a revenue surplus of the exact same size:
Cet. par. group 1s nfa will fall by the amount of its expenditure surplus while group 2s nfa will
increase by that amount. By assumption, group 1 finances its expenditure surplus by
depleting its pre-existing stocks of m. Consequently, group 2 finds that its holdings of m have
increased. The absolute amount of debt does not change as a consequence of the realised
current account balances. By assumption, aggregate expenditures (here = effective demand)
have risen relative to the previous period, and so, therefore, have aggregate revenues. At the
same time, however, the level of gross debt has not changed so that the term D in equation
(1), which is equivalent to our term L, is zero. Hence, even if the velocity variable became
arbitrarily large, Keens equation would show that effective demand had not changed at all
and would hence predict that aggregate income should remain constant. Table 1 summarises
these results 20.
Quite apart from these considerations, debt could also just as well decrease if group 2 uses
the m to pay off any pre-existing debt that it might have, or if the m is transferred back to
group 1 through some purely financial transaction (that is, a transaction which only affects the
financial account, e.g. the sale of a pre-existing financial asset) and consequently used by
that group reduce any pre-existing debt that it might have. Debt could, of course, also
increase if it is incurred to finance any other financial account transactions which may take
place. All of these effects would be picked up by variations in Keens velocity variable (in the
possible case where debt decreases but effective demand rises, the velocity would have to
become negative).
19
We choose this example case since it is well suited for showing the problematic nature of Keens
equation. More generally there is of course no necessary relationship whatsoever in the aggregate
between the size of any revenue or expenditure surpluses and the volume or growth of effective
demand, as Sttzel (1979) demonstrates at length.
20 Note that the first three rows show changes in the magnitude of flows relative to the preceding period,
whereas the last three rows show changes in stocks, i.e. flows, without reference to the previous period.
For the last three rows, the magnitude of the flow in the preceding period is of no consequence.
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Case 2
Another possible case is that in which it is group 2 that plans and realises an expenditure
surplus, i.e. the precise opposite from the situation depicted in equations (19) and (20). By
assumption, group 2 has to borrow from the banking sector (increase its liabilities l) to acquire
the m necessary to finance its current account deficit. Group 1 sees an increase in its nfa and
receives the m borrowed by group 2. If group 1 simply holds the additional money and no
other transactions of any kind take place, our analysis ends here. In this case, the absolute
level of debt has increased by an amount equal to group 2s expenditure surplus. Effective
demand has increased as well. This result, summarised in table 2, appears to be in line with
Keens argument at first sight.
However, if group 1 uses all the acquired m to decrease its own debt (if it has any), overall
debt will not change by the full amount of the expenditure surplus or even not at all. The same
outcome will occur if the m is transferred back to group 2 in a purely financial transaction and
then used by that group to pay off the debt just incurred 21. On the other hand, absolute levels
of debt could also increase through purely financial transactions by a far greater magnitude
than group 2s expenditure surplus while the changes in nfa for both groups remain the same.
Again, all these possible contingencies would, if they obtained, be reflected in fluctuations of
the velocity variable.
21 Recall that the two groups as we have defined them are not assumed to be in any way homogeneous,
so that this possibility is not as unlikely as it may appear.
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Implications
The conclusion to be drawn from the analysis above is that in the aggregate, changes in
absolute levels of debt bear no strictly necessary relationship whatsoever to the level of
effective demand. We have identified one case in which Keens equation does not hold. In the
other, it only does so through variations in the velocity variable. However, Keens paper
contains no theory of how this variable is determined. Indeed, it would be surprising if it did
since, being a concept similar to the velocity of money, Sttzels criticism of the latter applies
to the velocity of debt. It is worth quoting from Sttzels (1978, p. 236) discussion of the
velocity of money in a credit economy (own translation) 22:
[...] it is not apparent how one should conceive of a velocity of means of
payment under such circumstances - since there is no fixed supply of means
of payment which change hands more or less often. The means of payment
are there rather created ad hoc, and disappear again soon thereafter.
Change of hands or frequency of use all this presupposes an object
which exists in the one hand and still exists in the other, an object which
before and after use is identical. [...] [The concept] breaks down precisely in
those cases in which we are most in need of clear monetary theoretic
foundations, namely when stocks of means of payment change through
monetisation and demonetisation of financial assets.
It may be possible to measure the values of the other variables appearing in Keens equation
and to label the residual the velocity of debt, but any insight gained therefrom will be
minimal. The difficulty is that in contrast to net debt, gross debt can in principle always be
reduced through an equal reduction of assets (although note the complications potentially
arising from the paradox of liquidity (Lindner and Reissl, 2015; Dow, 1987)) and can also
theoretically increase without bounds without directly affecting net debt. The distinction
22 A worthwhile and more general discussion of what Sttzel terms the naive quantity theory of money
can be found in Sttzel (1979, Ch. 4).
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between debt incurred for the purpose of making expenditures in excess of revenues and all
other changes in debt is necessarily artificial and the magnitude of changes in debt per period
is not sufficiently determined by the size of planned and/or realised expenditure surpluses. In
this sense, debt is merely a residual 23, and ex-post changes in the absolute level of debt allow
no conclusions about the likely volume or growth of effective demand (and, by extension,
aggregate income) or even about whether expenditure or revenue surpluses have occurred
and to which extent. This is not to imply that changes in debt cannot have an influence on
effective demand or aggregate income. Rather, what it implies is that a black box-typerelation is unable to capture this notion other than, at best, in a tautological fashion. Keen has
demonstrated (e.g. Keen, 2014d) that it is perfectly possible to construct models in which
there is a stable link between debt and effective demand. However, it was demonstrated
above that while changes in debt may well closely correspond to changes in effective
demand, this is not necessarily so from a pure accounting perspective. Keen appears to
recognise this in section 10 of his paper, but attempts to navigate around the problem in a
questionable fashion.
5.2 Keens inclusion of speculation in financial assets
The previous section demonstrated that it is not possible to determine movements in the
aggregate level of indebtedness from changes in effective demand alone. Keen appears to
acknowledge this in section 10 of his paper when he writes that by far the major use of credit
creation today is to fund speculation in the FIRE [finance, insurance and real estate] sector
(Keen, 2014a, p. 284). He attempts to rectify this problem by claiming that a purchase of
financial assets should be classified as an expenditure and be counted as part of effective
demand. In section 4 of this article, we set out to define very carefully what is meant by the
term expenditure, as distinct from payment and consumption. It is a transaction which
alters the net financial assets of the unit undertaking it. This is surely a reasonable and
uncontroversial definition.
Keens redefinition would mean to effectively eliminate the accounting distinction between
financial assets on the one hand and non-financial assets, goods, and services on the other,
since the purchase or sale of either would have to be recorded as a current account
transaction if it gave rise to revenue/expenditure. This appears to be a rather arbitrary
redefinition of terms particularly as it still does not establish a link between debt and effective
demand, properly defined as a variable which determines aggregate income. This point is
also made by Fiebiger (2014), but it is worth elaborating upon. Aggregate income would still
be equal to aggregate production and a change in the number of purchases and sales of
existing financial assets, although under this redefinition giving rise to expenditures and
revenues, would not in and of itself have any influence on aggregate income. Keen, however,
appears to make precisely this claim, given that total expenditure is now taken to include
expenditures on financial assets, but that this sum still appears to correspond to effective
demand in that the level of these expenditures is taken to determine aggregate income.
The root of this problem is an insufficient distinction between income and revenues, as
becomes clear in section 12 of Keens paper. All he demonstrates is that a debt-financed
increase in (redefined) aggregate expenditure gives rise to an equal amount of (redefined)
revenue. Indeed, it is claimed that the volume of expenditures per period is equal to income
during that period, a proposition that is surely not generally true (as is also noted by Sttzel,
23
Which does not mean that debt levels cannot grow to excessive levels.
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1979, p.274) 24. For instance, in a hypothetical economy in which units only produce for their
own consumption and investment, or even in one where trade is exclusively conducted
through barter, aggregate income would differ from zero, since it would be equal to that
economys production, whilst revenues/expenditures would be nil. In a modern monetary
production economy, on the other hand, total gross expenditures and revenues recorded over
a period would be expected to be substantially greater than aggregate income, given that the
purchase and sale of, for example, intermediate goods also gives rise to expenditures and
revenues. Keens redefinition would sever the link between effective demand and aggregate
income which is a basic characteristic of post-Keynesian economics. The next section will
show that the lack of terminological clarity in Keens article stems in part from his
interpretation of Minskys work.
5.3 Keens reading of Minsky
Keen states that several authors held positions similar to his own. He lists Pigou, Schumpeter
and Minsky, drawing in particular on the work of the latter to formulate his own argument. For
his derivation of the hypothesis from Minsky, Keen mainly relies on the formers earlier work,
especially the article Can It Happen Again? (originally published in 1963 and reprinted as
chapter 1 in Minsky, 1982) and the book John Maynard Keynes (1975/2008).
He begins by quoting from Minsky (1982, Ch. 1). There, Minsky derives a condition that is
equivalent to the one developed above, namely that realised sectoral financial balances
necessarily have to sum to zero (i.e. NFAt = 0). However, Minsky goes on to state that this
must be the outcome of market processes (ibid. p. 6) which ensure that this condition is
fulfilled and that ex-ante saving and investment plans are reconciled (ibid. p. 6). Minsky, as
other writers from all schools of thought, interprets the S = I accounting identity as an
equilibrium condition that must somehow be produced, commonly through changes in
interest rates or income depending on the analysts theoretical outlook. We shall argue that
this notion can be misleading.
5.3.1 The Saving-Investment Identity
Equation (12) above which is reproduced here shows that the income of the aggregate
economy is equal to its production:
Drawing on the earlier definition of saving (equation 6) and the recognition that the net worth
of the aggregate economy can only change through changes in its stock of tangible assets
(equation 11), it follows that:
24
This is also the reason why our definition of effective demand is more specific than Keens.
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These relations imply that, in a macroeconomic sense, investment is saving, but also that
saving is investment. The quantities appearing on the two sides of the
S = I equation are two different ways of denoting what is in fact one and the same variable,
and not two distinct quantities that through some mechanism come to be equal to each other.
It then becomes clear that the identity cannot be an equilibrium condition. To be an
equilibrium condition, there would have to be a possibility for it to not hold. In fact, the identity
will hold at any point in time, regardless of whether or not the current plans of individual
economic units are congruent when aggregated. It also holds regardless of how agents
behave, and regardless of whether or not expectations are fulfilled (see also Lindner, 2015).
Thus, even if, to use more conventional terminology, planned investment and planned
saving differ in magnitude, actual investment and actual macroeconomic saving will be equal
at any point in time because they are the same thing 25. The preceding discussion shows why
it is vital to define precisely what is meant by the term saving in any particular context (see
also Sttzel and Grass, 1988, p. 365). One can easily construct cases in which the financial
saving of a group is arbitrarily large whilst investment equals zero, or vice-versa (Lindner,
2015). This terminological issue in turn besets Keens interpretation of Minskys John
Maynard Keynes.
5.3.2 Transcending Keynes?
In the passage from John Maynard Keynes (Minsky, 1975/2008, pp. 131-134) quoted by
Keen, Minsky constructs the bare bones of a model (ibid. p. 133) showing how investment is
financed. The formulation, however, is terminologically imprecise. Minsky constructs budget
constraint[s] (ibid. p. 131) for households and firms, and assumes that some portion of
(apparently previously created) household financial savings in the form of means of payment
m are available to finance investment, that is, presumably, they can be borrowed by firms or
acquired through share issues 26. According to Minsky, any investment exceeding
intermediated household (financial) savings has to be financed by some combination of an
increase in the money supply and of a decrease in the money holdings in portfolios, i.e. by an
increase in velocity (Minsky, 1975/2008, p.132) 27. Money holdings in porfolios, however, is
an imprecise or too general term in this context. It does not become clear what the conceptual
distinction between these and financial savings in the form of m is meant to be. The former
would comprise any money balances held by units, including the financial savings in the form
of m of all sectors, as well as any other money balances acquired through purely financial
25
Behavioural assumptions are needed to theorise about how units are likely to react to incongruent
plans/expectations but these are independent of accounting identities which will hold even if these
assumptions do not contain any equilibrating mechanisms.
26 Keen (2014a, p. 274) notes that any investment exceeding this amount has to be debt-financed.
Why borrowing from households does not create debt he does not say. This is another instance where
debt and bank debt are not distinguished.
27 Note the distinction between Keens conclusion that bank lending, i.e. an increase in the money
supply, is strictly required and Minskys more nuanced position.
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transactions 28. Minsky uses the concepts of saving, money holdings, household saving,
and what would correspond to financial saving in the terminology introduced above without
sufficient differentiation.
That the terms saving and household saving are also treated interchangeably by Keen is
shown when he interprets Minskys statement that the externally financed investment must
exceed the savings of households (Minsky, 1975/2008, p.133) to mean that investment
therefore [has] to exceed savings (Keen, 2014a, p. 274), appearing to suggest that the
recognition that the volume of aggregate investment can differ from the value of household
financial saving in some way contradicts the S = I identity. This becomes clear when he
claims that Minskys work
[t]ranscends Keynes on both income equals expenditure and savings equal
investment, with Keyness identities applying in the abstraction of equilibrium,
but Minskys applying in the (normally) growing economy in which we actually
live. (ibid. p. 275)
It is obvious that Keen treats the saving-investment identity as an equilibrium condition. In
addition, he asserts that an economy in equilibrium cannot be growing. However, it is easily
seen that the circular flow equilibrium presented above does not imply stationarity as Sttzel
(1978) demonstrates at length in his critique of Walrasian general equilibrium. Even although
the economy is unlikely to ever actually be in such an equilibrium, in principle it could be, and
at the same time be either growing, shrinking, or stationary as long as expectations are
congruent. The S = I identity will hold whether or not the economy is in equilibrium of any
description, and regardless of whether or not it is stationary. It says nothing about how
investment is financed. Keen may sometimes over interpret the works he utilises as a
foundation for his own argument, while these works themselves suffer from terminological
imprecisions. These imprecisions can, as demonstrated above, consequently also be found in
Keens own argument.
Keen presents some empirical data to support his argument. Fiebiger (2014) provides an
adequate critique of this and all that remains to note is that the evidence cannot resolve the
problems raised here, since they are not foremost of an empirical nature. One further issue is
that Keen sees his analysis as closely related to the credit impulse, a concept developed by
Michael Biggs (see also Keen, 2011c). This is defined as the change in new credit issued as
a percentage of GDP (Davies, 2008), and is found to be closely correlated with growth in
demand and GDP in many instances (Biggs, Mayer, and Pick, 2010). It should be noted,
however, that this concept is developed in the context of a model and no claim is made to the
effect that it reflects a relationship which necessarily holds or that it contradicts existing
economic accounting identities. In this respect, it must be clearly distinguished from Keens
analysis. Keen has since written a rejoinder in which he replies to Palley, Lavoie, and Fiebiger
(Keen, forthcoming). This will be published in the October 2015 issue of the ROKE.
28 It is true, however, that a given amount of financial savings in the form of m can finance a potentially
infinite volume of transactions, provided that the velocity of circulation becomes large enough (Lindner,
2015; Sttzel, 1979; Wicksell, 1936).
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6. Summary and conclusion

This article has provided a critique of Steve Keens argument that effective demand equals
income plus the change in debt, drawing upon a framework of analysis derived from the work
of Wolfgang Sttzel. The framework was applied for the first time to this issue, in the context
of an in-depth discussion of Keens most recent restatement of this proposition (Keen,
2014a).
With regard to the substantive part of Keens argument, we provided a balance mechanical
analysis of the relationship between effective demand and changes in debt, arguing that there
is no necessary relationship whatsoever between these variables. Specifically, we made a
novel contribution in showing that Professor Keens proposed relation does not hold under all
circumstances, and that it holds in others mainly through the introduction of and variations in
the velocity of debt-variable. What is presented in Keens paper hence does not prove his
proposition, in that he does not succeed in deriving a relation which necessarily holds.
Professor Keens velocity of debt variable, although necessary to (in most cases) prevent his
equations from returning an incorrect result, lacks theoretical underpinning and thus its
predictive and explanatory value is questionable. We also argued that Keens redefinition of
effective demand to include the purchase of financial assets does not appear fruitful since it
severs the link between effective demand and aggregate income which is a key element of
post-Keynesian economic analysis.
The debate around Keens hypothesis has nevertheless raised interesting points. In
particular, it would be desirable to obtain empirical evidence on the extent to which (if at all)
different types of lending (for instance bank credit on the one hand and non-bank credit on the
other, say for consumption or investment purposes) differ in their impacts upon demand and
growth. Stockhammer and Wildauer (2015) also note a lack of empirical literature on such
issues. However, the existing theoretical framework as well as existing economic accounting
identities appear sufficient to accommodate any such evidence. In addition, the debate also
serves as a reminder of the importance of definitional clarity in economic arguments and thus
recommends the balance mechanics framework as a method to examine both existing and
new theories to ensure internal consistency.
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SUGGESTED CITATION:
Severin Reissl, A critique of Keen on effective demand and changes in debt, real-world economics review, issue no.
72, 30 September 2015, pp. 96-117, http://www.paecon.net/PAEReview/issue72/Reissl72.pdf
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Commodities do not produce commodities: a critical

review of Sraffas theory of production and prices
Christian Flamant 1
[France]
Copyright Christian Flamant, 2015

Abstract
This paper revisits once more Sraffas well-known book Production of commodities by
means of commodities, and does so by digging up to its very foundations, i.e. its most
basic assumptions regarding the nature of production (section 1). This leads to
analyzing the definitions of the different categories of goods appearing in Sraffas
book: basic goods, subsistence goods, consumption goods and fixed capital goods.
The paper shows why this classification is wrong. It explains why subsistence goods
should not be considered as intermediate goods (section 2), that consumption goods
are final goods which are not part of a surplus, and that there is no surplus of
intermediate goods (section 3). It shows then that the way Sraffa introduces fixed
capital goods through joint production does not allow for the existence of a surplus for
this kind of goods (section 4), and leads to several contradictions (section 5). These
contradictions entail some serious consequences for the Standard system: neither the
definition of basic goods nor the notions of surplus and of Standard commodity can be
upheld (section 6). It comes therefore as no surprise that the problems created by the
introduction of land or other non-produced means of production cannot be resolved
(section 7). As developed in section 8, all these limitations explain why Sraffas
system has remained over the years such a puzzle, on which nothing has been built:
in particular the system is incompatible with a Keynesian theory of money. Finally
section 9 proposes briefly an alternative view of production as a transformation
process.
Keywords Sraffa, commodities, fixed capital, price theory, production theory
In 1960, when Sraffa published Production of commodities by means of commodities, it was

perceived by a number of economists as a kind of theoretical bomb. Indeed it hit a heavy blow
to the neo-classical theory of distribution, by showing that in a system with multiple
heterogeneous goods it was impossible to define fixed capital as a factor of production of
which the marginal productivity was determining the rate of profit. However, doing so implied
keeping some assumptions corresponding to the neo-classical paradigm, as regards the very
nature of production and of the goods involved in this process, in particular fixed capital. To
what extent this was done unknowingly is difficult to say, but this preservation brought about a
number of flaws.
After recalling briefly the background of Sraffas approach, this paper will show how these
flaws have emerged from the very beginning of the analysis, because of a blurred definition of
production, consumption, and an inaccurate classification of the goods involved in these
processes. On this basis, the introduction of fixed capital and of non-produced means of
production, like land and natural resources, cannot but lead to various contradictions and
inconsistencies, which will then be reviewed.
1. Sraffas approach: production as a circular process
1
I have a PhD in Economics from the University of Paris I Panthon-Sorbonne. I retired three years ago,
after a career as a country director in the French Development Agency, which involved being seconded
for three years to the IMF in Washington (1982-85), and three years to the OECD in Paris (1998-2001).
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In Appendix D of Production of commodities by means of commodities, 2 Sraffa connects his

conception of production to the old classical economists Quesnay and Ricardo who regarded
the system of production and consumption as a circular process. He even adds that this
conception, which he develops in his book, is in striking contrast to the view presented by
modern theory, of a one-way avenue that leads from factors of production to consumption
goods.
Sraffa says that his system is a generalization of that of Ricardo wherein wheat is both a
factor of production and consumer good, which allows one to define a surplus, irrespective of
the values or prices, and to determine the rate of profit regardless of them. In his system,
what he calls the basic goods are generally playing the role of wheat, when, through the
construction of the standard commodity, they appear in the same proportions in the means of
production and the net product, which thus seems to validate his reasoning by generalizing
the Ricardos case to a system with multiple heterogeneous goods.
It was important to start by recalling this, because, as far as science is concerned, the field of
validity of a scientific theory is generally constituted by the field delimited by its own
assumptions, the first of them consisting in the definition of its concepts. It is also generally
admitted that, for a theory to be considered as scientific, there is a need for consistency, both
internally and externally. By this we mean that the theorys assumptions must not contradict
themselves, which is the internal consistency, and that the assumptions must have a coherent
link with the reality which the theory wants to describe, which is the external consistency.
Everybody will certainly acknowledge that the definition of production is a very important
assumption, a fundamental one indeed, and in this regard it should normally have appeared,
not in an appendix at the very end of Production of commodities, but on the contrary in an
introduction, at the very beginning of the book. However, and quite strangely, this is not what
Sraffa does. Before starting to analyze his theses, let us state again that for Sraffa production
means production of a surplus, and that to be able to compare this surplus to the means of
production, there is an absolute need for the commodities to appear both in the means of
production and in the surplus, which is therefore a forced corollary to his circular conception
of production.
2. Production for subsistence
It is difficult to understand why Sraffa put back to the end of his book something as
fundamental as his definition of production, but maybe the reason was that he did not want to
put it too close to the first chapter of the book, entitled Production for subsistence, because
in this three-page chapter, there is no surplus, which seems completely contradictory to this
definition of production. Indeed what Sraffa wants to show is that there can be a price system,
even when there is no surplus. But can there be any production? Certainly not by Sraffas
own definition, unless we realize that the title of the chapter means that there is some kind of
individuals or producers behind the scene, which barely survive (subsist), by the
consumption of some of the commodities that are produced.
Sraffa, 1960.
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Saying that, however, which Sraffa implies when he writes that the system includes the
necessaries for the workers, means that on the left-hand side of the equations (like also on
the right-hand side) some of the means of production are in fact consumption goods, or more
precisely subsistence consumption goods, i.e. some kind of goods that are just sufficient to
allow the producers to survive.
However this raises another difficulty, which has to do with the definition of consumption,
something which does not appear in Sraffas book. Let us therefore give a definition, and then
discuss it. This definition is borrowed from Wikipedia (French version), and indicates that:
consumption characterizes the act of an economic agent (consumer) that
uses (final consumption) or transforms (intermediate consumption) goods and
services. This use or transformation causes the immediate (non-durable
goods) or progressive (durable goods) destruction of the items consumed.
From a general point of view, consumption (value-destroying) opposes
production (value-creating).
This definition is both interesting and misleading. Interesting, because it establishes a
distinction between the production process as an intermediate process, involving intermediate
goods and services, and final consumption as a final process. But this definition is also
misleading, because it tends to consider nevertheless both processes as consumption, since
both would cause the destruction (whether productive or final) of the goods involved. The
definition introduces however another distinction between final consumption, which uses,
and intermediate consumption, which transforms.
What we would like to argue is that this distinction is not a subtle one, but a fundamental one,
which should lead economists to reserve the use of the word destruction for only the goods
which are used for final consumption. A good reason for that is in fact given by the very last
sentence of this definition, pointing out that consumption, which is value-destroying, opposes
production, which is value-creating. It is indeed logical that a process, like final consumption,
which causes the immediate or progressive destruction, and in fact the disappearance of the
consumption goods involved, be value-destroying, whereas conversely it is not at all logical
that a process which is value-creating, like production, would cause the destruction of the
intermediate goods involved. On the contrary, and if we want to stay connected to reality, it is
easy to recognize that these goods used in the production process are not really destroyed in
the sense that they would definitively disappear, because they are only transformed in the
course of this process.
These explanations are not esoteric ones, and we do not want to split hairs on this question,
but they are necessary in order for the concepts used to have a connection with the real
world. In the real world indeed, final consumption is definitely a destruction. This is obvious for
all the non-durable goods, like for instance food, for which there is simultaneity between
consumption and destruction, this destruction being also a complete disappearance. But this
is also the case for durable goods, even if this destruction can be a very long process for
certain goods: in the end there is a complete impossibility for such a durable good to continue
to be used as it was initially and during its whole life span.
On the contrary, in the case of intermediate goods, like all the raw materials, they most often
disappear in the production process in their initial form, but only to reappear under another
form at the end of this process, which means literally that they are not destroyed, but only
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transformed. This is so because their substance is still there, incorporated in the final goods
of which they have become an element or a part. Furthermore, in a value-creating process, it
is logical for the value of these intermediate goods not to disappear, but to be transferred to
the value of the goods in which they become incorporated.
Evidence of this can be derived from the fact that at the end of the life span of a durable
consumption good it is more and more frequent that it can be dismantled and recycled, which
allows for many of the raw materials, i.e. the intermediate goods, to reappear and be
transformed again in new production processes, where they are reincorporated into new
goods. Within the production process itself, there are often some tailings, scraps or residues
from these intermediate goods, and most of the time, in particular each time that these
intermediate goods are valuable, they do not disappear but are recovered to be put back in
the process, rather than being wasted. Therefore the word destruction" is clearly
inappropriate to name what happens to intermediate goods in the course of the production
process, since they do not disappear completely, but on the contrary can reappear either
during this process or at the end of the life span of the final consumption goods in which they
are incorporated. It is only their original shape or form which are partially modified (rather than
destroyed), to be transformed into other ones.
All this explains that final consumption goods cannot at all be treated conceptually like
intermediate goods, since these last ones are not consumed but only transformed in the
production process, and as such are not the object of an intermediate or productive
consumption, but of a productive transformation. Therefore final consumption goods should
not in any case be put on the left-hand side of the equations of the production system, which
represents what enters into the production process, even if these goods are means of
subsistence, called also sometimes wage-goods.
Let us conclude that the analysis performed in this very first chapter of Production of
commodities by means of commodities, devoted to production for subsistence, is seriously
flawed. Indeed there is no surplus, and therefore there should be no production, according to
Sraffas own definition of production. Even if one thinks that there is a kind of notional surplus,
in the form of subsistence goods which would be both on the left and on the right-hand side of
the equations, this would be contradictory to the demonstration, which has just been carried
out, that consumption goods by their very nature are final goods which come out of the
production process and as such can never enter into this process. This should be kept in
mind when we now go further into the analysis of Production of commodities by means of
commodities.
3. Production with a surplus
It is a little ironic in this context to observe that it is in the following chapter of Production of
commodities by means of commodities, entitled Production with a surplus that Sraffa writes
that the introduction of a surplus makes the system become self-contradictory. But this is
because the allotment of the surplus, which is supposed to be made by a uniform rate of
profit, cannot be determined before the prices, and vice-versa. However Sraffa quickly
resolves the difficulty by explaining that in fact both are determined simultaneously by the
same mechanism.
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The interesting thing in this chapter is rather that it shows that the emergence of the surplus
has one effect which is the appearance, as part of this surplus, of a new class of products,
which are not used, whether as instruments of production or as articles of subsistence, in the
production of others. Sraffa names them luxury goods.
Building upon the demonstration performed in the previous section, it can immediately be
observed that, strictly speaking, this definition of luxury goods applies in fact to all
consumption goods. This follows because we have shown that the fact that a consumption
good be a subsistence good does not in itself transform it into an intermediate good, which
belongs to a totally different category of goods, those that can be put on both sides of the
equations representing a production process. It follows from this fact that as far as final
consumption goods are concerned, no surplus can be determined as a difference between
the quantities of these goods which are on the right-hand side and the quantities supposed
wrongly, to be on left-hand side of the equations.
To be sure, there are some particular goods or services which can be in the same physical
form, both means of production in the form of intermediate goods (circulating capital), and
final consumer goods. They are mostly fluids (water, energy), or some services. But electricity
itself does not produce electricity: we know that this is not its use in the production process
that makes it reappear for a larger amount at the end of this process. Even in this not so usual
case, the total quantity of this particular kind of goods or services produced during a period
totally disappears during the same period either as intermediate consumption or as final
consumption, without therefore the apparition of a surplus or net product.
In this respect, and to be more precise, even the example of wheat is misleading, because in
the real world wheat in the form of seeds (as an input) is increasingly a processed product
which has undergone some treatments, or even has been genetically modified etc., and
therefore is different from wheat as a pure consumer product. This last one is itself eaten only
after being transformed (conditioned, etc.), and this in a way which makes it a different
product from wheat which has just been harvested. Let us also point out that for most
agricultural products other than cereals, grains or seeds are in any case very different from
harvested products.
Having arrived at this stage, and putting aside fixed capital for the time being, to adhere to
Sraffas approach, we must understand that there is no surplus either for intermediate goods:
certainly the quantities of intermediate goods used in the production of these intermediate
goods themselves are smaller than the total quantities of these goods which are produced.
But it is obviously because the rest of these intermediate goods are used in the production
process of final consumption goods or fixed capital. Moreover, in a self-replacing state, where
Sraffa repeatedly locates his theory, there cannot be any place for stockpiles of intermediate
goods, which are produced in the exact quantities needed for both their own production and
the production of final goods. Therefore in a given period the total quantity of each of the
intermediate goods which enters the production process, and appears on the left-hand side of
all the equations of the production system using this intermediate good, is exactly equal to the
quantity which comes out of the system, and appears on the right-hand side of the equation of
the industry producing this good in the same system.
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4. The introduction of fixed capital
To begin with the definition of fixed capital, given at the beginning of Chapter X of Production
of commodities by means of commodities (73), Sraffa does not elaborate a lot, and limits
itself to writing that:
we shall regard durable instruments of production as part of the annual
intake of a process, on the same footing as such means of production (e.g.
raw materials) as are entirely used up in the course of the year; while what is
left of them at the end of the year will be treated as a portion of the annual
joint product of the industry.
There is therefore no doubt that fixed capital is considered in his book as a particular kind, or
a sub-species, so-to-say, of intermediate goods, with the only difference that the life of the
components of fixed capital is longer than the life of intermediate goods, which disappear (are
transformed) in the production process at the same time as they transfer their value to the
goods produced. Fixed capital is indeed made of durable instruments, or machines, which
implies that their use in the production process is a progressive one which lasts up to the end
of their life span, during which they progressively transfer their value, up to the end of the
production process in which they enter. The only difference with circulating capital seems
therefore for Sraffa only a question of time, having to do with the longer durability of their life
span and therefore of their participation in a production process. If one wonders why time is
so important, the only coherent explanation is that the rate of profits is defined not only as a
percentage, but as a percentage per unit of time (in fact, the year).
At a conceptual level, it is however extremely confusing to restrict the differences between
both types of capital to just this single element of time. Indeed, as we have already pointed
out earlier, intermediate goods participate in the production process in such a way as they are
effectively and entirely transformed in this process, where they can no longer be found under
their initial form at the end of it, because their substance itself has been incorporated in the
final goods which they have contributed to produce. In other words they enter into the
process, but do not come out of it.
One must immediately recognize that this is not at all the case for fixed capital goods, which
in the real world do not participate in the same way in the production process, whatever their
durability and independently of the duration of this participation. Indeed fixed capital goods
never disappear in the production process, where their true role is not to be incorporated in
the structure of final goods, but on the contrary to participate in the transformation of the
intermediate goods, which is an extremely different thing. In the real world, the tangible and
visible role of fixed capital is not to transfer its value to the products, or to deserve the
payment of a profit rate, but to help increase the productivity of the main actor of the
production process, which is human labor.
Since the whole treatment of fixed capital by Sraffa is based on the particular question of the
age of machines, as we shall see below, it is also important to note that in the real world there
is no such thing as a once and for all clearly defined age of a machine, which would remain
the same during its whole participation in the production process. In Production of
commodities by means of commodities, we are clearly at a technical level, but even at this
level there is no such thing as a predefined life span or age of whatever machine or piece of
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equipment, since this age will depend on many factors, like the intensity of the use of the
machine.
A machine working eight hours a day with a single shift obviously will not have the same life
span as exactly the same one working 24 hours a day with several shifts. The quality of
maintenance, which can vary from a firm to another due to multiple factors, as well as during
its own life time, can also greatly alter the real life duration of an equipment. Furthermore
most machines are not even used during the whole duration of their nominal life time, for the
well-known reason that they quickly become obsolete. New and cheaper or more productive
machines are indeed produced each year and after a few years make production with older
machines become no longer competitive. Hence the replacement of machines becomes
indispensable, even a long time before the day when they would have been worn out. The
result is that in the real economic world the composition of a collection of machines and the
way they are used vary continuously.
From a theoretical point of view all this is all the more annoying in that the whole treatment of
fixed capital by Sraffa, in 76 of his book, using a method first developed by Torrens 3,
consists in establishing a sub-system based on as many equations as there are separate
processes which correspond to the successive ages of a given machine. And the quantities
of means of production, of labor and of the main product are equal in the several processes in
accordance, with the assumption of constant efficiency during the life of the machine. This is
hardly compatible with the fact that neither the life span nor the efficiency of a machine can
ever be determined at any given point of time.
Nevertheless this is not the main criticism that can be made of the treatment of capital by
Sraffa. To consider it, let us recall that for each machine, there is a sub-system having as
many equations as the successive ages of this machine, for age 0, 1, 2,...n, where n is the
lifetime of each machine. Each of the n equations represents the joint production of good G
and of a machine of age 0 to n1 (on the left-hand side) and of age 1 to n (on the right hand
side). This sub-system covers a whole range of years, as many as the life span of the
machine. With a proper treatment, Sraffa then removes n1 equations corresponding to the
machines of intermediate ages to finally obtain a single equation containing only the newlyproduced machine, of age 0. This equation is the following (see 76 of the book):
M0pm0
r (1 + r )
(1 + r )
+ (Agpa + ... + Kgpk) (1 + r) + Lgw = Ggpg
The first term represents the annual depreciation of the machine, i.e. the value supposed to
be transferred by the machine to the final good G for a given year n.
However, when we come back to a whole system of production for a single given year, we
therefore turn, as Sraffa does in 83:
from the standpoint of the life-progress of a single machine to the stand point
of a complete range of n similar machines each being one year older than the
preceding one, and thus forming a group such as we might find in a selfreplacing system. The requirement that the life-sum of the depreciation
quotas should be constant and independent of the rate of profits is now
3
Torrens (1821) see pp. 28-29, where Torrens introduces the notion of residue of capital.
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embodied in the fact that under all circumstances such a group is maintained
simply by bringing in a new machine each year.
All this is quite coherent and means that in this self-replacing production system, we have n
machines in operation (from age 0 to age n1), with on the left-hand side of the n equations
like the one above n different depreciations. As Sraffa clearly demonstrates also, and this
demonstration is right, the price of the machines of the intermediate ages can vary with the
rate of profits, but for a given rate, as it appears from Figure 6 (in 83), the sum of these
different prices is always equal to the initial value of the machine pm0.
Up to now, everything might seem correct, but a problem arises when we realize that, when
we come to the calculation of the production prices, we are no longer in the sub-system in
which it was innocuous to make appear n different machines of age 0 to n1 (the machine of
age n being withdrawn from the production process). Indeed, in a self-replacing state there is
one and only one machine, of age 0, which is produced in a given year, with its own equation
representing the conditions of its production. In this equation the quantity of the machine M0 of
age 0 (since it is new) appears on the right-hand side. And for a good G, and/or any other
good in the production process of which this machine is used, including its own, there are in
total as many equations for each good as the number of years n corresponding to the life
span of this machine M0.
Turning now to the way this whole system works, on the left-hand side of each of these
equations there is a value
M0pm0
r (1 + r )
(1 + r )
which represents the contribution to production or the transfer of value of these machines of
age 0 to n1 to the price of the goods that they help produce. We also know that the sum of
these depreciations is M0pm0. But we are now in the real system itself, where only new
machines of age 0 are really produced each year, each of them with its equation of
production, and no longer in the sub-system where there was joint production of the machines
of various ages. This implies that there are no equations corresponding to the real production
of machines from age 1 to n, because these machines have in fact been produced previously,
in earlier periods. This means that on the right-hand side of all these equations these
machines of age 1 to n cannot and do not appear.
The interesting thing is that, as a consequence of this situation, and for the whole production
system, when we sum up all the equations in which a machine Mo appears, we have on the
left hand-side a value M0pm0 corresponding to the sum of the depreciations, and on the right
hand side exactly the same value M0pm0 of the newly produced machine M0. This signifies
clearly that, whatever the life span of the machines, in a self-replacing state the value of the
quantity of the machines which is produced in each period corresponds exactly to the quantity
which is supposed to disappear in the production process, where this value is supposed to
be transferred to the value of the goods that they contribute to produce, to the tune of the total
depreciation affecting the same machines of various ages.
The inescapable conclusion of this analysis is that there is no such thing as a surplus for the
machine M, nor for any machine, since the demonstration performed so far can obviously be
generalized. Although all this can easily be understood intuitively, since in a self-replacing
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state there is no net production of fixed capital, but only its replacement, we have therefore
analytically established a very important result: in the Sraffa system, and as long as the fixed
capital is supposed to transfer its value to the goods produced, there is no surplus of fixed
capital. This means reciprocally that, supposing that there is a surplus, it cannot include any
capital good.
5. The contradictions of Sraffas system with fixed capital
At the point where we have arrived, we cannot but observe that we face a double
contradiction: indeed Sraffa defines production as a circular process (meaning that what
comes out of the process also enters or rather re-enters into it) through which a surplus is
created.
However, what is to some extent circular in the production process, as exposed in Production
of commodities, is the production of intermediate goods and fixed capital, this last one
being assimilated to a particular type of intermediate good with a span of life longer than the
production period, because both are supposed to enter into and come out of the same
production process. This explains why they appear on both sides of the equations describing
this process. But at the same time, in a self-replacing state, where the whole Sraffa system is
located, and as we have already showed, there is no such thing as a surplus of either
intermediate goods or fixed capital, because fixed capital is itself a kind of intermediate good,
and therefore there should be no production according to Sraffas definition.
As for consumption goods, we have already showed that these goods do not enter into the
production process, but are destroyed (either instantaneously or more or less quickly, if they
are durable) in the consumption process. It is clear therefore that there is no circular
production process concerning consumption goods. However, since these consumption
goods cannot be found on the left-hand side of the equations describing the process, but
appear necessarily on the right-hand side, the difference between both sides, for consumption
goods only, is necessarily made of the whole production of these consumption goods. One
might possibly say that it constitutes a surplus, although it would be an artificial one,
because for the process as a whole the quantities of intermediate goods should normally be
deducted from this surplus, in order to obtain the true surplus of the system. But this is
obviously impossible, because of the heterogeneity of the goods on both sides of the
equations.
This brings us to a paradox: it is the Standard net product which has to be divided between
wages and profits, but because what might be called a surplus, and constitutes this net
product, is made only of consumption goods, then these profits should be devoted entirely to
buying consumption goods! More importantly, this obviously contradicts the statement made
by Sraffa (at the end of 29), according to which the rate of profits in the Standard system
thus appears as a ratio between quantities of commodities irrespective of their price. Indeed
there is no such thing as a ratio between consumption goods and intermediate goods!
Another contradiction comes from the fact that Sraffas system is built in such a way that:
the ratio of the net product to the means of production would remain the
same whatever variation occurred in the division of the net product between
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wages and profits and whatever the consequent price changes (see 28 of
Production of commodities ).
But, even with all other parameters remaining unchanged, if the rate of profit changes from
one period to another during one of the n periods corresponding to the life span of a machine,
the depreciations in the value of this machine already registered during the preceding periods
will naturally remain unchanged, but the amount of the depreciations that will take place in the
following periods, after the change in the rate of profit, will also change. It follows that the sum
of the n depreciations for a given machine will no longer be equal to the value of the machine,
but will be lower or higher.
The same phenomenon would take place each time that the actual life span of a given
machine would become shorter or longer than the original or nominal one. In both cases,
either because of a change in the rate of profit or in the real life span of a machine, the
resulting change in the overall amount of the depreciations will change the proportions in
which the machine enters in the production process, and therefore the nature of the Standard
system and the whole price system! This is indeed not compatible with Sraffas system.
Before going further, let us go back to the definition of fixed capital as a kind of long life
variety of intermediate goods, since we can now better realize that this vision is incorrect.
Indeed what appeared on the left hand side of the equations, and that we did not questioned,
has to be revisited, since it is clear that it was not the machine itself, but a purely virtual
element, i.e. its depreciation, which varies, as Sraffa explains, both with the age of the
machine and with the rate of profit. The only thing which does not vary, as we already pointed
out, is the sum of the depreciations for the n machines of age 0 to n1 in operation for a given
period, which is always equal to pm0 but only for a given rate of profit. This virtual quantity
introduces an irreducible element of heterogeneity with the other intermediate goods:
although they disappear in the process in their initial form, but only to be transformed,
intermediate goods enter into it as real goods, and not virtual ones.
6. The consequences for the Standard system
6.1 The notion of basic goods

An important conclusion that we can draw from these observations is that most goods are not
basic goods, whose main property, as defined by Sraffa in 6 of Production of commodities
is that they enter (whether directly or indirectly), in the production of all commodities.
Indeed, since these goods are also produced, it means that one has to find them both on the
left and right-hand side of the equations defining the system of production. We have showed
that consumption goods do not meet this criterion, but at this stage we must admit that it is
also the case for fixed capital goods. Indeed it is not these goods themselves, but only their
depreciation that enters into the production process, and this depreciation, as defined by
Sraffa, is not a tangible element, which can be put on the left-hand side of the equations in a
non-contradictory manner. From this we must derive that fixed capital goods have to be
considered as final goods, which like consumption goods can be found on the right-hand side,
but not on the left-hand side of the equations.
In fact this corresponds to the treatment applied to depreciation by Keynes, who devotes the
whole appendix of Chapter 6 of the General Theory to the question of what he calls user
cost. He defines the user cost as the reduction in the value of the equipment due to using
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it as compared with not using it, and indicates that aggregate income, equivalent to
aggregate supply price, is equal to A U, or as being net of aggregate user cost 4. It is clear
that this user cost is quite similar to what Sraffa calls the annual charge to be paid for interest
and depreciation for a machine, and that as we have seen, unlike Keynes, he includes
wrongly in the production cost.
As a result, the only goods that can be found on both sides of the equations are clearly the
intermediate goods, strictly defined as goods that disappear (in the sense only of being
transformed) within the production process, where they can be used in the production of any
other good (final or intermediate) as well as in their own production (directly or indirectly).
They are thus the only goods that can be called basics in the sense that Sraffa gives to this
word. There is however no reason why there should be any surplus of these intermediate
goods, which are produced for each of them in the same total quantity as the sum of the
quantities used in all the various industries, as Sraffa calls them.
6.2 The notion of surplus
To be sure, some particular goods might prima facie be considered as basic goods, with an
amount produced even greater than the amount used as an input (ignoring the differences
already mentioned between their nature as an input and as an output). This is the case of
some agricultural products. But it is because there is a biological mechanism of organic
production which as such does not come obviously from spontaneous generation, but
precisely from the transformation of elementary goods, free or not. Indeed, using Lavoisiers
formula, who has no reason to be false in economy, nothing is lost, nothing is created,
everything is transformed. These elementary goods are the oxygen and carbon in the air,
nitrogen, potassium and phosphorus in soils, among others, which thanks to the biological
mechanism of photosynthesis (among other processes at work), allow to harvest some
agricultural products in higher quantities than those which have been sown. But in terms of
material balance, the overall process is balanced, and it cannot logically be otherwise.
The same thing is true for production in its economic sense. Even for agricultural products,
apart from the part that is self-consumed by small individual producers, products sold on the
market for final consumption are not formally those harvested, because they have passed
through various successive stages of preparation, packaging and transportation, which make
them different from those goods which have been harvested, so that for them the concept of
the surplus as a difference is not appropriate. As for mineral raw materials, it is clear that
there can no more be any surplus in the form of any directly consumable good for any ore
whatsoever.
These observations have an important consequence on the very nature of what can be called
a surplus. They do not prevent from considering that production is a circular process, at least
for the goods that are part of the rightly-named circulating capital. In their case, one could
even imagine that there is a surplus, but that would only be true for the subsystem,
necessarily incomplete, which produces the circulating capital with circulating capital, since
only a portion of the circulating capital is used in its own production process.
However, at the level of the production system as a whole, all the circulating capital is used:
the portion that is not directly used for the production of the circulating capital itself obviously
4
Keynes, 1936. See Appendix on user cost in Chapter 6: The Definition of Income, Saving and
Investment.
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enters in the production of final goods: consumer goods and fixed capital. And this circulating
capital is always fully utilized: even in the case of expanded reproduction, the circulating
capital produced in excess during a period compared to that produced during the previous
period is fully used in the increased production of various goods, be they intermediate or final,
during this same period. Indeed production prices are actually reproduction prices, which
concern only a single period, during which there cannot be any surplus of intermediate goods
(assuming the absence of stockpiles).
As for final goods, since they do not enter as such in the production process, they exist only
as an output of the system, and not as an input. Therefore, it is true that we might think of a
difference at an individual level between the output and the input: since for each of them this
input is zero, the total quantity produced might be considered as a kind of individual surplus.
But if we did so we would forget to deduct all the intermediate goods that are on the left-hand
side of the equation of the system, and that have actually entered, directly or indirectly, into
the production process of this final good. Similarly, at the level of all of these final goods, this
is not true either, because at this global level all of the intermediate goods which enter as
inputs into the whole production process have to be deducted from the whole output, which is
impossible due to the heterogeneity of both types of goods. As a consequence, a so-called
surplus cannot be quantified, and has therefore no meaning.
6.3 The notion of Standard commodity
Sraffa devotes Chapter IV of his book to the Standard commodity, which he defines as a
commodity that would not itself change in value when the distribution between wages and
profit changes. He notes in 24 that the perfect composite commodity that could play this
role:
is one which consists of the same commodities (combined in the same
proportions) as does the aggregate of its own means of production.
In 26 he calls the set of equations taken in the proportions of the Standard commodity, the
Standard system. He continues by saying that:
in any actual economic system there is embedded a miniature system
which can be brought to light by chipping off the unwanted parts,
and he adds that: this applies as much to a system which is not in a self-replacing state as
to one which is. He then: takes as unit of the Standard commodity the quantity of it that
would form the net product of a Standard system employing the whole annual labor of the
actual system, calling it the Standard net product.
Finally in 28 Sraffa defines as the Standard ratio:
the rate by which the total product of the Standard system exceeds its
aggregate means of production, or the ratio of the net product to the means
of production of the system, underlining that:
the possibility of speaking of a ratio between two collections of
miscellaneous commodities without need of reducing them to a common
measure of price arises of course from the circumstance that both collections
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are made up in the same proportions from their being in fact quantities of
the same composite commodities.
It is easy to see that all this demonstration can be carried out only because the very first
assumptions made by Sraffa establish an ad hoc classification of the goods, where all the
goods, apart from the luxury goods as he names them, can in effect play both roles of means
of production and of final products, which entitles them to being basic goods. This is what
leads him to his particular treatment of fixed capital goods. However, we have showed that
this classification is wrong, and that the only goods which are simultaneously means of
production and products of the system are the intermediate goods part of the circulating
capital, but that there cannot be a surplus of them, because they are transformed in the
process of production of the final goods.
It follows therefore that in an actual economic system where no confusion is made between
the different types of goods, it is impossible to define either a Standard commodity such as
Sraffas, or a Standard system, or a Standard net product, or a Standard ratio. Moreover
Sraffa tells us in 43 that:
the last remaining use of the Standard net product is as a medium in terms
of which the wage is expressed and in this case there seems to be no way
of replacing it.
Consequently the fact that there is no such thing as a Standard net product implies in
particular that the wage cannot be expressed in terms of this medium. Therefore the relation
of proportionality r = R (1 - w) between the wage and the rate of profits established by Sraffa,
and at the heart of his theory, cannot exist.
7. The intractable problem of land and natural resources

An additional problem arises with the introduction of non-produced means of production, such
as land and mines, in Sraffas system, because this makes it again reach its conceptual limits.
Indeed, in the same way that goods appearing only as products but not as means of
production such as consumer goods, are not basics, and cannot be part of the standard
commodity, conversely land, or more specifically in this case the different land qualities, are
among the means of production used to produce agricultural products, but obviously are not
part of the product. They are not basic goods, but their existence implies the payment to their
owners of a rent which is part of the production price.
When an agricultural product, such as wheat, is produced by several lands of different
qualities (fertilities), to determine a price system including the price of this product (wheat),
implies that the rent be removed from the system of equations, which would include otherwise
more unknowns than equations. This in turn implies that the equation used for the production
of wheat in the system of equations is that which corresponds to the land without rent, i.e. the
least fertile land, but which yields however the average rate of profits. The rent of other more
fertile lands, with a lower production cost per unit, can then be obtained as a differential rent.
It is also clear that the least fertile land is one for which the production cost per unit of output
is the highest, or conversely that which produces the lowest amount for a given production
cost.
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The problem, long known (and recognized by Sraffa himself), is that the determination of the
least fertile land depends on the cost of production, i.e. on the price system. Fertility is not an
absolute, exogenously given and intrinsic quality of the land, but a relative parameter, which
itself depends on the price system. The introduction of land and generally of non- produced
means of production and of their income, that constitutes rent, drives the system into a
circular reasoning: to determine the price system, we must know which one of the different
lands is the land without rent, i.e. the least fertile one, which implies to know the price
system.
At a second level, the price system varies depending on the variation of the rate of profit or of
the wage level. As a result, for different levels of the rate of profit and wages, we necessarily
get different price systems, which leads to changes in the production cost of all goods
produced with non-produced means of production, such as land or natural resources. These
modifications in the price system in turn change the order of land fertility or of the productivity
of these natural resources.
Again, we see that fertility cannot be defined as a parameter which would be independent of
distribution. The equation defining the method of production for the marginal land or natural
resource can vary with distribution. Therefore the system of equations defining the methods of
production when using the least fertile land or other non-produced marginal resources does
not remain the same when distribution changes, which implies that the corresponding
Standard commodity also varies. Therefore, since the rate of profit or the level of wages are
defined in terms of the Standard commodity, it is the very notion of a variation in this rate of
profit or level of wages that becomes irrelevant, because it is by definition impossible to
compare two different Standard commodities: it is clear that each Standard commodity
consists of heterogeneous goods in different proportions, each set corresponding to a
different system of equations.
It must therefore be acknowledged that Sraffas theory fails to provide a coherent conceptual
framework which would be able to deal in a non-contradictory or non-circular manner with
non-produced means of production and rent, in a way that would maintain the internal
consistency of this theory.
8. Conclusions on the Sraffa system and Standard commodity
The Sraffa system is a brilliant construction, which had the great merit to dismantle the
neoclassical theory of distribution for which wages and profits are determined by the marginal
productivity of labor and capital at the equilibrium. It shows well that when multiple
heterogeneous goods and production are introduced, wages and profits have nothing to do
with any marginal productivity, but have to be defined as a share of a net product. It
nevertheless results from the above demonstration that the system faces insurmountable
problems, in fact partially recognized by Sraffa himself, especially when fixed capital and nonproduced means of production are introduced in the system.
Moreover, as soon as a price system is needed to express and determine a state of
distribution, and to the extent that the price system itself reflects a state of distribution, we fall
into a circular reasoning: we must know the price system to measure the distribution, but one
must know the distribution to determine this system. Sraffa resolves this dilemma by defining
an invariable Standard of value, which is invariable with respect to distribution, and in which
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distribution can therefore be expressed independently of prices. This invariable Standard is

the Standard commodity, which leads to the well-known formula r = R (1 w). But this is
achieved by paying a heavy theoretical price:
The Standard commodity is in fact a composite aggregate of heterogeneous goods,

which are by definition basic goods, thus appearing to the right and left of the
equations giving the prices. This Standard commodity made of basic goods allows to
some extent to reason, with all the limitations which have been reported, as if we
were in the universe with a single good of the neoclassical theory or the Essay on
Profits of Ricardo 5, of which Production of commodities constitutes an attempt of
generalization;
Any change in the composition of the Standard commodity is a change of system

which is unintelligible, since it is impossible to compare two different Standard
commodities, i.e. to sets of different heterogeneous goods. Each Standard commodity
corresponds to a period during which the methods of production cannot change : in
the real world this implies that such a period must be extremely short ;
Since production is generally a continuous process, with a continuous change in the

methods of production and therefore in the Standard commodity, this prevents from
considering this Standard of value as a unit of measure for money, which has to link
the present to the future. This makes it impossible to introduce into this system a
money with Keynesian characteristics, meaning that its elements are pure numbers
without dimension, or scalars 6;
Therefore a change in distribution becomes unintelligible as soon as the methods of

productions change by the slightest amount, since the composition of the Standard
commodity changes simultaneously;
While prices are expected to ensure the reproduction of the system, no mechanism is
provided to connect the expense of wages and profits to this reproduction, unless we
assume that workers like capitalists share the same set of basic goods in the same
proportions, which is absurd;
One could even say that the system cannot be strictly speaking the capitalist system,
since the difference between workers and capitalists is suppressed by the fact that
what they share is in fact the same Standard commodity.
9. An alternative view: production as a transformation process
What has been established in this paper is that all the problems encountered by Sraffas
theory cannot but come from its very roots, i.e. from his initial assumption that production is a
circular process, which leads Sraffa to an erroneous definition and classification of the goods
which are part of this process, either as entering into it or as coming out of it. While Sraffa
thinks rightly that there is no such thing as a productivity of capital, this is what leads him to
consider fixed capital goods as if they were intermediate goods, and to put the depreciation
5
Ricardo, 1951.
That Keyness units of measure were not compatible with a Standard of value made of heterogeneous
goods was shown in Flamant, 1975.
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of capital on the left of his equations, which implies that fixed capital transfers its value to the
products, an assumption rejected by Keynes.
Does this mean that production must therefore be regarded, as Sraffa also said to
characterize the alternative view, as a one-way avenue that leads from factors of production
to consumption goods? This paper does not fully validate this view either. It has showed
indeed that production is a transformation process only for intermediate goods, and that part
of these goods are used in their own production, which is indeed a circular process. However
the remaining part of intermediate goods is transformed into final goods, that are either
consumption goods or fixed capital goods, and for this very reason never enter again to be
transformed in the production process once this transformation has occurred and is over.
It has been shown also that fixed capital, while it plays an indispensable role in the production
process, by helping to transform intermediate goods, is not itself transformed in this process.
It is not either a factor of production in the sense that it would have a measurable
productivity, independent of distribution and of the price system. Therefore production can
only be defined as a work process that takes place in the context of specific social relations,
where wages are paid in money, and in which fixed capital plays an important role, but as a
catalyst which as such is present and unchanged at the beginning as well as at the end of the
production process, and increases in considerable proportions the productivity of labor.
All these flaws explain why the Sraffas system cannot be a solution to the Marxist problem of
the transformation of values into prices of production, which has been wrongly expressed and
therefore left unsolved by Marx. This is not surprising, because Marx, like Torrens and Sraffa,
also thought that fixed capital transferred its value to the product. 7
Let us conclude that, on the basis of the above analysis, commodities do not produce
commodities. Labor, helped by capital as a catalyst, produces commodities. Maybe Sraffa
was a little aware of that, which would help explain the enigmatic character of his subtitle to
Production of commodities: Prelude to a critique of economic theory.
References
Flamant, C. (2014). Marx, Keynes et la Crise. Published on lulu.com:
http://www.lulu.com/shop/search.ep?keyWords=marx%2C+keynes+et+la+crise&type=Not+Service&site
search=lulu.com&q=
Flamant, C. (1975). Remarques sur le chapitre 4 de la Thorie gnrale: le choix des units de mesure.
In Controverses sur le systme keynsien. Economica. Paris 1975.
Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. Cambridge University
Press.
Ricardo, D. (1951). Essay on the influence of the low price of corn on the profits of stocks, in Works and
Correspondence, Vol. IV, pp. 9-41, P. Sraffa (Ed.), Cambridge.
Sraffa, P. (1960). Production of commodities by means of commodities. Cambridge University Press.
Cambridge.
Torrens, R. (1821). An Essay on the Production of Wealth. London, Longman, Hurst, Rees, Orme and
Brown, 1821. California Digital library: https://archive.org/details/essayonproductio00torrrich
Flamant, C. (2014). provides a comprehensive analysis of these questions. Chapter 14 exposes a

coherent price theory (pp.159-184).
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___________________________
SUGGESTED CITATION:
Christian Flamant, Commodities do not produce commodities: a critical review of Sraffas theory of
production and prices, real-world economics review, issue no. 72, 20 September 2015, pp. 118-134,
http://www.paecon.net/PAEReview/issue72/Flamant72.pdf
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Economic consequences of location: European

integration and crisis recovery reconsidered
Rainer Kattel 1
[Tallinn University of Technology, Estonia]
Copyright: Rainer Kattel, 2015

Henry crosses the room. Stamp, stamp stamp in his riding boots; he is ready
for la chasse. He turns, rather slowly, to show his majesty to better effect:
wide and square and bright. We will pursue this. What constrains me? The
distance, he says (Hilary Mantel, Wolf Hall).
The European Union as a whole has not recovered from widespread financial cum fiscal crisis
that emerged in 2008. However, as is well known, this does not mean that some countries or
even regions have not left recession behind. Typical official political answer for why some
have recovered involves a combination of well-applied austerity measures (indicates correct
choices once the crisis hit) and relatively less corrupted elites (indicating healthier political
economy prior the crisis). There are ample reasons to doubt this official line of reasoning,
most of them pinpointing to financial and fiscal architecture of the Union as fundamentally
faulty and at fault. Essentially these doubting arguments take two often interrelated forms:
either the European crisis is caused and perpetuated by balance of payment imbalances
between surplus and deficit countries without a clearing union, or by the lack of (transparent)
lender of last resort. 2 Simply put, European architecture assumes all countries within the
Europe Union can be successful with exports based development strategy; everybody just
needs to be competitive enough to manage in good and bad times without the help from
exchange rate management or lender of last resort. In what follows, I argue that under such
circumstances what becomes important for economic success and failure are accidental
features of a country and not the ones based on political and especially policy choices. And
more precisely, under above mentioned specific European circumstances geographic location
distance from core European economies becomes a key determinant in how countries
fare in Europe. However, geography is not a policy choice, its an accident.
Location as an important feature in economic development is obviously not a new argument.
From Johann Heinrich von Thnens Der Isolierte Staat (1826) to modern research on
economic agglomerations by Jane Jacobs (1984) and Ann Markusen (1996) to regional
innovations systems studies (Asheim and Gentler 2006) and to explaining the rise of the West
as location based historical development (Morris 2010) and, most recently, to research on
global value chains (Gereffi 2013; Ernst 2009) location is seen as one of the key economic
factors in all the mentioned avenues of economics. This short paper does not pretend to add
to any of these research strands. Rather, the paper assumes primacy of human agency
(choices made by entrepreneurs and policy makers available to researchers as institutional
facts and interactions) and it aims to show under which circumstances and how location
becomes to dominate over human agency, that is, over policy choices.
1 This note was originally prepared for Network Ideas conference in Chennai, India, January 2015. I am
grateful to Bjrn Asheim for his comments on an earlier draft.
2 For the former type of argument, see Kregel 2011; for the latter, see Mitchell 2015.
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Analytically, the paper is based on what could be dubbed a Schumpeter-Minsky-Kregel

institutional framework. 3 Any economic unit (company, country) can be institutionally (in the
sense of various interactions it has and rules that govern these interactions) viewed from both
its innovation profile (its technological, managerial, etc capabilities; well established in
Schumpeterian line of research, see Schumpeter 1912, 1939 and 1942) and from financial
profile (also already present in rudimentary form in Schumpeters analysis but later
substantially further developed by Minsky (1986a; 1986b) and by Kregel, particularly in the
sense of international institutional dimension (2004)). According to Minsky, economic unit can
be either in hedged (all its liabilities are well covered by assets), speculative (it has to sell
some of the assets or borrow to make position, that is to cover liabilities) or Ponzi (neither
selling of assets or borrowing is enough to cover liabilities) financial position. This institutional
framework can be expressed in a greatly simplifying figure as follows (Figure 1):
Figure 1. Analytical framework
Financing position of economic
unit
Hedged
Innovation profile of economic
unit
Speculative
Financial profile of economic

unit
Ponzi
Within this framework, economic units financing position (health of its balance sheet, in other
words), depends both on changes in innovation profile (e.g., licensing new technology, setting
up new factory) and financial profile (e.g., changes in interest or exchange rates). Geography
and location have played a marginal role in such analysis. In what follows, I try to show that at
least within the European context, location has become a huge factor in determining health of
balance sheets (of countries and companies).
I Post-crisis Europe: deceptive simplicity

One of the first things in terms of location one notices is that Europe has indeed become a
region of different growth (or crisis recovery) speeds. More precisely, we can see three
different sets of countries as depicted on Figure 2. 4
See also Burlamaqui and Kattel 2014 for more detailed discussion.
Here and on following figures not all EU or eurozone countries are depicted; in order to keep figures
less clattered, the figures look at Germany and diverse regions within the EU: Northern European
(Netherlands, Finland, Denmark, Sweden), Southern European (Greece, Italy, Spain, Portugal), Eastern
European (Czech Republic, Hungary, Poland, Slovakia and Slovenia) and Baltic (Estonia, Latvia,
Lithuania) countries. Here and on other figures regional figures are based on simple averages.
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Figure 2. Gdp per capita since 2007, selected European regions (averages), in 1990 gk$,
2007=100.
Source: The Conference Board Total Economy Database, January 2014, http://www.conferenceboard.org/data/economydatabase/ calculations by the author.
We can see a three tier Europe emerging:

First, Germany and Eastern European economies tightly knit together via Germanys
transport equipment production networks 5 experienced virtually no crisis (with the exception
of Hungary);
Second, Northern Europe and Baltics knit together via electronics and tourism value chains
of Northern Europe have converged around similar growth rates after deep shocks in the
Baltics in 2009-2010; 6 and
Third, Southern Europe, with low levels of exports and accordingly without significant intraEuropean value-chain interdependence (see further below), are in continuous slow decline.
There seems to be also a obvious culprit austerity is killing the South; all other regions
under consideration here have rather noticeably increased government expenditures from
2007 to 2013 (latest year available), as we can see from Figure 3.
5
6
For a detailed discussion, see IMF 2013.

Kattel and Raudla 2013 offer further details; see also Reinert and Kattel 2013.
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Figure 3. Growth of government expenditure in selected European regions, 2007-2013,

current prices.
Source: Eurostat; calculations by the author.
If we think of labour productivity as a proxy for competitiveness of an economy, then this

impression that the Southern countries suffer under artificial external constraints (i.e. why they
do not increase government spending), is only strengthened. In terms of labour productivity,
Europe looks a rather linear ladder going upwards, as we can see on Figure 4: countries grow
gradually more productive from the Baltics and Eastern Europe over Southern Europe
towards Germany and Scandinavia.
Figure 4. Real labour productivity per hour worked, selected European economies, 2013.
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Source: Eurostat.
However, this straightforward picture remove fiscal and monetary shackles and the South
will catch up with the North is deceptive. In other to get a better and more complex
understanding, we need to also understand innovation and financial profiles of European
economies, in the sense depicted above in the analytical framework.
II Innovation and financial profiles of European economies

Both innovation and financial profiles of economies are obviously highly complicated and
complex issues. In what follows, I use therefore rather simplified proxies to get a quick and
somewhat birds-eye view on these issues.
In terms of innovation, we know that most companies (or economic units) innovative
incrementally, learning from daily activities to avoid mistakes, waste materials and time, and
finding slightly better, faster ways of creating products and services, or servicing clients. 7
What we thus need to understand is how do companies behave in different economies, what
sort of routines are dominating within companies. Holm and Lorenz have utilised the
European Working Conditions Survey which is based on individual interviews with
employees about working conditions to come up with a taxonomy of organisations. 8 (Holm
an Lorenz 2014) Their taxonomy is based on the way work is organised at the shop level:
how hierarchical are decision making processes (for instance, when something goes wrong,
who decides how and what should be done?); how complex are tasks; how much team work
there is, etc. And they show that there are four key types of organisations: from discretionary
learning based organisations over lean and tayloristic organisations to simple organisations.
Particularly the former are interesting for the purposes of the current paper as these
organisations called learning organisations hereafter are geared towards continuous and
incremental learning and innovations. (See also Holm et al 2010) To put it very simply: the
more there are such learning organisations in an economy, the more innovative the economy
is. If we plot productivity and learning organisations data from European economies, we get a
surprising picture, see Figure 5.
Instead of a linear catching up path as labour productivity data would suggest , we see
rather a veritable valley of death as we proceed from low productivity countries towards high
productivity countries. The gulf between low and high productivity countries is filled with
countries were innovations are not that important for companies and where more hierarchical
organisation types prevail. In other words, as Eastern European and Baltic economies are
highly integrated with German and Northern European economies respectively, this is also
reflected in their innovation profiles as these are converging, albeit without being
accompanied by productivity growth. The channel for such convergence is, on the one hand,
high share of foreign ownership (FDI, see next figure), and, on the other hand, tightly
interwoven trade networks. Southern European countries seem to have distinctly different
innovation profile and hence integration patterns.
Community innovation surveys periodically conducted in European countries offer ample empirical
proof, see http://ec.europa.eu/eurostat/web/microdata/community_innovation_survey for datasets and
questionnaires. For a theoretical background, see Nelson and Winter 1982 and their discussion of
various routines and capabilities.
8 As there have been numerous waves of the survey, Holm and Lorenzs taxonomy is based on 33 187
interviews distributed across 81 country-waves. (2014, 5)
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Figure 5. Learning organizations and labour productivity, 2010.
Source: Eurostat; Jacob Holm. 9
In terms financial profile, Europe is in a rather unique situation as countries are strongly
constrained in their fiscal policies and eurozone countries lack monetary policy entirely; in
addition, free movement of goods and services means that simultaneously most countries are
highly integrated with each other. Accordingly, in order to gauge country financial profiles, we
can look at financial account (capital flows) and at foreign ownership of banking assets as
proxies for where does financing come from and who makes financing decisions. Figure 6
does this.
9 I am grateful for Jacob Holm for sharing his datasets. Holm et al 2010 have also calculated the share
of learning organisations for 2005, differences are not large.
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Figure 6. Financial account and share of foreign owned banking assets, ten year averages,
selected European economies.
Source: Eurostat; ECB reports (2003-2007), ECB consolidated banking database (2008-2012);
calculations by the author.
Also in financial profiles we see regions with distinctly different profiles: Germany and other
Northern economies have low shares of foreign ownership and are exporting capital; South is
the exact mirror image of the North as it has low foreign ownership and is importing capital;
Eastern European and Baltic economies have extremely high shares of foreign ownership
and massively import capital. Particularly latter two regions Eastern Europe and Baltics
have financial profiles with extremely constrained financial decision making spaces: what gets
funded is decided somewhere else. 10
III Location as destiny?

Looking at the European map, it is somewhat obvious to think that geography should play a
crucial role, at least in some more apparent cases. Thus, for instance, it would come as a
great surprise if Finland and Estonia (distance between capital cities 80km) were not
strongly integrated economically. What speaks for it even more is that these two countries
share a long-term political past (both were incorporated into Tsarist Russia until World War I)
and strong cultural affinity (both languages belong to the same language family). 11 On the
other hand, it can be argued that entire point of economic policy making is to overcome
disadvantages (e.g. remote location, or natural resource abundance) and utilise advantages
10
One could also discuss here public investment programmes (into infrastructure, R&D, etc), however
these are typically few orders of magnitude lower than financing of investments by private sector.
11 See Boschma 2005 on different types of proximity.
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(e.g. vicinity to large markets, or highly educated labour force). What is interesting is how
location and policy mix.
Famously, von Thnens 19th century model showed that they do not: as argued by Reinert
2013 and Fuijta and Krugman 1995, von Thnens model indicates that the farther a location
is from increasing returns activities of the city at the centre of isolated state, the more primitive
economic activities become. 12 Conversely, Mukand and Rodrik (2002) have shown how in the
Eastern European and former Soviet Union context policy ideas are copied with different
earnestness: countries closer to Brussels tend to mimick policy ideas more closely (and gain
according economic benefits) than countries in far periphery (who thus retain larger policy
space and could potentially benefit from this), and those in the middle faring worst as they
somewhat feebly attempt to mimic core countries without clear economic benefits.
If we add location as a variable to innovation and financial profiles described above, we get
indeed a picture reminiscent of von Thnens circles of decreasing returns. (It is important to
note that in what follows dynamics within a country are not considered.) As a proxy for
location I have taken a very simple measure: average distance to three top export partners
(distance between capital cities; over past 3 years up to 2014).
Figure 7 shows innovation profiles with location figured in and Figure 8 does the same for
financial profiles.
Figure 7. Innovation profiles and location, selected European economies
Source: Eurostat; Jacob Holm; calculations by the author.
12
Fuijta and Krugman 1995 model under what circumstance there will emerge another city, i.e another
agglomeration of increasing returns activities.
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In the case of innovation profiles, we can in fact see modern version of von Thnens (half-)
circles: in the core we have Northern European economies, closely surrounded by Eastern
European and Baltic economies (first half circle), while the Southern economies remain at
quite a distance (second half circle). In the case of financial profiles, we see again regional
groupings emerging clearly and again distance making a big difference, in this case in the
much higher levels of foreign financial ownership and levels of FDI stock (only outlier is
Slovenia that groups with the Northern core economies). This leads us to venture that
potential financial instability sources are quite different at the opposite ends of financial von
Thnens circles in Europe: what threatens the South is not what threatens the East (see
more below).
We can draw two tentative conclusions from these location based figures:
First, modern von Thnen circles in Europe do not express increasing distance from
increasing returns activities but rather decreasing returns to integration: the farther a country
is from core surplus and capital exporting economies, the less returns (in terms of companies
mimicking innovation behaviour of the core economies) it reaps from integration. This is also
expressed in lower exports and export potential as indicated through much lower FDI.
Second, under these circumstance it seems particularly non-sensical for countries farther
from the core the Southern European economies to follow similar structural and other
policies as those in the core and its Eastern and Baltic satellites as they likelihood of reaping
economic benefits seems rather low (as Mukand and Rodrik 2002 predicted, albeit in a
somewhat different context).
Figure 8. Location and financial profiles, selected European economies.
Source: Eurostat; ECB reports (2003-2007), ECB consolidated banking database (2008-2012);
calculations by the author.
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In the case of satellite economies of Eastern Europe and Baltics, it is interesting to observe
that during the crisis they did not experience significant capital outflows (which would have
doomed these economies to a severe shock). However, following Jan Kregels work (2004),
we can construct a simple formula to see how vulnerable these economies are to external
shocks. Kregel argues that countries relying on foreign borrowing to pay for their imports in
other words, countries with large current account deficits, such as Eastern European and
especially Baltic economies can experience self-reversal of their growth strategies when the
rate of incoming capital is lower than interest on existing foreign borrowing. If that is the case,
these countries move into Ponzi financing position (as described above). Figure 9 does a
simple exercise along these lines, looking at financial account and FDI flows in Eastern
European and Baltic economies over the past decade.
Figure 9. Financial stability in Eastern Europe and Baltics, 2004-2013
speculative financial position
hedged financial position
speculative financial position
Ponzi financial position
Source: Eurostat.
As we can see, during most of the period, these economies oscillated between speculative
and hedged financing positions. This suggests that while these economies are highly
integrated into core European financial networks, reversal of capital flows can in fact quite
easily happen. In other words, while innovation profiles of these countries suggests close
mimicking of core countries profiles, without increasing labour productivity (and translating it
into higher wages and stronger domestic demand), Eastern European and Baltic economies
remain in a rather speculative financing position: their growth depends on flows and stocks of
capital that these economies themselves are not in charge of.
IV Implications
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This brief note shows above all that in a world based on trade and financial openness and
where development strategies are increasingly foreign savings based (in form of borrowing
and exports), location vicinity to main export partners becomes to dominate innovation and
financial profiles of countries and companies. In effect, polices become secondary. Success
or failure becomes a matter of geographical accidents. Geography becomes destiny.
If this is halfway true then farther European periphery has hardly any realistic hope of
converging with the core in terms of its innovation profiles that is, in terms of its
competitiveness. In essence, periphery in the South needs to overcome location bias forced
upon it by rules of the game of the European Union. In other words, these economies need
changes in the rules of the game. Given the EUs fiscal constraints on countries (meaning
governments in the South cannot massively increase investments into the real economy and
productive infrastructure), the most realistic option these countries have is to change rules
governing their financial sectors and induce in such a way higher investments into the real
sector.
References
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in Jan Fagerberb, David C. Mowery and Richard Nelson, eds., The Oxford Handbook of Innovations,
Oxford: Oxford University Press, 291-317.
Boschma, Ron A. (2005). Proximity and Innovation: A Critical Assessment, Regional Studies, 39, 1,
6174.
Burlamaqui, Leonardo and Rainer Kattel (2014). Development Theory: Convergence, Catch-up or
Leapfrogging? A SchumpeterMinskyKregel Approach, Dimitri Papadimitriou, ed., Contributions to
Economic Theory, Policy, Development and Finance: Essays in Honor of Jan A. Kregel, London:
Palgrave Macmillan, 175-195.
Ernst, Dieter (2009). A New Geography of Knowledge in the Electronics Industry? Asias Role in Global
Innovation Networks. East West Center, Policy Studies 54.
Fuijta, Masahisa and Paul Krugman (1995). When is the economy monocentric?: von Thnen and
Chamberlin unified, Regional Science and Urban Economics, 25, 505-528.
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Holm, Jacob R. and Edward Lorenz (2014). Has Discretionary Learning Declined during the Lisbon
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copy available at: http://ssrn.com/abstract=2487849.
Kattel, Rainer and Ringa Raudla (2013). The Baltic Republics and the Crisis of 20082011, EuropeAsia Studies, 65(3), 426-449.
Kregel, Jan (2004). External Financing for Development and International Financial Instability, G-24
Discussion Paper No. 32., October 2004.
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Kregel, Jan (2011). Debtors Crisis or Creditors Crisis? Levy Economics Institute, Public Policy Brief
121, available at http://www.levyinstitute.org/pubs/ppb_121.pdf.
Markusen, Ann (1996). Sticky places in slippery space: a typology of industrial districts, Economic
Geography, 72(3), 293313.
Minsky, Human (1986). Stabilizing an Unstable Economy, New Haven, CT: Yale University Press.
Minsky, Hyman (1986b). Money and Crisis in Schumpeter and Keynes, in H.-J. Wagener and J. W.
Drukker, eds., The Economic Law of Motion of Modern Society. A Marx-Keynes-Schumpeter
Centennial, Cambridge: Cambridge University Press, 112-122.
Mitchell, William (2015). Eurozone Dystopia: Groupthink and Denial on a Grand Scale, Cheltenham:
Elgar.
Morris, Ian (2010). Why the West rules for now. The patterns of history and what they reveal about the
future, London: Profile Books.
Mukand, Sharun and Dani Rodrik (2002). In search of the holy grail: policy convergence,
experimentation, and economic performance, available at http://www.nber.org/papers/w9134.
Nelson, Richard R. and Sydney G. Winter (1982). An Evolutionary Theory of Economic Change,
Cambridge: The Belknap Press of Harvard University Press.
Reinert, Erik S. (2013). Primitivization of the EU Periphery: The Loss of Relevant Knowledge,
Informationen zur Raumentwicklung / Informations on Spatial Development, Bonn, Germany:
Bundesinstitut fr Bau-, Stadt- und Raumforschung (BBSR), No 1, 2013.
Reinert, Erik S. and Rainer Kattel (2014). Failed and Asymmetrical Integration: The Baltics and the
Non-financial Origins of the European Crisis, in Jeffrey Sommers and Charles Woolfson, eds., The
Contradictions of Austerity. The Socio-Economic Costs of the Neoliberal Baltic Model, London:
Routledge, 64-86.
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Capitalist Process, Volume 1, London and New York: McGraw-Hill.
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von Thnen, Johann Heinrich (1826). Der isolirte Staat mit Beziehung auf Landwirtschaftund
Nationalkkonomie, Hamburg: Perthes.

___________________________
SUGGESTED CITATION:
Rainer Kattel, Economic consequences of location: European integration and crisis recovery reconsidered, realworld economics review, issue no. 72,30 September 2015, pp. 135-146,
http://www.paecon.net/PAEReview/issue72/Kattel72.pdf
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Global production shifts, the transformation of finance

and Latin Americas performance in the 2000s
Esteban Prez Caldentey 1
[Economic Commission for Latin America and the Caribbean]
Copyright: Esteban Prez Caldentey, 2015

Abstract
There are two main distinguishing features that characterize the performance of Latin
American in the 2000s in relation to its past history. During the 2000s Latin America
witnessed one of the most significant expansions of the last thirty years. At the same
time, LAs recovery from the effects of the Global Financial Crisis (2007-2009), the
most important crisis since the Great Depression, was V shaped. This paper argues
that Latin Americas (LA) performance in the 2000s in good and bad times is
explained by the way in which capitalism organizes production and finance. The focus
is placed in part on the global production shifts of multinational corporations to move
industries, production and employment across the globe taking advantage of cheaper
production costs, expanding markets and the increasing importance of production
chains. During the 2000s decade China became a hub for developed country
corporate production restructuring. Another contributing factor is the increased
integration of the real and financial spheres as epitomized by the use of commodities
as financial assets and collaterals. At a more general level the analysis questions the
widely held perception that developed economies have lost pre-eminence at the
global level and that the distribution of world economic and political power is shifting
towards the developing world.
Introduction
There are two main distinguishing features of the performance of Latin American in the 2000s
in relation to its past history. During the 2000s Latin America (LA) witnessed one of the most
significant expansions of the last thirty years. At the same time, LAs recovery from the effects
of the Global Financial Crisis (2007-2009), the most important crisis since the Great
Depression, was V shaped.
This paper argues that Latin Americas performance in the 2000s in good and bad times is
explained by a process of global production restructuring and a greater integration between
the real economy and finance. The process of global production restructuring refers to a trend
of multinational corporation networks to move a wide variety of industries, production and
employment across the globe taking advantage of cheaper production costs, expanding
global markets and the increasing importance of global production chains. Due to its size,
strategic location, favorable tax treatment and open door policy, China became a linchpin of
this transformation.
The global production restructuring movement has been a key contributor to the increase in
the demand for raw materials, commodities and other inputs which constitute some of the
major exports of Latin American countries. The available empirical evidence shows that a
significant part of Chinese imports and exports do not respond to the demands and
Economic Commission for Latin America and the Caribbean. The opinions here expressed are those of
the author and may not coincide with those of the institutions with whom he is affiliated. The author
wishes to thank Manuel Cruz for his contributions to the ideas developed in the paper.
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possibilities of the domestic Chinese economy but rather to the needs of foreign multinational
corporations operating, under very favourable conditions, in China.
At the same time that the restructuring of global production intensified in the 2000s, the
financial sector became intertwined with the real economy. This is illustrated by the trends
observed in the commodities market in the same period. Commodities took on an increasing
role as financial assets which affected their price trends and their volatility. Part of this
consisted in the use of commodities as collaterals to obtain loans and liquidity.
The relation between both changes in production and finance and Latin American
performance in the 2000s decade is not coincidental. During this time Latin American
economies benefitted from high commodity prices and high export demand which had
important positive effects on its external accounts and also its fiscal position. More to the point
these softened Latin Americas external constraint. In fact, the regional performance in the
period running from 2003 to 2007 is atypical in the sense that it is the first time that Latin
America experienced a high growth with a surplus in its current account at the regional level.
Moreover, during this time Latin America also benefitted from easy access to liquidity
resulting from the increased interrelation between commodity prices and finance.
The paper is divided into five sections. The second section briefly describes Latin Americas
performance during the 2000s. The third and fourth sections analyze, respectively, the
restructuring of global production and the transformation of finance. The fifth section
concludes.
Latin America in the 2000s: a different performance in good and bad times
During the period 2003-2007 Latin America witnessed one of the most significant expansions
over the last thirty years. The regional average per capita growth rate reached 2.8 percent,
surpassing not only that of the 1980s lost decade and that registered during the free market
structural reform era (19912000; 1.3 percent), and was only surpassed by that of the 1970s
(4.4 percent).
Table 1: GDP per capita growth in Latin America and the Caribbean, 19712013
Period
GDP per capita
1971 - 1980
4.4
1981- 1990
-0.3
1991 - 2002
1.3
2003 - 2007
2.7
2008 - 2009
-0.2 (-2.7% for 2009)
2010 - 2013
2.7
Source: World Development Indicators, World Bank (2015)
This vigorous expansion was interrupted by the Global Financial Crisis (2007-2009) whose
effects did not spare the countries of Latin America. In line with the impact of the crisis
worldwide, Latin American countries witnessed, on average, a decline in the regional GDP
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per capita growth rate of -2.7% for 2009. At the national level 10 out of 18 (or 55% of the total)
Latin American economies experienced output contractions.
From a comparative sub-regional perspective the effects of the crisis are far from
homogeneous and were felt with much greater intensity in Central America than in South
America. On average the rate of growth in 2009 plunged by -2.3% on average for Central
America (Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua) and -1.8% if
Panama and the Dominican Republic are included. South America also registered a
contraction but with lesser intensity than Central America as can be seen in Figure 1.
Figure 1: Rates of growth of GDP for South and Central America 1961-2013 (Averages)
Source: World Development Indicators, World Bank (2015)
However as clearly shown in Figure 1, both sub regions were able quickly to bounce back and
regain the levels in the rates of growth that had prevailed in the pre-crisis period. In fact the
short duration of this last crises episode and the swift recovery distinguishes the impact of the
Global Financial Crisis episode (2007-2009) from other crises including the 1980s Debt-Crisis
(1980), the Mexican Crisis (1994-1995) and the Asian-Russian-Argentine crises (1998-2002).
Global shifts and the restructuring of world production

The performance of Latin American countries and in particular of commodity exporting
countries during the 2000s decade responds to the increasing importance of multinational
corporation (MNC) production networks and to the way countries have positioned themselves
within these networks. The formation of global production chain networks stretch across a
number of developed countries and developing regions as reflected by the rising importance
of intermediate inputs in world trade. According to the World Forum (2012) intermediate
inputs represent half of the goods imported by the OECD and three-fourths of the imports of
the larger developing economies such as China which is the main trade partner of some of
the countries in Latin America. In addition, for some economies intermediate inputs constitute
an important share of exports. The OECD reports that the imported intermediate input content
represents on average 25% of the OECDs exports and 20% of the European Union extra
regional exports. In the case of the developing world China is one of the countries whose
exports have one of the highest import content.
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In the last three decades the imported input content has evolved alongside Chinas growth in
trade, openness and consolidation as a world economic power. Currently Chinas economy is
one the six largest economies of the world. China represents 8% of world GDP; 17% of world
investment, 5% of world final consumption, and 10% of world exports (measured in constant
2005 dollars).
Since the start of economic reforms in 1979 and until very recently, Chinas real gross
domestic product (GDP) increased at an annual average rate of 10% expanding its real GDP
14-fold. As part of the reform process which included among others the decentralization and
partial deregulation of trade, and the establishment of development zones run by free market
principles with the objective to import foreign direct investment (FDI) and high technology
imports, China opened up its economy to external trade and finance. 2 As part of these
outward oriented initiatives China joined the World Trade Organization (WTO) in 2001 which
resulted in reductions in tariff and non-tariff barriers. 3
This open door policy led to a significant increase in trade and changed the countrys
composition of aggregate demand as well as its sources of funding. Imports and exports
which represented less than 10% of GDP in 1978 amounted on average to 60% in the 2000s
decade. A decomposition of aggregate demand from 1998 to 2011 in its different components
shows that the external sector is the main driver of growth. Currently China is the world's
second largest exporter and remains the third largest importer of goods and services. 4
Figure 2: China. Decomposition of aggregate demand into the financial balances of the
government, private sector and the current account. 1998-2010 (Percentages of GDP).
Source: On the basis of WTO (2007 and 2012)
According to WTO estimates in 2003, 60% of the countrys GDP is generated by private sector activity.
According to the WTO the average applied NMF tariff rate was reduced from 35% in 1994 to 15.6% in
2001 and to 9.7% in 2005 and has remained around that level. Duty free tariff lines accounts for roughly
9% of more than half of all tariff lines have tariff rates above zero and below 10%.. Import quotas and
trading rights were discontinued in 2004 and import prohibitions and licensing have bee reduced
progressively.
4 This excludes intra-EU trade). (WTO, 2012, p. ix)
3
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A significant part of the growth of trade that has accompanied Chinas open door policy is
explained by the expansion of inward processing. Inward processing is defined as the
customs procedure under certain goods can be brought into a customs territory (free trade
zones or special economic areas) conditionally relieved from payment of import duties and
taxes, on the basis that such goods are intended for manufacturing, processing or repair and
subsequent exportations(General Administration of Customs of the Peoples Republic of
China, 2011). 5 The available data shows that on average inward processing exports and
imports represented 54% and 40% of the total (both processing trade and ordinary (or nonprocessing trade)) respectively.
Table 2: China. Ordinary and inward processing exports and imports as percentage of total
imports and exports. 1995 and 2000-2010.
Ordinary
exports
Ordinary
imports
Inward processing
exports
Inward processing
imports
1995
48
33
50
44
2000
41
44
55
41
2001
42
47
55
39
2002
42
44
55
41
2003
42
45
55
39
2004
41
44
55
40
2005
41
42
55
42
2006
43
42
53
41
2007
44
45
51
38
2008
46
51
47
33
2009
44
53
49
32
2010
Average
(2000-2007)
Average
(2008-2010)
46
55
47
30
42
44
54
40
45
53
48
32
Source: General Administration of Customs of the Peoples Republic of China, 2011
The two major components of processing trade include process with assembly and process
with import materials which for 2010 represented 22.8% and 40% of imports and exports
respectively followed by entrepot trade by bonded area and warehousing trade (4.3% and
2.2% ; 7.8% and 2.3% of imports and exports). 6 The differences between process with
assembly and import materials of trade lie in the reduced cost of the former relative to the
5
China has different types of free trade zones: special economic zones (SEZ), economic and
technological development zones (ETDZ), high technology industrial development zones (HTIDZ) and
exports processing zones (EPZ). In 2010, there were 150 special economic zones. In terms of the
processing of imports the most important types of zones include the EPZ and the ETDZ. Both accounted
for more than 23% of the processing of imports for that year.
6 Chinese Customs recognize 19 types of trade regimes these include: ordinary trade, international aid,
donation by overseas Chinese, compensation trade, goods on consignment, border trade, equipment for
processing trade, goods for foreign-contracted project, goods on lease, equipment/materials investment
by foreign-invested enterprise, outward processing, barter trade, duty-free commodity, warehousing
trade, entrepot trade by bonded areas, equipment imported into export processing zone. In the case of
the assembly regime Chinese companies import raw materials and parts from foreign companies free
of cost, assemble or process the raw materials and parts into finished goods domestically in mainland
China, and then export the finished goods to foreign companies and receive only a processing charge.
In the case of processing Chinese companies import raw materials and parts from foreign companies
for value, assemble or process the raw materials and parts into finished goods domestically in mainland
China, and then sell the finished goods to foreign companies.
http://www.yusen-logistics.com/china/english/law/trade/about.html
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latter. The process with assembly regime does not incur raw material, intermediate costs and
payment of import duties. However, the process with import materials regime has become
since the 1990s the most used type of trade regime.
Processing trade is carried out mainly with both Asian and Western economies. In total terms
more than half of imports for processing originate in Asian countries (17% from the Republic
of Korea, 17% from Taiwan, 17% from China itself, 15% from Japan and 15% from ASEAN)
and about 10% from Western countries (5% from the European Union and 6% from the
United States). On the exports side, Western and Asian countries account for more than 40%
of Chinas processing exports (22% and 20% for the European Union and the United States;
22%, 9%, 7% and 5% for Hong Kong, Japan, ASEAN and Korea).
The decomposition of Chinas processing imports by industry show that high technologically
intensive imports such as electrical machinery and equipment, machinery and mechanical
appliances, and optical photographic instruments account for the bulk total imports (64%). For
its part natural resource based imports including mineral fuels, plastics, copper, iron and
steel, and rubber represent 18% of the total.
Latin American economies do not represent an important trade partner for this trade regime in
total terms. However, these have also contributed to the expansion of processing trade
through the provision of specific products including both non-natural and natural resource
based products. The former include integrated circuits, electrical capacitators, electrical
machinery and parts, semi-conductors, machinery parts and accessories and textiles. The
latter and by far the most important category comprises mostly commodities including soya
beans, oil, nickel, zinc, tin, iron, wood, meat, textiles, wool, and copper.
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Table 3: Latin America and the Caribbean: main products exported to China. Averages 20062008.
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Latin American economies have become some of the top exporters to China for some of
these commodities. In the case of copper, Chile ranks as the main exporter to China of
copper ores and concentrates (36% of total imports) followed by Peru. Chile is also an
important exporter of copper generated from smelting processes (blister/anodes) and of
refined copper (38% of total imports). 7
Chile and Peru as well as the other copper exporting developing countries play a significant
role in the copper global supply chain and more specifically in the earlier stages of raw
material extraction (mining, concentration) and processing (smelting, refining, fabrication).
The secondary stages including material processing (smelting, refining, fabrication), and
product manufacturing take place in China. The final stages which involve consumption and
recovery (product use, recycling infrastructure, and landfill disposal) are carried out in China
and through China in other regions and countries (Europe, United States and other countries
in Asia).
Recent data for the case of copper for 2013 shows that 46% of copper imports are
undertaken by trade modes associated with processing trade rather than ordinary trade. As
expected all copper exports are classified within trade regimes other than ordinary trade.
Table 4: China. Refined copper imports and exports by trade regime (September, 2013)
Imports
Exports
General trade
53.0
0.0
Storage of transit goods in bonded warehouses
21.2
38.4
Inbound and outbound goods in bonded areas
18.3
13.1
Feeding processing trade
6.5
48.5
Processing and Assembly Trade with Supplied Materials
1.0
0.0
Total
100.0
100.0
Source: Shanghai Metals Markets. Copper Monthly. 2013.
On the other side of the transaction while the importance of China as an export destination
varies widely among Latin American countries, it ranks, along with the Asia-Pacific region
among the main trade partners for some of the economies of South and Central America.
The firms that actually engage in this type of trading mode are not in their majority of Chinese
origin. In fact more than half of the firms that process imports are foreign and 17% are joint
Chinese-foreign ventures. Only 20% of the firms are purely Chinese owned (state-owned
private enterprises).
Other main exporters include Australia, Mongolia and Kazakhstan for ores and concentrate, Namibia
and Finland in the case of blister/anode and Japan and Kazakhstan for refined copper. See Five Winds
International, 2011.
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Table 5: Proportion of imports by ownership of firms, 2010 (in percentage of total)

Firm type
Processing
Ordinary
Total
State-owned enterprise
12.24
41.23
28.16
Sino-foreign contractual joint venture
0.66
0.44
0.54
Sino-foreign equity joint venture
15.53
14.14
15.22
Foreign invested enterprise
58.76
20.7
37.86
Collective enterprise
1.42
3.45
2.54
Private enterprise
10.17
20
15.57
Other including foreign company's office in China
0.01
0.01
0.01
Source: Yu and Tian (2012, p.33, Table 8.13)
The establishment of foreign owned firms is not particular to China and has occurred in a
number of developing countries including Mexico, China, India, and other Asian counties. It is
part of a corporate restructuring strategy explained by cheaper production costs, expanding
global markets and the need to increase and deepen insertion into global production chains.
The availability of data on changes in the location of production is limited and there is no
monitoring system to track production shifts around the globe or even at the country level. A
study commissioned by the USA-China Economic and Security Review Commission (2004)
which focused on the relocation of productive activities from the United States into China with
some data for other countries, shows that in 2004, the greater part of production shifts to
China originated in developed countries (the United States (38%), United Kingdom (15%),
Continental Europe (21%), Australia, Canada and New Zealand (4%), and Japan (15%)). The
same trend is found to exist for other preferred locations of production restructuring including
India, other Asian countries, Mexico, other Latin American countries and Eastern Europe.
Developed economies account for more than 90% of the production shifts to these
destinations.
Global production shifts are not specific to any particular industry or product line but rather
occur across a wide spectrum of industries and products. This is illustrated in table 6 which
shows global production shifts out of the United States by industry and destination. As can be
seen from table 6 the industries or lines of production that have relocated comprise from
aerospace, to chemicals to textiles and wood and paper. Note that in the particular case of
the United States, the industries include those that exported products of Latin America to
China including metals, wood, and textiles.
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Table 6: Global production shifts out of the US by industry and destination country
China
India
Aerospace
33%
0%
Other
Asia
67%
0%
Other Latin
America
0%
Eastern
Europe
0%
All
Other
0%
Apparel and footwear
39%
0%
11%
33%
11%
6%
0%
Appliances
47%
0%
21%
26%
0%
5%
0%
Auto parts
17%
20%
0%
49%
2%
12%
0%
Automobiles
33%
0%
0%
33%
33%
0%
0%
Chemicals and petroleum

Communications/Information
technology
Electronics/electrical
equipment
Finance, insurance, and real
estate
Food processing
50%
16%
9%
9%
6%
6%
3%
4%
39%
23%
0%
27%
0%
7%
48%
5%
24%
9%
0%
11%
3%
6%
88%
6%
0%
0%
0%
0%
0%
0%
38%
25%
13%
0%
25%
Household goods
Industrial equipment and
machinery
Metal fabrication and
production
Plastics, glass and rubber
33%
0%
20%
20%
13%
0%
13%
36%
7%
4%
36%
0%
10%
7%
44%
0%
11%
26%
11%
4%
4%
28%
0%
4%
36%
4%
16%
12%
Sporting goods and toys
89%
0%
11%
0%
0%
0%
0%
Textiles
42%
0%
0%
13%
29%
0%
17%
Wood and paper products
44%
13%
0%
33%
11%
11%
0%
Mexico
Source: Bronfenbrenner and Luces (2004, Table 15, p.70).
An additional and significant piece of evidence that illustrates the importance of the
restructuring of production is that for obvious reasons it involves well established multinational
corporations mostly in the manufacturing sector (with some exceptions) and that United
States based multinational corporations constitute a significant proportion of the total. The
study cited above found that the majority of the restructuring firms have been in operation for
more than two decades and in some cases closely to fifty years. U.S. based multinational
corporations represent on average more than half of the total and more than 70% in the cases
of production restructuring to Latin America. In the particular case of China the study found
that U.S.-based multinational companies represented 60% of the total. More recent
information in the case of China for 2012 shows that as a result of its open door policy more
than 650,000 foreign entities have been approved to operate in the country. 8
This overall evidence clearly shows that global re-structuring has become a pervasive
phenomenon. China due to the sheer size of its market, and economic transformation
including its outward orientation and open door policy to foreign investment and incentives
firm location, is an important part of this story. But as Bronfenbrenner and Luce (2004, p. 7879) remark, it is only part of the story:
it is a story of the worlds largest multinational corporations buying and
selling companies and pieces of companies, opening and closing plants,
8
PWC (2012).
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downsizing and expanding operations, and shifting employment from one

community to another, all around the world. With no particular loyalty to
country, industry, community of product, what our data suggest is that this
global race to the bottom is driven by several unifying factors: the search for
ever cheaper production costs, accessibility to expanding global markets, and
the flexibility that comes from diverse supply chains in an ever more volatile
global economic and political climate.
In the same way, the United States and the restructuring of Corporate America have played a
key and leading role in this transformation but there are other developed countries that are
following a similar strategy around the globe.
Bronfenbrenner and Luce (2004) and other authors indicate that major changes in the
restructuring of production took place in the 2000s which coincide precisely with a period
within which different countries, including Latin American ones, developed and developing
alike, increased their degree of co-movement and synchronicity across time (see Figure 3).
Figure 3: Moving average correlation coefficient (5 year window) of the normalized GDP for
China-OECD, China-Europe, Europe-Asia and US-China. 1990-january to 2014-may (monthly
data)
Source: Authors own on the basis of OECD (2015)
An analysis of the synchronicity of the Latin America business cycle with that of the United
States, Europe and China yields the same results. The synchronicity between one
country/region (say region i) and a reference region (say States, Europe and/or China) (region
r) is computed as (Mink, Jacobs, de Hahn, 2012),
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and
represent the rates of growth of country/region i and that of the
Where,
reference country/region r. The synchronicity indicator
measures the fraction of the
time during a given period that country/region i is in the same cycle phase as country/region r.
The available data for the period 1990-2012 show that Latin America and the Caribbean, and
all of its sub regions degree of synchronicity with all reference regions considered (United
States, Euro Zone and China) tends to rise over time and in particular staring in the 2000s
decade. Between 1990 and 2002, the degree of LAs and of its sub regions cycles is
synchronous with that of the United States and Europe more than 70% of the time on
average. But during the 2003-2007 period the degree of synchronicity between LA and the
United States increases to 89% and similar increases are recorded for LA and Europe (89%)
and LA and China (87%).
Table 7. Synchronicity between the business cycle Latin America and the Caribbean and its
sub-regions (and Mexico) with that of the United States, the Euro Zone and China (19902012)
Latin America and
the Caribbean
1990-1994
1995-2002
2003-2007
2008-2009
2010-2012
Average
74
73
89
57
83
75
1990-1994
1995-2002
2003-2007
2008-2009
2010-2012
Average
73
89
64
68
74
1990-1994
1995-2002
2003-2007
2008-2009
2010-2012
Average
69
87
64
75
74
South America
United States
68
72
99
45
92
75
Euro Zone
Central America
Mexico
85
78
80
73
80
79
80
75
100
75
100
86
72
99
58
74
76
China
64
87
68
76
74
78
80
80
67
76
75
100
88
70
83
77
86
60
71
74
77
90
50
78
74
Source: Prez Caldentey and Titelman (2014)
Overall the available evidence thus shows that far from decoupling from the business cycle of
developed and developing countries such as China countries, Latin America remains very
much coupled to their fluctuations of economic activity. In this sense it is an indication of the
degree to which Latin American performance is tied to the phenomenon of global shifts and
the global restructuring of production.
The transformation of finance

Concomitantly with the restructuring of global production of the 2000s, another change that
took place within the global economy during this time, and that has had a significant impact
for Latin Americas development, is the increased interrelation and interdependence between
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the real and the financial spheres of economic activity. This is exemplified by the recent
trends observed in the commodities market.
In the case of Latin America and more precisely, South America, commodities are, on the one
hand, an important component of real activity. Commodities are a major export (more than
50% of the total in several countries). These contribute substantially not only to balance of
payments stability but are also a main source of government revenue. In some cases the
government revenue earned from commodities far surpasses that of other sources of public
income. In addition, the evolution of the price of commodities is also tied to the gross
formation of fixed capital Finally, the sectors of economic activity that depend on
commodities explain a large share of the generation of output and income, and of FDI inflows.
On the other hand, commodities have taken on an increasing role as financial assets in the
sense that prices respond to changes in expectations about future demand conditions rather
than to actual supply and demand market conditions. Some of the manifestations of the
growing role of commodities as financial assets include the growth in activity in commodity
future markets including commodity derivatives, the strengthening of the co-movement among
different commodity prices and between commodities and stock markets, and the use of
commodities as collaterals for loans and credit.
Between 1995 and 2012 the number of outstanding contracts on commodity exchanges
increased from 36.6 to 182 million for futures, and from 373.6 million to 2.1 billion for options.
Similarly between 1998 and 2014, the volume of over-the-counter (OTC) commodity
derivative contracts expanded from US$ 4.3 billion to $2.2 trillion (notional amounts
outstanding). Currently commodity derivatives represent less than 0.3% of the total across all
asset classes and exchange commodity futures and options represent roughly 14% of their
total sum (FCA, 2014).
The growing role of commodities as financial assets is also illustrated by the fact that
commodities show over time a higher degree of association (correlation) with traditional
financial assets such as equities. Table 7, below, shows the cross-correlations between the
returns and volatilities of and between different commodity indices (agriculture, energy,
industrial metals, livestock, precious metals and non-energy), the Dow Jones AIG and
Standard and Poor Commodity Indices (DJAIG, GSCI), and with equity indices,
including the Dow Jones Industrial Average (DJIA), Standard and Poors 500 (S&P500). The
correlations were computed for the period 1991-2000, 2001-2007, 2008-2009 and 2010-2014
on a monthly basis. The results show that both in the case of returns and volatilities the
percentage of statistically significant correlations (at 1%, 5% and 10% levels) increases over
time. 9
For the first period considered (1991 to 2000) the percentage of statistically significant
correlations and volatilities reached 37.8% and 20%. For the second period, these increased
to represent 55.6% and 28.9% of the total. In the last period analyzed the proportion of
significant correlations and volatilities is even higher, 75% and 66.7% of the total respectively.
Following Buyuksahin, Haigh and Robe (2010a), the rate of return on the Ith investable index in period
where
t is equal to
period t is
where
is the value of the index I at time t. The volatility of an index in
is the mean value of
over the sample period.
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Table 8: Monthy Cross correlation between returns and volatilities of commodity and equity
indices (1991-2000, 2001-2007, 2008-2009 and 2010-2014)
Monthly Returns Correlations, Jan 1991 to Dec 2000

DJIA
1.00
S&P500 0.91***
DJAIG
0.10
GSCI
0.02
Agriculture 0.12
Energy
-0.01
Ind. Metals 0.13
Livestock 0.06
Prec. Metals -0.02
NonEnergy 0.14
S&P500 DJAIG
GSCI
Agriculture Energy
Ind.
Prec. NonLivestock
Metals
Metals Energy
DJIA
1.00
0.06
0.02
0.12
0.01
0.05
0.01
-0.07
0.09
1.00
0.86*** 1.00
0.46*** 0.26*** 1.00
0.74*** 0.96*** 0.04
0.39*** 0.19** 0.08
0.23** 0.19** 0.12
0.27*** 0.11
0.00
0.58*** 0.35*** 0.80***
1.00
0.10 1.00
0.05 0.04 1.00
0.05 0.20** 0.04 1.00
0.09 0.34*** 0.59*** 0.14
1.00

DJIA
S&P500 DJAIG
GSCI
Agriculture Energy
1.00
S&P500 0.94*** 1.00
DJAIG
0.14 0.16 1.00
GSCI
-0.05 -0.03 0.86*** 1.00
1.00
Agriculture 0.23** 0.20* 0.37*** 0.12
Energy
-0.11 -0.08 0.79*** 0.98*** 0.00
Ind. Metals 0.44*** 0.45*** 0.50*** 0.30*** 0.10
Livestock -0.03 -0.05 0.04 -0.03
0.03
Prec. Metals 0.03 0.07 0.51*** 0.35*** 0.20*
NonEnergy 0.34*** 0.31*** 0.56*** 0.26** 0.79***
Ind.
Prec. NonLivestock
Metals
Metals Energy
DJIA
1.00
0.21* 1.00
-0.10 0.07 1.00
0.30***0.37*** -0.07 1.00
0.10 0.59*** 0.35*** 0.41*** 1.00

DJIA
DJIA
S&P500 DJAIG
GSCI
Agriculture Energy
Ind.
Prec. NonLivestock
Metals
Metals Energy
1.00
S&P500 0.98*** 1.00
0.39* 0.50** 1.00

GSCI
0.47** 0.56*** 0.94*** 1.00
Agriculture 0.30 0.37* 0.82*** 0.66***
Energy 0.44** 0.54*** 0.89*** 0.99***
Ind. Metals 0.55*** 0.59*** 0.86*** 0.78***
Livestock 0.37* 0.39* 0.41** 0.51**
Prec. Metals 0.11 0.13 0.51** 0.39*
NonEnergy 0.42** 0.48** 0.91*** 0.78***
DJAIG
1.00
0.54***
0.61***
0.18
0.57***
0.95***
1.00
0.74*** 1.00
0.51** 0.32 1.00
0.30 0.32 0.39* 1.00
0.67***0.80*** 0.33 0.63*** 1.00
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Monthly Returns Correlations, Jan 2010 to Jun 2014

DJIA
S&P500
GSCI
Agricult
ure
Energy
Prec.
Ind.
Livestock
Metals
Metals
NonEnergy
1.00
S&P500 0.98*** 1.00
GSCI 0.72*** 0.73*** 1.00
Agriculture 0.41*** 0.39*** 0.57*** 1.00
Energy 0.70*** 0.71*** 0.97*** 0.39*** 1.00
Ind. Metals 0.71*** 0.75*** 0.73*** 0.44*** 0.64*** 1.00
Livestock -0.07 -0.04 0.07 -0.25* 0.10
0.06 1.00
Prec. Metals 0.15 0.19 0.52*** 0.36*** 0.44*** 0.46*** -0.03 1.00
NonEnergy 0.55*** 0.56*** 0.75*** 0.92*** 0.57*** 0.73*** -0.04 0.55*** 1.00
DJIA
One, two or three stars indicate that an estimate is statistically significantly different from zero
at the 10%, 5% or 1% level, respectively.
Correlations of Monthly Adjusted-Return Volatilities, Jan 1991 to Dec 2000

DJIA
1.00
S&P500 0.91***
0.12
DJAIG
GSCI
0.06
Agriculture -0.01
Energy
0.02
Ind. Metals -0.02
Livestock -0.03
Prec. Metals 0.09
NonEnergy 0.01
S&P500 DJAIG
GSCI
Agriculture Energy
Ind.
Prec. NonLivestock
Metals
Metals Energy
DJIA
1.00
0.20**
0.08
0.05
0.03
-0.12
0.01
0.05
0.07
1.00
0.78*** 1.00
0.37*** 0.11
1.00
063*** 0.94*** 0.06
0.05 -0.03 -0.03
0.14 0.04
0.05
0.05 0.06 -0.05
0.33*** 0.09 0.77***
1.00
0.00 1.00
-0.04 -0.06 1.00
0.08 0.02 -0.08 1.00
0.03 0.09 0.29*** -0.03 1.00

DJIA
DJIA
S&P500 DJAIG
GSCI
Agriculture Energy
Ind.
Prec. NonLivestock
Metals
Metals Energy
1.00
S&P500 0.86*** 1.00

DJAIG
GSCI
Agriculture
Energy
Ind. Metals
Livestock
Prec. Metals
NonEnergy
0.06
0.02
0.02
0.03
0.06
0.24**
-0.09
0.21*
-0.07
-0.06
-0.02
-0.04
0.02
0.19*
-0.12
0.11
1.00
0.72*** 1.00
1.00
0.28*** 0.08
0.64*** 0.97*** 0.03
0.18 0.01 -0.08
-0.02 -0.06 -0.13
0.13 -0.01 0.01
0.42*** 0.09 0.63***
1.00
-0.01 1.00
-0.02 0.01 1.00
-0.04 0.41*** -0.06 1.00
0.01 0.39*** -0.06 0.32*** 1.00
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DJIA
S&P500 DJAIG
GSCI
1.00
S&P500 0.93*** 1.00
DJAIG 0.55*** 0.69*** 1.00
GSCI 0.56*** 0.76*** 0.93*** 1.00
Agriculture 0.34* 0.41** 0.77*** 0.60***
Energy 0.50** 0.70*** 0.87*** 0.99***
Ind. Metals 0.64*** 0.83*** 0.85*** 0.88***
Livestock 0.39* 0.55*** 0.59*** 0.67***
Prec. Metals 0.50** 0.68*** 0.74*** 0.83***
NonEnergy 0.58*** 0.73*** 0.94*** 0.87***
Agriculture Energy
Ind.
Prec. NonLivestock
Metals
Metals Energy
DJIA
1.00
0.53***
0.83***
0.27
0.40*
0.84***
1.00
0.83*** 1.00
0.64***0.67*** 1.00
0.80***0.81*** 0.61*** 1.00
0.79***0.87*** 0.59*** 0.75*** 1.00
Correlations of Monthly Adjusted-Return Volatilities, Jan 2010 Jun 2014

DJIA
S&P500
GSCI
Agricult
ure
Energy
Prec.
Ind.
Livestock
Metals
Metals
NonEnergy
1.00
S&P500 0.95*** 1.00
GSCI 0.72*** 0.74*** 1.00
Agriculture 0.28** 0.35** 0.45*** 1.00
Energy 0.72*** 0.72*** 0.94*** 0.21
1.00
Ind. Metals 0.53*** 0.60*** 0.69*** 0.69*** 0.46*** 1.00
Livestock -0.04 -0.06 0.04 0.02
0.07 -0.06 1.00
Prec. Metals 0.14 0.20 0.26* 0.36*** 0.14 0.54*** 0.09 1.00
NonEnergy 0.41*** 0.48*** 0.65*** 0.88*** 0.38*** 0.89*** -0.04 0.53*** 1.00
DJIA
Source: Authors own on the basis of Bloomberg (2014).
One, two or three stars indicate that an estimate is statistically significantly different from zero
at the 10%, 5% or 1% level, respectively.
These results throw severe doubt on the explanation that investment in commodity futures
offers an opportunity to hedge equity risk. The diversification benefits of commodity futures
view is based on two assumptions. The first is that commodities and stocks yield similar
returns over time so that they are adequate investment substitutes. The second is that that
commodities and stocks are, in terms of levels and volatilities, either not correlated or
negatively correlated over time so that investing a part of the portfolio in commodities lowers
its total risk. 10
10This
view has been advanced by Gorton and Rouwenhorst (2004) and more recently by Buyuksahin,
Haigh and Robe (2010b). Gorton and Rouwenhorst find for a 45 year period running from July 1959 to
the end of 2004 that the average annualized return to a collateral investment in commodity futures
(5.23%) is comparable to the return on the SP500 (5.65%) and that both outperformed corporate bonds
(2.22%). Also both authors sustain that commodity futures have a lower volatility that stocks (with
standard deviations of 3.47 and 4.27 respectively). Finally the coefficient of correlation between
commodity futures and stocks are statistically insignificant (0.05 and -0.06 on monthly and quarterly
basis). These results are corroborated by Buyuksahin, Haigh and Robe for the period January 1991 to
May 2008. These authors also find that there is no co-movement between the returns and volatilities of
equities and commodities suggesting that commodities have retained their role as a portfolio
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A more realistic explanation is that investment in commodities can present substantial profit
opportunities. Commodity futures trading as well as the derivative industry, and in particular,
the derivatives on mortgage backed securities, expanded significantly around the time of the
burst of the bubble dot com and the ensuing stock market crash in the early 2000s. This may
indicate the fact that commodities futures along other derivatives became a portfolio asset
class, as other financial investments such as equities lost their profitability lure.
Also the highly liquid-low interest environment that prevailed before the Global Financial
Crisis combined with the high rate of return of commodity futures relative to equities from
2004 to 2008 provided an incentive to invest in commodities. According to Bhardwaj (2010),
between January 31, 2004 and June, 2008, commodity futures rate of return (19.5%) more
than doubled that of equity (6.0%). Finally, the commodity investment option was sanctified by
Gorton and Rouwenhorst (2004) who showed that the risk of investing in commodities was
lower than that of equities. Thus, investing in commodities yielded a high rate of return to
investment and with a lower risk relative to other investment alternatives. 11
Finally, another recent illustration of the consideration of commodities as a financial asset is
the use of commodities as collaterals in financing deals to raise and invest liquidity. This has
become a general practice for a wide range of commodities including gold, copper, iron ore,
and to a lesser extent, nickel, zinc, aluminum, soybean, palm oil and rubber. Some of the
most illustrative examples are available in the case of China where financing commodity
deals occur in the presence of capital controls and a significant positive local to foreign
interest rate differential. 12
The most simple financing deal consists, in general terms, in a domestic company using a
warrant of a commodity (a document issued by logistic companies which represent the
ownership of the underlying asset, in this case a commodity) to borrow a foreign exchange
short-term loan. The warrant is then sold for cash in the domestic market and the proceeds
are invested in an asset yielding a higher rate of return than the interest to be paid on the
foreign exchange loan (due to the significant positive local to foreign interest rate differential,
i.e. the difference between a US letter of credit interest and a Chinese wealth management
asset). The asset is then liquidated and the foreign loan is paid. 13
This procedure can be made continuous to earn recurrent returns as follows: a domestic
company using a warrant of a commodity (a document issued by logistic companies which
represent the ownership of the underlying asset, in this case a commodity) to borrow a shortterm loan in foreign exchange. The warrant is then sold (i.e., exported) by the company to an
offshore subsidiary and receives the equivalent of the value of the warrant in foreign
exchange. In this way foreign exchange in brought into the country circumventing any existing
diversification tool (p. 4). Using a longer time series (August 1959-April 2009) Bhardwaj (2010)
concludes that the correlation between the US equities and commodity returns has increased over time
(much in line with our results presented above). The correlation coefficient for both equals roughly 0.15
and 0.37 for the periods August 1959-April 2009 and January 2001-April 2009.
11 Besides the hedging hypothesis investment in commodities is rationalized in terms of the search for
yield which refers to choosing riskier assets when the return on safe assets is low. In the case of
commodities however Gorton and Rouwenhorst (2004) along with other research provided the
intellectual foundation for showing that the search for yield did not apply to commodities. In a low
interest rate environment the rate of return on some safe assets such as commodities can be very high
relative to other investment alternatives.
12 See Credit Suisse (2014a, 2014b), Goldman Sachs (2014), Morgan Stanley (2014) and Tang and Zhu
(2014).
13 According to Goldman Sachs (2014, p. 13) the commodity- related outstanding FX borrowings are
roughly 31% of Chinas short-term FX loans (duration less than a 1 year).
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capital controls. The foreign exchange is then converted to local money and invested in asset
yielding a higher rate of return than the interest to be paid on the foreign exchange loan (due
to the significant positive local to foreign interest rate differential). The company then obtains
a new foreign exchange loan and buys a warrant from the offshore subsidiary and then sells
the warrant again bringing in foreign exchange. With the proceeds the company pays the first
loan but in this case does not need to liquidate the investment. The process of buying and
selling warrants between the domestic company and the offshore subsidiary is repeated to
pay back the second foreign exchange loan. 14
The profits that can be made through these financial deals depend on the velocity of
circulation, the volume of the commodity in inventory, and the spot unit price of the
commodity. The velocity of circulation refers to the frequency of rolling the trade forward and
depends on the excess benefit or cost of owning the asset, i.e., on the roll yield. The volume
of the commodity in inventory depends on the demand for commodity as collateral. Finally,
the spot price of the commodity depends on the conditions of demand (or more precisely
excess demand) in the market for that particular commodity.
These effects of these variables and their interrelationships on profits and returns can be
ascertained by expressing the real return on a commodity (or risk premium) as a function of
the collateral return, the spot return and the roll return. That is,
Where,
= real commodity return,
=collateral return,
spot return, and
= roll
return.
The collateral return refers to the interest income earned on the investment of the value of the
collateral needed to purchase the commodity or in the above case the commodity warrant.
Traditionally the collateral return is equated with the yield on a short-term US treasury bill
since the normal practice is to avoid high levels of risk, invest in a highly liquid asset and
preserve the capital value of the investment. However, in the particular where commodities
themselves are used as collaterals for loans, the collateral return is equal to the domesticforeign currency interest rate differential. That is,
Where,
14
More complicated financing deals involve more than one loan per unit of copper with staggered due
dates (Credit Suisse, 2014a and 2014b). Goldman Sachs (2014, p.11) explains the commodity collateral
financing deal as follows: While commodity financing [round tripping] deals are very complicated, the
general idea is that arbitrageurs borrow short-term FX loans from onshore banks in the form of LC (letter
of credit) to import commodities and then re-export the warrants (a document issued by logistic
companies which represent the ownership of the underlying asset) to bring in the low cost foreign capital
(hot money) and then circulate the whole process several times per year. As a result, the total
outstanding FX loans associated with these commodity financing deals is determined by: the volume of
physical inventories that is involved, commodity prices and the number of circulations. Our
understanding is that the commodities that are involved in the financing deals include gold, copper, iron
ore, and to a lesser extent, nickel, zinc, aluminum, soybean, palm oil and rubber.
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return on domestic assets;
= interest on foreign denominated loans and >0.
The spot return is the difference between the expected spot price of a commodity in the future
at time t+i (
) and the price of the same commodity in the present (at time t) ( ).
The spot return depends on the demand and supply of the stocks of a commodity. As the
supply stock of a commodity is fully inelastic, the spot return depends on the expected
change in the demand for that given commodity (Davidson, 1978, 2008; Choski, 1984). As a
result the spot return can be expressed as function of (expected) excess demand in the
commodity market (
.
, where >0.
The roll return captures the differences in prices along a commodity term structure and is in
fact the carry return for holding a commodity contract. It can be simply be defined as the
difference between the price for commodity contract in the nearby future at time t+i (
) and
the current or most recent future at time t ( ) (Hannan, 2015). That is,
Where T = time horizon. For analytical purposes T=1. 15

Contrary to the spot price, the future price of a commodity contract reflects flow-supply
considerations. As a result the elasticity of the future price to changes in demand is much
lower than that of the spot price (Choski, 1984; Davidson, 1978, 2008).
Equations (4) and (6) also allow seeing the effects of backwardation and contango on the real
commodity returns. Other things being equal, backwardation (
leads to positive
returns
and increases in the spot price over and above its future price translate into
an increase in returns
>0. A situation of contango (
has the opposite
effect,
and
<0. Under this scenario positive returns require that the interest rate
differential and/or excess commodity demand must offset the negative effect of contango.
Substitution of (5), (4) and (3) into (2) yields,
Equation (7) states that commodity real returns under the scheme of financing involving
commodities as collateral for loans, depends on the domestic-foreign interest rate differential
(
), on the (expected) excess demand for the commodity and on the commodity term
structure.
15
According to Hannan,
towards
converges towards the expected spot price
so that
converges
, which is the definition for the risk premium found in Gorton and Rowenhorst (2004) in the
absence of the return on collateral.
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Where
Assuming backwardation as the norm and that the relationship between

stable over time, equation (7) can be expressed as,
remains
Equation (9) shows that rising real commodity returns depend on the increase in the interest
rate differential and increased excess demand in the commodity market.
For any given spot price level of a commodity i, an increase in commodity inventories or what
is the same thing an increase in the demand for commodity collateral can increase the
revenues from interest rate differential provided the domestic return and the foreign rate of
interest do not change. A higher value of the collateral translates into a higher volume of
investment and hence into a higher revenue stream. A similar effect occurs if positions are
rolled more frequently over time (i.e., if the velocity increases).
However, most likely, if the demand for commodity collateral increases (i.e., higher
inventories) and it is sufficiently important, this will not only translate into higher returns via an
income effect such as that described above. It will also create excess demand for the
commodity
>0) and generate higher returns
via a price effect. 16
Figure 4 below shows the evolution of the return on the Goldman Sachs commodity index
during the period 1970-2006 and of its components. The figure shows that, for the most part,
roll returns play a minor part in the explanation of the total return. The roll return explains only
10% of the total return on average for the whole period. And it is negative in the 1990s and in
the first half of the 2000s during the commodities boom. 17
16
As put by Credit Suisse (2014a, p.6) in the case of copper: Financing deals have increased apparent
demand (domestic production plus imports less exports) for the red metal (not necessarily real industrial
use) and consequently lend support to the copper price.
17 This fact has also been noted by Kemp (January, 2015) in What went wrong with the Great
Commodity Boom?.
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Figure 4: Components on the total return on the Goldman Sachs Commodity Index, 19702006
Source: Demidova-Henzel & Heidorn (2007)
As a result, in line with our analysis above, the total return on commodities seems to be
driven mainly by spot and collateral returns. For the entire period spot and collateral returns
account for 53% and 67% of the total return on average. Moreover, the evidence shows that
the spot return was the greater part of the total return in the periods 1970-1980 and 20012006. The former period coincides with the oil shocks and oil price hikes of 1973 and 1979. 18
The latter period 2001-2006 coincides with the commodity boom. 19
In the aftermath of the Global Financial Crisis (2007-2009), as the dynamism of spot prices
slowed in relation to the first half of the 2000s, and given the recent history of negative roll
yields, focusing on collateral returns to maintain high total returns is simply a reasonable
capitalist business strategy. Heightening the importance of the collateral return requires
accumulating inventories of commodities. And in fact this constitutes one of the main stylized
facts that characterizes commodity markets in the aftermath of the Global Financial Crisis.
Also the available evidence indicates that the accumulation of inventories is carried out by the
financial sector and more precisely by some of the former investment banks of the United
States, including Goldman Sachs, JP Morgan, and Morgan Stanley. As noted by the United
States Senate Permanent Subcommittee on Investigations in their report on Wall Street Bank
involvement with Physical Commodities (November, 2014, p.3):
18 Bhardawj also mentions the fall of the Breton Woods monetary management system. Gorton, Hayashi
and Rouwenhorst (2012) argue that inventory shortages in a number of commodities created greater
uncertainty in the market and led to higher risk premiums, and that as a result the increase in spot prices
responded to fundamentals. See Choski (1984) for a different interpretation of the increase in spot
prices in the 1970s attributing it to speculation.
19 Similar results obtain using the Dow Jones-AIG Commodity Index for the period 1991-2006
(Demidova-Menzel and Heidorn, 2007). Between 2001-2006 the spot , roll, and collateral return yielded
14.5%, -.5.5% and 11.3% respectively. The roll return is also negative for the three sub-periods
analyzed (1991-2000, 1991-2006 and 2001-2006).
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Until recently, Morgan Stanley controlled over 55 million barrels of oil storage
capacity, 100 oil tankers, and 6,000 miles of pipeline. JPMorgan built a
copper inventory that peaked at $2.7 billion, and, at one point, included at
least 213,000 metric tons of copper, comprising nearly 60% of the available
physical copper on the worlds premier copper trading exchange, the LME.
In 2012, Goldman owned 1.5 million metric tons of aluminum worth $3 billion,
about 25% of the entire U.S. annual consumption. Goldman also owned
warehouses which, in 2014, controlled 85% of the LME aluminum storage
business in the United States. Those large holdings illustrate the significant
increase in participation and power of the financial holding companies active
in physical commodity markets 20
Following this reasoning it would not be uncommon to observe a positive association between
the demand for commodities as collateral (and higher levels of inventories) and the cost of
storage net of the convenience yield (measured as the spread between spot and future
prices divided by spot prices, i.e., the rate of return) can be observed in the market for
commodities. To put it another way, within this context, higher levels of inventories need not
be accompanied by a lower price spread as the standard theory suggests.
In fact the positive association between volume and the cost of storage net of the
convenience yield is a characteristic feature displayed by some commodities markets during
at least the last decade. We illustrate this with the case of copper and oil in Figure 5-6 below.
These figures show a scatter plot between quarterly data of the cost of storage net of the
convenience yield (measured as the spread between spot and future prices divided by spot
prices, i.e., the rate of return) on a commodity and its inventory level for several sub periods
between January 1995 for crude oil, and July 1997 for copper, to September 2014 for both of
these commodities.
The figures 7-8 show a clear change in the relationship between both variables over time by
taking the whole period and then rolling forward the start of the period to focus on the
empirical evidence of the past decade. In the case of oil the relationship starts as negative for
the whole period (January 1995-September 2014). As we roll forward in time the start date
maintaining constant the end date the negative relationship between becomes much weaker
as can be seen by a shallower slope and a reduction in the value of the correlation coefficient.
The correlation coefficient that captures the negative association between both the cost of
storage net of the convenience yield on commodities and their inventory levels declines from
0.26 between January 1995 and September 2014 to 0.03 between January 2004 and
September 2014. From January 2005 onwards the negative relationship changes to a positive
one.
A similar story occurs in the case of copper. For the whole period spanning from July 1997 to
September 2014, the relationship is negative with a correlation coefficient of -0.33, declining
(in absolute value) to -0.13 and -0.11 between January 2004-September 2014 and January
2008-September 2014 respectively. Thereafter the relationship becomes positive, as in the
case of crude oil, albeit at a later date.
20
It should be noted that these former investment banks renamed commercial banks after the Crisis
saw an important decline in leverage. Goldman Sachs, and Morgan Stanley saw their leverage fall from
roughly 33 to 12 between 2007-2008 and 2012 (according to our calculation based on Bloomberg) and
thus had to turn to other business strategies such as investment in commodities to maintain their profit
levels.
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Figures 5-6 Scatter plot between rate of return on copper and inventories (July 1997September 2014)
Source: On the basis of Bloomberg (2014).
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Figures 7-8 Scatter plot between rate of return crude oil and inventories (January 1990 and
September 2014) (Continuation)
Source: On the basis of Bloomberg (2014).
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The positive relationship between the rate of return on a commodity and its inventory level
seem to defy the traditional explanation of commodities prices at different delivery dates
based on the theory of storage. At a very general level, the theory of storage states that as
inventory increases (a decline), spot prices tend to fall (increase) below (above) future prices
(the cost of storage decreases) net of carrying costs. Nonetheless the empirical evidence
positing a positive relationship between the spread between spot and future prices and
inventories presented above is consistent with the concept of user costs developed by
Keynes (1936).
Keynes developed the concept of user cost as a component of the supply price of a firm. He
also used it in a discussion of the decision to produce raw materials and focused on the case
of copper.
Keynes defined user cost as (1936, p. 70): the reduction in the value of the equipment due to
using it as compared with not using it after allowing for the cost of the maintenance and
improvement which it would be worthwhile to undertake and for purchases from other
entrepreneurs. Its amount is determined by the expected sacrifice of future benefit involved
in present use. In the particular case of copper, the marginal cost of producing, say a ton of
copper today instead of tomorrow must include the future value of copper. And if the price of
a ton of copper is expected to increase in the future, the cost of producing a ton of copper in
the present must include the cost of the foregone profits that could have been obtained by
deciding to abstain from producing copper today in order to produce tomorrow and sell at a
higher price. 21
The same reasoning and logic applies to the commodity financing deals described above
whose focus is the trading commodity futures. In this particular case user costs are computed
with regard to holding or not holding a commodity as inventory rather than to the decision of
producing or not producing it. Also user costs can be directly related to commodity rates of
return rather than to their price. If a commodity dealer trading in commodity futures decides to
reduce inventory by a given volume, say by x, then, within the context described above, the
user cost associated with this decision is the foregone profits (determined by the collateral
return) that the dealer could have obtained by holding and using the x volume of inventory in
a commodity collateral financing deal. In short, the capitalist commodity collateral business
strategy can be rationalized as a means to reduce user cost to increase profits.
Conclusion
In the 2000s decade Latin America performance exhibited two unique historical features.
First, the region expanded at one of the fastest pace in three decades with a current account
surplus. Second, for the first time the region recovered V- shaped from a global financial
crisis.
The paper argues that this unusual economic performance is due to changes in the way
global capitalism organizes production and finance. The former refers to a corporate strategy
using multinational corporation networks to move industries, production and employment
across the globe taking advantage of cheaper production costs, expanding global markets
and the increasing importance of global production chains. These production shifts occur
21
This example is taken from Davidson (2008).
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across a wide spectrum in industries of developed economies and in particular of the United
States. During the 2000s decade, due to its strategic location, size and open door policies,
China, along with other Asian countries became an important center of operations for this
corporate strategy. At the same time there were changes in the organization of finance
exemplified by the increasing integration between the real and the financial spheres and is
exemplified by the way commodities were used in the 2000s decade as financial assets.
The changes in the way capitalism organizes production and finance had an important impact
on Latin Americas performance. These changes are at the root of the commodity boom that
softened Latin Americas external constraint, improved fiscal position and space resulting in
higher levels of domestic investment and greater access to external finance. These same
factors account for the current economic deceleration that is affecting all of Latin American
economies.
This hypothesis questions those interpretations that place the weight of the explanation of
Latin Americas performance on the improved macroeconomic management, a set of
favorable and fortuitous external conditions and on the changes in the global economic
geography led by the emergence of developing economies. By extension the analysis also
throws doubt on the perception that developed economies have lost preeminence at the
global level and that the distribution of world economic and political power is shifting towards
the developing world. Moreover, the changes in production and finance have increased the
complexity in the organization and workings of market economies and also the difficulty in
predicting their future behavior and performance.
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SUGGESTED CITATION:
Esteban Prez Caldentey, Global production shifts, the transformation of finance and Latin Americas performance
in the 2000s, real-world economics review, issue no. 72, 30 September 2015, pp. 147-173,
http://www.paecon.net/PAEReview/issue72/Caldentey72.pdf
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Fight against unemployment: rethinking public works

programs
Amit Bhaduri, Kaustav Banerjee and Zahra Karimi Moughari
[Centre for Economic Studies & Planning, Jawaharlal Nehru University, New Delhi, India; Centre for the Study of
Discrimination & Exclusion, Jawaharlal Nehru University, New Delhi, India; and Department of Economics, University
of Mazandaran, Babolsar, Iran]
Copyright: Amit Bhaduri, Kaustav Banerjee and Zahra Karimi Moughari, 2015

Abstract
The processes of globalization have succeeded in shifting the focus from productive
employment generation and expansion of domestic markets to export
competitiveness. The disastrous effects of such a shift have been exacerbated by the
recent global crisis. The need of the hour is to rethink public works programs to
mitigate such effects and to move societies towards full employment. The paper
addresses precisely these issues with arguments for rethinking public works programs
for the skilled and unskilled workforce. The question of externalities, principle of
financing and the positive social impacts of inclusion are also discussed.
Keywords unemployment, public works, effective demand, skill, inclusion
1. Introduction
As the global crisis deepens and most industrialized and developing countries continue facing
the risk of a prolonged labour market recession, it is leading to a catastrophic rise in
unemployment and decline in real wages. Several countries have used neoclassical tools to
mitigate this, primarily by moving legislation to have more flexible labour markets. The oftrepeated neoclassical logic has been that rigidities in labour markets are the barriers to
recovery. The economic mechanism being that of lowering interest and wage rate to
incentivize private investment; but the plans have not succeeded so far due to a lack of
effective demand. On the other hand, public investment driven public work projects, by
encouraging social participation, can be the way to stimulate economic recovery and
expansion in employment. Along similar lines, the International Labor Organization (2009)
reiterates that it is crucial to implement a coherent, job-oriented recovery strategy to address
the basic needs of millions workers and their families, and emphasizes that employment and
social protection must be at the centre of fiscal stimulus measures to protect the vulnerable
groups and to reactivate investment for raising aggregate demand in the economy.
Public works become closely interlinked to social programs in contemporary democracies
under the tension of various kinds of identity politics of exclusion and inclusion. It has the
potential to alleviate these tensions and contrariwise, if badly conceived such programs can
also heighten such tensions. This paper explores new frontiers of public works program from
this viewpoint; and investigates how public work programs can be effective in combating
labour market problems in economically and socially meaningful ways. The paper consists of
six parts. The second part, after this introduction, reviews briefly the theoretical debate of
market mechanism and unemployment related to classical and Keynesian paradigms
regarding voluntary and involuntary unemployment and their policy implications. Section three
draws a clear distinction between Keynesian demand management and new public works
programs with emphasis on the distinction between demand side and supply side of the
problem. Section four focuses on two issues which could be the basis for demarcating new
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employment policies, i.e. public works programs with and without skill components relating it
to questions of benefits, externality and labour productivity. Section five discusses the
principle of finance sharing of public works programs and its possible effects on inflation and
private investment. In the last section, we conclude with a discussion of possible inclusion
benefits of newly designed public works programs.
2. Market mechanism and unemployment

The issue that divides economists most sharply into opposing camps is unemployment
because it impinges directly on how the relation between the market and the state affects the
majority of citizens in market democracies. The course of the debate and policies reflect this
abundantly. Keynes rejected the concept of voluntary unemployment as misleading, the
classics and neo-classics insists on it in various ways to date. The debate does not die down
and, at every turn with the revival of the ideology that, the market always knows the best and
reconciles public with private interest, the notion of voluntary unemployment continues to be
recreated in new mathematical guises, basically as choice between leisure and work, 1 search
under incomplete information 2, persistent frictional unemployment; 3 even Marxs notion of the
reserve army of labour 4 may be reinterpreted with some twist as natural rate of
unemployment defined by the Phillips curve 5 formulation and non-accelerating inflation rate of
unemployment (NAIRU) 6. Fashions come and go, but unemployment continues to haunt
market democracies, at times with a low rate, but at times at threateningly high rates, as in
parts of Europe today.
The alternative understanding associated with the names of Keynes and Kalecki places at the
centre of the problem of unemployment deficient demand in the market for products, not for
labour. Marx diagnosed lack of demand and under-consumption as a recurrent problem of
capitalism with insightful comments about how money interferes with Says law in his
formulation of money-capital-money circuit. 7 Never the less, his theory was incomplete in a
crucial respect in so far as he failed to link his theory of exploitation of individual worker with
the theory of realization of aggregate surplus through adequate demand in the market.
Greater exploitation of individual worker creates more surplus value per worker; however
unless we know how many workers would be employed by the capitalists in view of market
demand the total surplus that can be realized into monetary profit is indeterminate. That
essential link was provided by Kalecki 8 in his theory of profits along with his theory of mark up
pricing pointing out the link between money wage and the price level. Keynes with his circle
of economists in Cambridge developed the same theory independently enriching it with the
theory of how the multiplier works as a convergent geometric series, 9 how money as a store
of value in an uncertain world interferes to create deficiency in demand and ineffectiveness in
monetary policy. He also questioned the policy lowering money wage by pointing out the link
between price and money wage (also pointed out by Kalecki) which makes real wage an
endogenous variable unsuitable as a policy instrument.
1
See Lucas (1981), Studies in Business Cycle Theory.

See Diamond (1982) on Search unemployment.
3 See Pigou (1933) Theory on Unemployment.
4 See Marx (1885) Capital, Volume I.
5 See Phillips (1958) The Relationship between Unemployment and the Rate of Change of Money
Wages in the United Kingdom 18611957, Economica.
6 See Friedman (1968) The role of monetary policy
7 See Marx, (1893) Capital Vol. 2.
8 See Kalecki, (1971) Selected Essays on the Dynamics of the Capitalist Economy.
9 See Kahn, (1931) The relation of home investment to unemployment
2
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Keynes and Kalecki provided economists with the powerful idea that, income determination
should be viewed as a circular process in which expenditure determines income breaking the
analogy between the individual and the society. Aggregate income is driven by aggregate
demand, consisting of the level of consumption and investment expenditure and net export
surplus in an open economy. The link with under-consumption theory and class distribution of
income is clear. Redistribution in favour of the working class with a higher propensity to
consume would stimulate demand. Higher public and private investment would also stimulate
demand, but higher private investment would requires a better climate for private investment
which is usually difficult to achieve in depressed situations, particularly in the short run.
Similarly, achieving greater export surplus would increase the size of the domestic market.
However, one countrys export is another countrys import in a zero sum game. It is hard to
see how this can be achieved by most countries suffering from unemployment in a globalizing
world.
Keynes (1936) argued that market economies have two fundamental failings: they are
incapable of generating full employment and of improving the income distribution when are
left to their own devices. So, governments must intervene to solve the market failures. Public
works circumvent the problems of relying on private spending and investment for full
employment. Robinson (1949) had analysed how public works can serve as a counterweight
to the fluctuations in investment undertaken by profit seeking entrepreneurs. Public spending
on employment-intensive activities tends to have a high multiplier. Public investment
represents a major opportunity to generate both employment and address some development
challenges. However, Kalecki 10 had clearly foreseen the tension that creeps up between
capitalists and workers when States followed continuous full employment policies over time.
The relation between the market and policies to tackle unemployment is indeed fraught with
tensions in a democracy 11.
14F
15F
In contemporary times, public works schemes are viewed by many economists as programs
of promoting inclusive development. 12 Such programs can modify the economic growth path,
so as to include segments of the population that have been hitherto excluded from
remunerative productive employment; This could potentially also lead to a reduction in a
number of other social and economic costs which tend to increase along with unemployment.
Hence, designing a new kind of public work programs, with direct involvement of local
communities, will make a maximum impact in creating jobs and will help to raise productivity
and skills to empower people in deprived regions and will mitigate ecological problems;
eventually even private investment would crowd in as the domestic market expands to
revitalize the whole economy. 13
10
See Kalecki (1943) for Political Aspects of Full Employment, where he underlines this tension.
Marx had argued rather optimistically that the right of the working class to vote would turn out to be
incompatible with private ownership of property because it would lead from political to social
emancipation of workers.
12 See for example, Minsky 1986; Mitchell 2001; Bhaduri 2005; Hirway 2006; and Kregel 2006.
13 See (ILO 2009) "Global Jobs Pact, which argues for environment friendly and labour intensive public
works to combat prolonged joblessness and its social economic consequences. ILO assessment of
employment effects of different fiscal measures has revealed that the greater the employment
orientation of the measure, the stronger the stimulus for the real economy.
11
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3. Public works: demand side vs. supply side

The management of aggregate demand can take many different routes and, the logic can be
applied to justify in almost diametrically opposite political views. In a closed economy,
employment generation through demand led growth can work in two ways, through either
investment or consumption. In the former case wealth and income tax concession for the
rich, restraint on wages despite productivity growth or an engineered stock market boom is
attempted in trying to bring about profit led growth. Alternatively, redistribution in favor of the
poor and increase in public consumption through social welfare measures would be policies
of wage led growth (Bhaduri and Marglin, 1990). Such policies are likely to be more effective
in the short run by raising the rate of utilization of existing capacities as Keynes and Kalecki
had originally argued. It was pointed out by Steindl (1953) that an accelerator-like capacity
utilization effect would affect investment and, fixed investment would continue to be sluggish
without higher capacity utilization. When theis capacity utilization effect is sufficiently strong ,
pure redistribution in favour of the rich (or support to the banks as happens in the Stimulation
package in the U.S) may be ineffective. Globalization has also turned out to be detrimental to
a pro-poor policy of wage led growth so far largely because its obsessive focus on unit cost
reduction for international competitiveness at the expense of expanding the domestic market
encourages restraint on wage in relation to labor productivity growth.
Multi-party democracies have to work with a short time horizon with regular accountability at
election times. Although much favoured by conservative economists, the argument that
improvement of private investment climate is the only way to solve the problem reaches
barrier in situations of depressed economic activity and employment on this count.
Improvement of business expectations is a sluggish process involving confidence building
because investments in long lived fixed capital goods once made are sunk costs. Favorable
business expectations have to be firmly in place for private investment climate to improve. In
addition there are imponderable shocks which would require elected governments to act
immediately without focus on improving investment climate. In contrast the remarkable
advantage of a well-conceived public works program to fight unemployment, if necessary
financed by budget deficit, has both flexibility and quick short term impact on the
unemployment problem.
Escalating unemployment and low-paid insecure jobs and increasing concern about economic
and social costs of raising poverty force governments to react to these problems by effective
policies. In unfavourable business climate, public works scheme is an effective active labour
market policy that can be used as an instrument of last resort in fighting chronic
unemployment and poverty and in the meantime create valuable assets. New public work
schemes, with direct involvement of local communities, can be the most efficient program to
prevent unemployment and income inequality from becoming a social disruption. Developing
countries typically have enormous investment deficit in infrastructure and public services, such
as soil conservation, improvement of irrigation and water delivery systems, forestation, flood
control, roads, drainage, sewage and sanitation, schools and health care, especially in remote
and backward regions coexisting with unemployed people who are willing to work at
reasonable wage but are excluded from productive employment.
In this context new public work projects can be designed in collaboration with local
communities, government officials and NGOs, environment protection groups, and women
rights groups. Local residents can participate in beneficial community-based activities that
provide most needed infrastructures decided by them. Furthermore, engagement of local
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community in the process of project implementation can improve community members

abilities to assume responsibility of completed projects, thus guaranteeing better maintenance
of the assets created. We emphasise later in the paper how the possible disadvantages of
higher inflation and over-burden of public debt which could be alleviated at least partly through
a clear rethinking about the choice and design of the public investment program.
4. Public works: skilled and unskilled workforce

One of the main planks of attack against Keynesian public works programs have been the
lack of focus on productivity. Old fashioned Keynesian demand management policies have
been caricatured as digging holes and filling them up. Any new public works program has to
face this issue along with the other problem of absorption and development of skilled labour in
public works programs. This in itself is not a new problem, but has remained relatively underemphasized in the design of conventional public works programs focused exclusively on
demand management with the consequence that structural problems of existing educated
unemployment and skilled artisans have been seldom addressed.
However, exclusive focus on skill development for strengthening the supply side is mistaken It
can turn out to be like a game of musical chairs or a long queue in which more skilled have
the advantage of being reshuffled to the front, but the length of the queue does not
decrease 14. Unless complemented by sufficient expansion of aggregate demand not even all
skilled workers, leave alone the unskilled workers would get jobs. It is a common experience
in many third world countries that skilled labor largely subsidized by public money and
institutions end up supplying labour to advanced countries for the lack of effective market
demand in the less developed nations. Skill formation must not therefore be delinked from the
design of demand generation through public works.
4-1. Public works without skill
The Keynesian public works program can be thought of as a miniature wage led expansion
program in local contexts. The wages earned by working on the program is partly or wholly
consumed which could potentially have the multiplier effect through successive rounds of
expansion. One has to distinguish between utilization of the capacities of existing stocks and
building new capacities. Let us return to Keynes metaphorical example of pyramids rather
than the oft repeated one about digging holes. 15 However we need to decipher the example.
Pyramid building would have definitely kept the local population of slaves employed as long
as it is being built. The problem however is that the pyramid has very limited local use and in
fact then resembles digging and filling the holes. The emphasis on just keeping labor
employed has limited relevance in a modern democracy. It increases consumption
expenditure to expand aggregate demand but in the absence of expanding supply potential it
can reduce inequality in consumption only by redistributing consumption between the
employed and the unemployed through inflationary price rise or through a rationing scheme 16.
14
See Vickerey (1998) for a lucid exposition.

See Keynes in The General Theory of Employment, Interest and Money, Book III The Propensity to
Consume, Chapter 10: The Marginal Propensity to Consume and the Multiplier where he states that
Ancient Egypt was doubly fortunate, and doubtless owed to this its fabled wealth, in that it possessed
two activities, namely, pyramid-building as well as the search for the precious metals, the fruits of which,
since they could not serve the needs of man by being consumed, did not stale with abundance. The
Middle Ages built cathedrals and sang dirges. Two pyramids, two masses for the dead, are twice as
good as one; but not so two railways from London to York.
16 See Kahn, Collected Economic Papers.
15
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To be politically sustainable in a democracy labour employed in public works program must

be productive. This is the first major departure from older Keynesian demand management
policies in recession where demand activates underutilized supply but does not create new
capacity.
Productivity can be brought in through two channels either building productive assets (as an
example, the National Rural Employment Guarantee Act in India has a list of permissible
works which are designed to increase productivity) or, by increasing particular skill required
for public projects. For example, public works program could give rise to a demand for
cement, bricks etc which could be produced locally with technology designed with the help of
the center. An interesting example of new product not related directly to the project could be
given from Orissa-India, where the public works program done in scorching hot summer
months gave rise to an immediate demand for towels and an expansion of the market. Local
market demand can be made through traders bringing the supply from outside or setting up
local production could arrange new supply in response to local demand, but all this would
happen with varying time lags depending on the circumstances. Local supply reduces this
time and a major consideration in the design of local projects is to build warehouse and
storing facilities for goods. Grain banks exist in some parts of India mostly under private
initiatives or NGOs, but detailed consideration of how supply lines of different types can be
locally created and managed (with absorption of skilled labor) as complements to the project,
deserves far greater attention. Indeed one way of reducing the fear of inflation is to have
decentralized response through local grain storage and other supplies.
Even the
management of certain types of common property resources like forests, water bodies, etc.
should be considered also from this standpoint.
Local politics and tensions are almost inevitable around the question of who benefits from the
creation of productive assets. For example a pond or a well being built would contribute to
increase in local agricultural production and benefit the local population; or the building of
infrastructures like schools or roads, hospitals, childrens playgrounds etc. However, not all
assets need to be a public good and there could well be situations where the asset is created
on private land. The question of benefits or positive externality is one of local inclusiveness
and that could be the general principle of designing such public works program, e.g. a rich
farmer may need a well on his private land and might be the largest employer of agricultural
labor in the area. Thus indirectly a well or water source constructed on his land could boost
local employment and productivity. The central problem in such a situation is to separate the
ownership right of land from the use right of the public with prior consultation and a
management design which gives control of water use to the larger community and not to the
individual owner of the land. Theoretically a public works program could have a place for
public-private partnership provided the incidence of the financial burden for these kinds of
assets, separating ownership from use right.
However the problem is not simply divergence between private and the public benefit .The
current literature on social exclusion points to many instances in public works program from
which the socially vulnerable groups are altogether excluded or grossly marginalized.
Depending on the particular context the design of projects for financing of public works needs
to build into its criteria of acceptability the extent of inclusiveness involving issues of race,
gender, minorities, and caste. Recent studies in India throws light on discrimination faced by
excluded groups in India in matters of public health, 17 education 18 and even government
17
18
See Acharya (2010) for analysis of exclusion and public health.

See Nambissan (2009) for examples of exclusion in schooling.
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sponsored food programs. 19 In fact, children from excluded communities grow up with this
kind of stigmatization even today in India and which manifests itself in everyday forms of
exclusion from government sponsored programs. The situation of women and minority groups
is similar in terms of denial of access from full participation in public programs.
Similar are the problems of social exclusions due to unemployment faced by Iran. Irans
economic growth has been on the decline since 2008, Irans unemployment and
underemployment have increased considerably. At present, unemployment rate is about 11
percent, but this rate for youths is more than 25 percent, and for young women 42 percent.
About 35 percent of unemployed young workers have been searching for job more than 19
months. Only 4 percent of Iranian unemployed receive unemployment benefits, and about 96
percent of unemployed who have not paid for social insurance have no access to
unemployment benefits. 20 Unemployment is one of the most important causes of poverty and
escalating social problems such as addiction, divorce and violence in Iran, which have caused
raising government expenditure regarding police and prisons.
The kind of work that could be done under the new public work program would be primarily of
an unskilled kind implying that it would be requiring more of repetitive manual labour. The
question of labour productivity in such a program would have a limited role. The
complementary increases in land productivity by creation of productive assets for simple
water management, warehouses, primary schools, health centers, local forest management
etc would necessarily be the major factor for direct and indirect increases in productivity. This
implies that the wage share and material cost of such labour intensive activities could
primarily be borne by the State. In the case of assets being created on private land, the
material cost burden could be shared by the owner of the land. In this way the primary
increase in local consumption demand is to be ensured through the wage channel, and basic
wage guarantee could be looked upon as a generator of sustained local demand.
In such programs, however, there would be leakages. The point is to see whether this
leakage is within the region/local area e.g. the local contractor siphoning of materials or the
wages being siphoned off by local powers but all wage income spent mostly locally. Formally,
the leakage would act as the saving propensity of an indirect internalized multiplier
mechanism which leads to damped demand generation locally. As opposed to this, suppose
rich people take advantage and dont put the money back into local circulation. In such a case
the benefit is externalized beyond the local region. The principle of financing should be
accordingly drawn up particularly in case of public- private cooperation with greater possibility
of externalization of benefits.
4- 2: Public works with skill
The relatively neglected component of a public works program in skill formation reminds one
of Adam Smiths famous observation that the extent of division of labor (read skill) is limited
by the size of the market. As already pointed out, the supply side fallacy needs to be avoided.
Instead it needs to be emphasized that skill formation in itself is not a guarantee for more jobs
but a reshuffling among job-seekers with fixed number of jobs determined by the size of the
market and the composition of demand (Vickerey, 1998). Training for skill development is
usually of the vocational kind but it does not interfere with the basic idea that without demand
creation more jobs cannot happen. The principle is the same everywhere, say for example in
19
20
See Thorat and Lele (2004) for examples of exclusion from food programs.
See Iran Statistics Center (2015) for changes in unemployment in Iran.
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a university. Not all people who apply will find a place in the same university. Given limited
capacity in the university, it would raise the bar and ask for higher qualifications for applying.
All this will do is to put some people at the head of the queue but not shorten the queue as in
the game of musical chairs with limited seats.
Skill formation can be linked to the issue of raising effective demand in two ways. Returning to
the earlier idea of profit led growth, skill formation can raise profitability of investment by
reducing search for the right skill by an enterprise and the required sharing skill formation cost
through extensive consultation and tie-up with industries. The apprenticeship model in
Germany could be a possible sort of model to consider in this context.
The financing principle has to be flexible for skill formation depending on how and to what
extent it is internalized as benefit by public and private sector. Skill creation and absorption
with short time lags need emphasis with longer on the job training rather than putting the
entire burden on publicly funded schooling. On the job training and longer duration of training
would become crucial in terms of skill creation and hence retention in the same industry or
firm-specific skills.
One immediate policy could be to create a pool of available skilled people through registration
and developing government sponsored service centers in various cities and even small
towns. The needed skill can be provided from these centers for commonly needed services
including not merely plumbing, electrical and construction works, but also nursing for the sick
and caring for old and disabled people. It is essential for the quality of service to be
maintained by evaluation with feedback from the client, and giving only a retention fee to the
service provider. The rest has to be collected on satisfactory completion of service from the
client on a piece-meal basis for each job. This method would not only keep some supervisory
check but would indicate indirectly what services are in relatively short supply. The economic
principle of relative scarcity may then be applied to raise the relative price of those services or
to help with government subsidies.
5. Inflationary pressures of public works

Concern about inflation is often raised in connection with public works programs. Some
economists insist that higher fiscal deficits lead to higher inflation. The argument goes, if
government spends more in creating employment for the poor, in providing infrastructure,
basic facilities, providing better health care, drinking water, mid-day meals etc., it essentially
falls short of earning revenue. To cover that deficit might take to printing money which will
lead to an inflationary pressure. Alternatively, if the government borrows from the market
(against bonds lowering interest rate) it leads to crowding out of private investment. This
issue essentially reduces to whether the Government fights serious unemployment and
provides basic facilities to its poorer citizens or suffers paralysis from the fear of possible fall
outs of fiscal deficit? Once the focus of this debate shifts to (a) emphasizing the matching of
demand and supply through formation and expansion of local markets through
decentralization, and (b) the need for socializing consumption of some essential commodities
for the poor through social rather than private money wage, the problem of inflation becomes
less unmanageable. And, this might be a better approach to tackle the problem than through
conventional debates on fiscal and monetary policies.
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The current obsession with growth rates and fiscal deficits, prevalent amongst policy makers
and economists globally, has its lineage in orthodox economic theory. Most governments
under the aegis of globalization usually use the trade off between inflation and unemployment
(i.e. if one targets unemployment there will be higher inflation), as an excuse to not pursue full
employment policies. Just as the Great Depression was setting in, the British Treasury
released a White Paper in 1929 called, memorandum on certain proposals relating to
unemployment which laid out the theoretical foundations for the view that the government
should at all times balance the budget in effect refraining from expenditure in mitigating
unemployment. The Treasury view was a response to Lloyd Georges suggestion that the
British government should spend more money on public works to tackle the increasing
unemployment. Old views continue to be revived to disable governments from fighting
unemployment
Broadly, there are two ways to finance an increase in government spending: tax the rich or
borrow either from the central bank (deficit financing) or from the market.
Let us assume that there exists a demand constraint rather than a supply bottleneck. Let us
take the case of a typical social sector scheme where workers work on a public work program
and are paid wages in cash or grains or both (essentially food for work programs, unskilled
public works etc.). We concentrate on deficit borrowing as the route taken by the government
to finance such a scheme. What is by and large true for contemporary times is that the
majority of the workforce in the unorganized sector lives at below subsistence levels. Thus
any increase in wage incomes of the poorest would mean that it would be consumed. The
mechanism is deceptively simple the government injects money (in public works) which
leads to an increase in incomes and output by an amount more than the injection. This is
what economists call the multiplier mechanism. Effectively, higher income means higher
spending and hence more income - which means that there would be an increase in the
governments tax revenue collection (even with unchanged tax rates). Similarly the increase
in labour productivity through skill formation, if absorbed locally can also lead to successive
rounds of multiplier effects. So higher governmental spending does not necessarily mean
higher deficits.
The increase in social sector spending leads to two situations being conjured up by the
economic orthodoxy: (a) the government will borrow out of a fixed pool of savings hence
leaving lesser investment for the private players thus crowding out of private investment;
and, (b) to cover that deficit it might take to print money which in effect will lead to an
inflationary pressure. First, through the multiplier mechanism, increased incomes mean that
households increase consumption expenditure and savings. So increased government
spending does not eat away the pool available for private investment (the crowding out effect)
but in fact increases the pool (a sort of crowding in). Hence higher government spending by
deficit financing would actually lead to a scenario where the fiscal deficit finances itself
through the multiplier mechanism. The second strain of thought (i.e. more money means
more inflation) is associated with various versions of Monetarism (Friedman) and forms the
intellectual backbone of arguments to curb state action in the social sector and more
privatization. Given demand constraint, more injections would give rise to more output and
thus more money would not necessarily chase the same goods and hence would not give
rise to inflation. The bogey of sound finance was precisely raised and articulated to usher in
neoliberalism in countries across the world which would imply moving away from a full
employment objective. Given such a situation the new public works program will have to
ensure that it is necessarily a question of destination or who benefits. The next issue is that of
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enhancing productivity with a major component of it being internalized. The principle of

financing should necessarily follow form the principle distinguishing inclusion from exclusion.
Regarding the problems of social exclusion one needs to revisit the importance of the social
wage. If the focus is on citizens and the processes that lead to their social exclusion, then the
social wage would be comprising of (but not limited to) a guaranteed income, universalized
healthcare, public transportation, educational aid etc. steps that will lead to a amelioration of
exclusionary outcomes. The social wage has traditionally been used by early social
democratic parties, especially in Scandinavian countries, and a revival of the concept of social
wages in contemporary times would be particularly effective in containing the devastating
effects of inflation.
6. Conclusion
Apart from the productivity enhancing benefits of public works programs, the other social
dimension is of inclusion. What we can expect from such programs in contemporary times is
the large influx of socially excluded groups especially, women. There are large numbers
women who are interested to work, if job is accessible. Large part of potentially active women
frustrated of useless job searching, stay at home and become inactive. By implementing
public work schemes in backward regions, considerable number of such women will
participate in the programs. In fact, such programs will reveal the real number of potential
active women. Therefore, it is necessary to design special jobs in health clinics, child and
elderly care centres, projects accounting and supervision for educated and less educated
women, especially women head of households. While, such works will empower women in
deprived regions, it alone cannot reduce women's unemployment and underemployment rates
considerably; as many women will enter the labour market in the areas that new job
opportunities will emerge.
For millions of unemployed and underemployed workers decent living is out of reach.
Although, pro-growth, pro-private investment strategy has failed in sufficient job provision in
the past three decades, it has still remained the main tool for dealing with serious labour
market problems. However, the need to find more sustainable sources of economic growth,
particularly through domestic demand and wage-led alternatives, encouraged a group of
countries to implement alternative policies, such as public work programs. Post recent global
economic downturn, academics and even ILO have insisted that it is crucial to implement a
coherent, job-oriented strategy to address the basic needs of millions workers and their
families and emphasized that employment and social protection must be at the centre of fiscal
stimulus measures to protect the vulnerable groups and reactivate investment and demand.
This approach relies on strong positive multiplier effects to create virtuous cycles of
employment and productivity growth.
Most developing countries facing labour market crisis, try to change the trend by providing
subsidized loans to private sector via state-owned banks. However, generous loans were not
successful to generate sufficient employment opportunities. In sluggish economic situation
and unfavorable business environment, private sector is not interested in productive
investment; and credit facility cannot bond the creditor to use the money in productive and job
generating businesses. Escalating unemployment and low-paid insecure jobs and increasing
concern about economic and social costs of raising poverty force governments to react to
these problems by effective policies.
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Public work schemes can be the most efficient program to prevent unemployment and income
inequality from becoming a social disaster. Public work schemes can be implemented in
deprived regions mostly overrepresented by ethnic and religious minorities that suffer badly
from chronic unemployment, underemployment and poverty. Public works scheme, with direct
involvement of local beneficiaries, can stimulate the economy, create most needed
infrastructure, improve the standard of living of people, reduce tensions of exclusion and
encourage private investment.
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real-world economics review, issue no. 72

(Source: authors compilation, data retrieved from AMECO (2014). 3)

Refer to Appendix A for a more detailed description of the data.

real-world economics review, issue no. 72

(Source: Wade 2011, 66.)

real-world economics review, issue no. 72

real-world economics review, issue no. 72

Figure 4: U.S. Compensation of Employees and Profits, 1950-2012

(Source: authors compilation, date retrieved from FRED (2014). 4)

Figure 5: U.S. Tax Receipts by Source as Percentage of GDP, 1950-2013

(Source: authors compilation, data retrieved from Historical Tables (2014).)

Refer to Appendix B for a more detailed description of the data.

real-world economics review, issue no. 72

Figure 6: U.S. Effective Corporate Tax Rate, 1950-2013

(Source: authors own compilation, based on FRED (2014). 5)

Refer to Appendix B for a more detailed description of the data.

real-world economics review, issue no. 72

(Source: OECD 2014, 3)

Refer to Appendix B for a more detailed description of the data.

real-world economics review, issue no. 72

real-world economics review, issue no. 72

real-world economics review, issue no. 72

real-world economics review, issue no. 72

real-world economics review, issue no. 72

Appendix A: Description of Data based on AMECO (2014)

(Source: AMECO (2014).)

Appendix B: Description of Data based on FRED (2014)

Effective Tax Rate

(Source: FRED (2014).)

Author contact: [email protected]

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A never ending recession? The vicissitudes of

Copyright: Alicia Puyana, 2015

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real-world economics review, issue no. 72

real-world economics review, issue no. 72

2 Economic crises and the crisis of economic theory

3 From the classics to the neoclassics: what is economic science for?

real-world economics review, issue no. 72