Mariana Mazzucato

T H E VA L U E O F E V E RY T H I NG
Making and Taking in the Global Economy

2018
 Contents

Preface: Stories About Wealth Creation

Introduction: Making versus Taking

Common Critiques of Value Extraction
What is Value?
Meet the Production Boundary
Why Value Theory Matters
The Structure of the Book

1. A Brief History of Value

The Mercantilists: Trade and Treasure
The Physiocrats: The Answer Lies in the Soil
Classical Economics: Value in Labour

2. Value in the Eye of the Beholder: The Rise of the Marginalists

New Times, New Theory
The Eclipse of the Classicals
From Objective to Subjective: A New Theory of Value Based on Preferences
The Rise of the ‘Neoclassicals’
The Disappearance of Rent and Why it Matters

3. Measuring the Wealth of Nations

GDP: A Social Convention
The System of National Accounts Comes into Being
Measuring Government Value Added in GDP
Something Odd About the National Accounts: GDP Facit Saltus!
Patching Up the National Accounts isn’t Enough
4. Finance: A Colossus is Born
Banks and Financial Markets Become Allies
The Banking Problem
Deregulation and the Seeds of the Crash
The Lords of (Money) Creation
Finance and the ‘Real’ Economy
From Claims on Profit to Claims on Claims
A Debt in the Family

5. The Rise of Casino Capitalism

Prometheus (with a Pilot’s Licence) Unbound
New Actors in the Economy
How Finance Extracts Value

6. Financialization of the Real Economy

The Buy-back Blowback
Maximizing Shareholder Value
The Retreat of ‘Patient’ Capital
Short-Termism and Unproductive Investment
Financialization and Inequality
From Maximizing Shareholder Value to Stakeholder Value

7. Extracting Value through the Innovation Economy

Stories about Value Creation
Where Does Innovation Come From?
Financing Innovation
Patented Value Extraction
Unproductive Entrepreneurship
Pricing Pharmaceuticals
Network Effects and First-mover Advantages
Creating and Extracting Digital Value
Sharing Risks and Rewards

8. Undervaluing the Public Sector

 The Myths of Austerity
Government Value in the History of Economic Thought
Keynes and Counter-cyclical Government
Government in the National Accounts
Public Choice Theory: Rationalizing Privatization and Outsourcing
Regaining Confidence and Setting Missions
Public and Private Just Deserts
From Public Goods to Public Value

9. The Economics of Hope

Markets as Outcomes
Take the Economy on a Mission
A Better Future for All

Notes
Bibliography
Acknowledgements
Follow Penguin
 Preface: Stories About Wealth Creation

We often hear businesses, entrepreneurs or sectors talking about

themselves as ‘wealth-creating’. The contexts may differ – finance, big
pharma or small start-ups – but the self-descriptions are similar: I am a
particularly productive member of the economy, my activities create
wealth, I take big ‘risks’, and so I deserve a higher income than people
who simply benefit from the spillovers of this activity. But what if, in the
end, these descriptions are simply just stories? Narratives created in order
to justify inequalities of wealth and income, massively rewarding the few
who are able to convince governments and society that they deserve high
rewards, while the rest of us make do with the leftovers.
In 2009 Lloyd Blankfein, CEO of Goldman Sachs, claimed that ‘The
people of Goldman Sachs are among the most productive in the world.’1
Yet, just the year before, Goldman had been a major contributor to the
worst financial and economic crisis since the 1930s. US taxpayers had to
stump up $125 billion to bail it out. In light of the terrible performance of
the investment bank just a year before, such a bullish statement by the
CEO was extraordinary. The bank laid off 3,000 employees between
November 2007 and December 2009, and profits plunged.2 The bank and
some its competitors were fined, although the amounts seemed small
relative to later profits: fines of $550 million for Goldman and $297
million for J. P. Morgan, for example.3 Despite everything, Goldman –
along with other banks and hedge funds – proceeded to bet against the
very instruments which they had created and which had led to such
turmoil.
Although there was much talk about punishing those banks that had
contributed to the crisis, no banker was jailed, and the changes hardly
dented the banks’ ability to continue making money from speculation:
between 2009 and 2016 Goldman achieved net earnings of $63 billion on
net revenues of $250 billion.4 In 2009 alone they had record earnings of
$13.4 billion.5 And although the US government saved the banking system
with taxpayers’ money, the government did not have the confidence to
demand a fee from the banks for such high-risk activity. It was simply
happy, in the end, to get its money back.
Financial crises, of course, are not new. Yet Blankfein’s exuberant
confidence in his bank would have been less common half a century ago.
Until the 1960s, finance was not widely considered a ‘productive’ part of
the economy. It was viewed as important for transferring existing wealth,
not creating new wealth. Indeed, economists were so convinced about the
purely facilitating role of finance that they did not even include most of the
services that banks performed, such as taking in deposits and giving out
loans, in their calculations of how many goods and services are produced
by the economy. Finance sneaked into their measurements of Gross
Domestic Product (GDP) only as an ‘intermediate input’ – a service
contributing to the functioning of other industries that were the real value
creators.
In around 1970, however, things started to change. The national
accounts – which provide a statistical picture of the size, composition and
direction of an economy – began to include the financial sector in their
calculations of GDP, the total value of the goods and services produced by
the economy in question.6 This change in accounting coincided with the
deregulation of the financial sector which, among other things, relaxed
controls on how much banks could lend, the interest rates they could
charge and the products they could sell. Together, these changes
fundamentally altered how the financial sector behaved, and increased its
influence on the ‘real’ economy. No longer was finance seen as a staid
career. Instead, it became a fast track for smart people to make a great deal
of money. Indeed, after the Berlin Wall fell in 1989, some of the cleverest
scientists in Eastern Europe ended up going to work for Wall Street. The
industry expanded, grew more confident. It openly lobbied to advance its
interests, claiming that finance was critical for wealth creation.
Today the issue is not just the size of the financial sector, and how it has
outpaced the growth of the non-financial economy (e.g. industry), but its
effect on the behaviour of the rest of the economy, large parts of which
have been ‘financialized’. Financial operations and the mentality they
breed pervade industry, as can be seen when managers choose to spend a
greater proportion of profits on share buy-backs – which in turn boost
stock prices, stock options and the pay of top executives – than on
investing in the long-term future of the business. They call it value
creation but, as in the financial sector itself, the reality is often the
opposite: value extraction.
 These stories of value creation are not limited to finance. In 2014 the
pharmaceutical giant Gilead priced its new treatment for the life-
threatening hepatitis C virus, Harvoni, at $94,500 for a three-month
course. Gilead justified charging this price by insisting that it represented
‘value’ to health systems. John LaMattina, former President of R&D at the
drugs company Pfizer, argued that the high price of speciality drugs is
justified by how beneficial they are for patients and for society in general.
In practice, this means relating the price of a drug to the costs that the
disease would cause to society if not treated, or if treated with the second-
best therapy available. The industry calls this ‘value-based pricing’. It’s an
argument refuted by critics, who cite case studies that show no correlation
between the price of cancer drugs and the benefits they provide.7 One
interactive calculator (www.drugabacus.org), which enables you to
establish the ‘correct’ price of a cancer drug on the basis of its valuable
characteristics (the increase in life expectancy it provides to patients, its
side effects, and so on), shows that for most drugs this value-based price is
lower than the current market price.8
Yet drug prices are not falling. It seems that the industry’s value
creation arguments have successfully neutralized criticism. Indeed, a high
proportion of health care costs in the Western world has nothing to do with
health care: these costs are simply the value the pharmaceutical industry
extracts.
Or consider the way that entrepreneurs in the dot.com and IT industry
lobby for advantageous tax treatment by governments in the name of
‘wealth creation’. With ‘innovation’ as the new force in modern
capitalism, Silicon Valley’s do-gooders have successfully projected
themselves as the entrepreneurs and garage tinkerers who unleash the
‘creative destruction’ from which the jobs of the future come. These new
actors, from Google to Uber to Airbnb, are often described as the ‘wealth
creators’.
Yet this seductive story of value creation leads to questionable broader
tax policies by policymakers: for example, the ‘patent box’ policy that
reduces tax on any products whose inputs are patented, supposedly to
incentivize innovation by rewarding the generation of intellectual property.
It’s a policy that makes little sense, as patents are already monopolies
which should normally earn high returns. Policymakers’ objectives should
not be to increase the profits from monopolies, but to favour investments
in areas like research.
Many of the so-called wealth creators in the tech industry, like the co-
founder of Pay Pal, Peter Thiel, often lambast government as a pure
impediment to wealth creation.9 Thiel went so far as to set up a
‘secessionist movement’ in California so that the wealth creators could be
as independent as possible from the heavy hand of government. When Eric
Schmidt, CEO of Google, was quizzed about the way companies control
our personal data, he replied with what he assumed was a rhetorical
question: ‘Would you prefer government to have it?’ His reply fed a
modern-day banality: entrepreneurs good, government bad.
Yet in presenting themselves as modern-day heroes, Apple and other
companies conveniently ignore the pioneering role of government in new
technologies. Apple has unashamedly declared that its contribution to
society should not be sought through tax but through recognition of its
great gizmos. But doesn’t the taxpayer who helped Apple create those
products and the record profits and cash mountain they have generated
deserve something back, beyond a series of undoubtedly brilliant gadgets?
Simply to pose this question, however, underlines how we need a radically
different type of narrative as to who created the wealth in the first place –
and who has subsequently extracted it.
If there are so many wealth creators in industry, the inevitable
conclusion is that at the opposite side of the spectrum featuring fleet-
footed bankers, science-based pharmaceuticals and entrepreneurial geeks
are the inert, value-extracting civil servants and bureaucrats in
government. In this view, if private enterprise is the fast cheetah bringing
innovation to the world, government is a plodding tortoise impeding
progress – or, to invoke a different metaphor, a Kafkaesque bureaucrat,
buried under papers, cumbersome and inefficient. Government is depicted
as a drain on society, funded by obligatory taxes on long-suffering
citizens. In this story, there is always only one conclusion: that we need
more market and less state. The slimmer, trimmer and more efficient the
state machine the better.
In all these cases, from finance to pharmaceuticals and IT, governments
bend over backwards to attract these supposedly value-creating individuals
and companies, dangling before them tax reductions and exemptions from
the red tape that is believed to constrict their wealth-creating energies. The
media heap wealth creators with praise, politicians court them, and for
many people they are high-status figures to be admired and emulated. But
who decided that they are creating value? What definition of value is used
to distinguish value creation from value extraction, or even from value
destruction?
Why have we so readily believed this narrative of good versus bad?
How is the value produced by the public sector measured, and why is it
more often than not treated simply as a more inefficient version of the
private sector? What if there was actually no evidence for this story at all?
What if it stemmed purely from a set of deeply ingrained ideas? What new
stories might we tell?
The Greek philosopher Plato once argued that storytellers rule the
world. His great work The Republic is in part a guide to educating the
leader of his ideal state, the Guardian. Plato recognized that stories form
character, culture and behaviour: ‘Our first business is to supervise the
production of stories, and chose only those we think suitable, and reject the
rest. We shall persuade mothers and nurses to tell our chosen stories to
their children, and by means of them to mould their minds and characters
rather than their bodies. The greater part of the stories current today we
shall have to reject.’10
Plato disliked myths about ill-behaved gods. This book looks at a more
modern myth, about value creation in the economy. Such myth-making, I
argue, has allowed an immense amount of value extraction, enabling some
individuals to become very rich and draining societal wealth in the
process. Between 1975 and 2015 real US GDP – the size of the economy
adjusted for inflation – roughly tripled from $5.49 trillion to $16.58
trillion.11 During this period, productivity grew by more than 60 per cent.
Yet from 1979 onwards, real hourly wages for the great majority of
American workers have stagnated or even fallen.12 In other words, for
almost four decades a tiny elite has captured nearly all the gains from an
expanding economy. You do not have to look far to see who is in that elite.
Mark Zuckerberg dropped out of Harvard at the age of nineteen to launch
Facebook. He is now in his early thirties. According to Forbes,13
Zuckerberg’s fortune increased by $18 billion in the year to mid-2016,
making his current total estimated worth $70.8 billion. He is the fourth-
richest man in the US and the fifth-richest in the world.14
It defies reason to maintain, as the dominant narrative does, that the
inequality that has increased in the US, and in many other economies, is
due to very smart individuals doing particularly well in innovative sectors.
While wealth is created through a collective effort, the massive imbalance
in the distribution of the gains from economic growth has often been more
the result of wealth extraction, whose potential scale globalization has
greatly magnified.
At the end of the second quarter of 2016, Facebook had 1.71 billion
monthly active users, almost one in every four people on the planet. The
imbalance in the distribution of gains from economic growth is a primary
cause of widening social inequalities in many mature economies, which in
turn has deep political consequences – arguably including the UK’s
referendum vote to leave the European Union. Many people who felt
globalization had left them behind chose Brexit.
Economists must take a sizeable share of the blame for the lamentable
outcomes of the prevailing story about value. We have stopped debating
value – and, as a result, we have allowed one story about ‘wealth creation’
and ‘wealth creators’ to dominate almost unchallenged.
The purpose of this book is to change this state of things, and to do so
by reinvigorating the debate about value that used to be – and, I argue,
should still be – at the core of economic thinking. If value is defined by
price – set by the supposed forces of supply and demand – then as long as
an activity fetches a price (legally), it is seen as creating value. So if you
earn a lot you must be a value creator. I will argue that the way the word
‘value’ is used in modern economics has made it easier for value-
extracting activities to masquerade as value-creating activities. And in the
process rents (unearned income) get confused with profits (earned
income); inequality rises, and investment in the real economy falls. What’s
more, if we cannot differentiate value creation from value extraction, it
becomes nearly impossible to reward the former over the latter. If the goal
is to produce growth that is more innovation-led (smart growth), more
inclusive and more sustainable, we need a better understanding of value to
steer us.
This is not an abstract debate. It has far-reaching consequences – social
and political as well as economic – for everyone. How we discuss value
affects the way all of us, from giant corporations to the most modest
shopper, behave as actors in the economy and in turn feeds back into the
economy, and how we measure its performance. This is what philosophers
call ‘performativity’: how we talk about things affects behaviour, and in
turn how we theorize things. In other words, it is a self-fulfilling prophecy.
If we cannot define what we mean by value, we cannot be sure to
produce it, nor to share it fairly, nor to sustain economic growth. The
understanding of value, then, is critical to all the other conversations we
need to have about where our economy is going and how to change its
course.
 Introduction: Making versus Taking

The barbarous gold barons – they did not find the gold, they did not mine the gold, they
did not mill the gold, but by some weird alchemy all the gold belonged to them.
Big Bill Haywood, founder of the Unites States’ first industrial union1

Bill Haywood expressed his puzzlement eloquently. He represented men

and women in the US mining industry at the start of the twentieth century
and during the Great Depression of the 1930s. He was steeped in the
industry. But even Haywood could not answer the question: why did the
owners of capital, who did little but buy and sell gold on the market, make
so much money, while workers who expended their mental and physical
energy to find it, mine it and mill it, make so little? Why were the takers
making so much money at the expense of the makers?
Similar questions are still being asked today. In 2016 the British high-
street retailer BHS collapsed. It had been founded in 1928 and in 2004 was
bought by Sir Philip Green, a well-known retail entrepreneur, for £200
million. In 2015 Sir Philip sold the business for £1 to a group of investors
headed by the British businessman Dominic Chappell. While it was under
his control, Sir Philip and his family extracted from BHS an estimated
£580 million in dividends, rental payments and interest on loans they had
made to the company. The collapse of BHS threw 11,000 people out of
work and left its pension fund with a £571 million deficit, even though the
fund had been in surplus when Sir Philip acquired it.2 A report on the BHS
disaster by the House of Commons Work and Pensions Select Committee
accused Sir Philip, Mr Chappell and their ‘hangers-on’ of ‘systematic
plunder’. For BHS workers and pensioners who depended on the company
for a decent living for their families, this was value extraction – the
appropriation of gains vastly out of proportion to economic contribution –
on an epic scale. For Sir Philip and others who controlled the business, it
was value creation.
While Sir Philip’s activities could be viewed as an aberration, the
excesses of an individual, his way of thinking is hardly unusual: today,
many giant corporations are also guilty of confusing value creation with
value extraction. In August 2016, for instance, the European Commission,
the European Union’s (EU) executive arm, sparked an international row
between the EU and the US when it ordered Apple to pay €13 billion in
back taxes to Ireland.3
Apple is the world’s biggest company by stock market value. In 2015 it
held a mountain of cash and securities outside the US worth $187 billion4
– about the same size as the Czech Republic’s economy that year5 – to
avoid paying the US taxes that would be due on the profits if they were
repatriated. Under a deal with Ireland dating back to 1991, two Irish
subsidiaries of Apple received very generous tax treatment. The
subsidiaries were Apple Sales International (ASI), which recorded all the
profits earned on sales of iPhones and other Apple devices in Europe, the
Middle East, Africa and India; and Apple Operations Europe, which made
computers. Apple transferred development rights of its products to ASI for
a nominal amount, thereby depriving the US taxpayer of revenues from
technologies, embodied in Apple products, whose early development the
taxpayer had funded. The European Commission alleged that the
maximum rate payable on those profits booked through Ireland which
were liable for tax was 1 per cent, but that in 2014 Apple paid tax at 0.005
per cent. The usual rate of corporation tax in Ireland is 12.5 per cent.
What is more, these ‘Irish’ subsidiaries of Apple are in fact not resident
for tax purposes anywhere. This is because they have exploited
discrepancies between the Irish and US definitions of residence. Almost all
the profits earned by the subsidiaries were allocated to their ‘head offices’,
which existed only on paper. The Commission ordered Apple to pay the
back taxes on the grounds that Ireland’s deal with Apple constituted illegal
state aid (government support that gives a company an advantage over its
competitors); Ireland had not offered other companies similar terms.
Ireland, the Commission alleged, had offered Apple ultra-low taxes in
return for the creation of jobs in other Apple businesses there. Apple and
Ireland rejected the Commission’s demand – and of course Apple is not
the only major corporation to have constructed exotic tax structures.
But Apple’s value extraction cycle is not limited to its international tax
operations – it is also much closer to home. Not only did Apple extract
value from Irish taxpayers, but the Irish government has extracted value
from the US taxpayer. Why so? Apple created its intellectual property in
California, where its headquarters are based. Indeed, as I argued in my
previous book, The Entrepreneurial State,6 and discuss briefly here in
Chapter 7, all the technology that makes the smartphone smart was
publicly funded. But in 2006 Apple formed a subsidiary in Reno, Nevada,
where there is no corporate income or capital gains tax, in order to avoid
state taxes in California. Creatively naming it Braeburn Capital, Apple
channelled a portion of its US profits to the Nevada subsidiary instead of
reporting it in California. Between 2006 and 2012, Apple earned $2.5
billion in interest and dividends reported in Nevada to avoid Californian
tax. California’s infamously large debt would be significantly reduced if
Apple fully and accurately reported its US revenues in that state, where a
major portion of its value (architecture, design, sales, marketing and so on)
originated. Value extraction thus pits US states against each other, as well
as the US against other countries.
It is clear that Apple’s highly complex tax arrangements were
principally designed to extract the maximum value from its business by
avoiding paying substantial taxes which would have benefited the societies
in which the company operated. Apple certainly creates value, of that there
is no doubt: but to ignore the support taxpayers have given it, and then to
pit states and countries against each other, is surely not the way to build an
innovative economy or achieve growth that is inclusive, that benefits a
wide section of the population, not only those best able to ‘game’ the
system.
There is yet another dimension to Apple’s value extraction. Many such
corporations use their profits to boost share prices in the short term instead
of reinvesting them in production for the long term. The main way they do
this is by using cash reserves to buy back shares from investors, arguing
that this is to maximize shareholder ‘value’ (the income earned by
shareholders in the company, based on the valuation of the company’s
stock price). But it is no accident that among the primary beneficiaries of
share buy-backs are managers with generous share option schemes as part
of their remuneration packages – the same managers who implement the
share buy-back programmes. In 2012, for example, Apple announced a
share buy-back programme of up to a staggering $100 billion, partly to
ward off ‘activist’ shareholders demanding that the company return cash to
them to ‘unlock shareholder value’.7 Rather than reinvest in the business,
Apple preferred to transfer cash to shareholders.
The alchemy of the takers versus the makers that Big Bill Haywood
referred to back in the 1920s continues today.

COMMON CRITIQUES OF VALUE EXTRACTION

The vital but often muddled distinction between value extraction and value
creation has consequences far beyond the fate of companies and their
workers, or even of whole societies. The social, economic and political
impacts of value extraction are huge. Prior to the 2007 financial crisis, the
income share of the top 1 per cent in the US expanded from 9.4 per cent in
1980 to a staggering 22.6 per cent in 2007. And things are only getting
worse. Since 2009 inequality has been increasing even more rapidly than
before the 2008 financial crash. In 2015 the combined wealth of the
planet’s sixty-two richest individuals was estimated to be about the same
as that of the bottom half of the world’s population – 3.5 billion people.8
So how does the alchemy continue to happen? A common critique of
contemporary capitalism is that it rewards ‘rent seekers’ over true ‘wealth
creators’. ‘Rent-seeking’ here refers to the attempt to generate income, not
by producing anything new but by overcharging above the ‘competitive
price’, and undercutting competition by exploiting particular advantages
(including labour), or, in the case of an industry with large firms, their
ability to block other companies from entering that industry, thereby
retaining a monopoly advantage. Rent-seeking activity is often described
in other ways: the ‘takers’ winning out over the ‘makers’, and ‘predatory’
capitalism winning over ‘productive’ capitalism. It’s seen as a key way –
perhaps the key way – in which the 1 per cent have risen to power over the
99 per cent.9 The usual targets of such criticism are the banks and other
financial institutions. They are seen as profiting from speculative activities
based on little more than buying low and selling high, or buying and then
stripping productive assets simply to sell them on again with no real value
added.
More sophisticated analyses have linked rising inequality to the
particular way in which the ‘takers’ have increased their wealth. The
French economist Thomas Piketty’s influential book Capital in the
Twenty-First Century focuses on the inequality created by a predatory
financial industry that is taxed insufficiently, and by ways in which wealth
is inherited across generations, which gives the richest a head start in
getting even richer. Piketty’s analysis is key to understanding why the rate
of return on financial assets (which he calls capital) has been higher than
that on growth, and calls for higher taxes on the resultant wealth and
inheritance to stop the vicious circle. Ideally, from his point of view, taxes
of this sort should be global, so as to avoid one country undercutting
another.
Another leading thinker, the US economist Joseph Stiglitz, has explored
how weak regulation and monopolistic practices have allowed what
economists call ‘rent extraction’, which he sees as the main impetus
behind the rise of the 1 per cent in the US.10 For Stiglitz, this rent is the
income obtained by creating impediments to other businesses, such as
barriers to prevent new companies from entering a sector, or deregulation
that has allowed finance to become disproportionately large in relation to
the rest of the economy. The assumption is that, with fewer impediments
to the functioning of economic competition, there will be a more equal
distribution of income.11
I think we can go even further with these ‘makers’ versus ‘takers’
analyses of why our economy, with its glaring inequalities of income and
wealth, has gone so wrong. To understand how some are perceived as
‘extracting value’, siphoning wealth away from national economies, while
others are ‘wealth creators’ but do not benefit from that wealth, it is not
enough to look at impediments to an idealized form of perfect competition.
Yet mainstream ideas about rent do not fundamentally challenge how
value extraction occurs – which is why it persists.
In order to tackle these issues at root, we need to examine where value
comes from in the first place. What exactly is it that is being extracted?
What social, economic and organizational conditions are needed for value
to be produced? Even Stiglitz’s and Piketty’s use of the term ‘rent’ to
analyse inequality will be influenced by their idea of what value is and
what it represents. Is rent simply an impediment to ‘free-market’
exchange? Or is it due to their positions of power that some can earn
‘unearned income’ – that is, income derived from moving existing assets
around rather than creating new ones?12 This is a key question we will look
at in Chapter 2.

WHAT IS VALUE?

Value can be defined in different ways, but at its heart it is the production
of new goods and services. How these outputs are produced (production),
how they are shared across the economy (distribution) and what is done
with the earnings that are created from their production (reinvestment) are
key questions in defining economic value. Also crucial is whether what it
is that is being created is useful: are the products and services being
created increasing or decreasing the resilience of the productive system?
For example, it might be that a new factory is produced that is valuable
economically, but if it pollutes so much to destroy the system around it, it
could be seen as not valuable.
By ‘value creation’ I mean the ways in which different types of
resources (human, physical and intangible) are established and interact to
produce new goods and services. By ‘value extraction’ I mean activities
focused on moving around existing resources and outputs, and gaining
disproportionately from the ensuing trade.
 A note of caution is important. In the book I use the words ‘wealth’ and
‘value’ almost interchangeably. Some might argue against this, seeing
wealth as a more monetary and value as potentially a more social concept,
involving not only value but values. I want to be clear on how these two
words are used. I use ‘value’ in terms of the ‘process’ by which wealth is
created – it is a flow. This flow of course results in actual things, whether
tangible (a loaf of bread) or intangible (new knowledge). ‘Wealth’ instead
is regarded as a cumulative stock of the value already created. The book
focuses on value and what forces produce it – the process. But it also looks
at the claims around this process, which are often phrased in terms of
‘who’ the wealth creators are. In this sense the words are used
interchangeably.
For a long time the idea of value was at the heart of debates about the
economy, production and the distribution of the resulting income, and
there were healthy disagreements over what value actually resided in. For
some economic schools of thought, the price of products resulted from
supply and demand, but the value of those products derived from the
amount of work that was needed to produce things, the ways in which
technological and organizational changes were affecting work, and the
relations between capital and labour. Later, this emphasis on ‘objective’
conditions of production, technology and power relationships was replaced
by concepts of scarcity and the ‘preferences’ of economic actors: the
amount of work supplied is determined by workers’ preference for leisure
over earning a higher amount of money. Value, in other words, became
subjective.
Until the mid-nineteenth century, too, almost all economists assumed
that in order to understand the prices of goods and services it was first
necessary to have an objective theory of value, a theory tied to the
conditions in which those goods and services were produced, including the
time needed to produce them, the quality of the labour employed; and the
determinants of ‘value’ actually shaped the price of goods and services.
Then, this thinking began to go into reverse. Many economists came to
believe that the value of things was determined by the price paid on the
‘market’ – or, in other words, what the consumer was prepared to pay. All
of a sudden, value was in the eye of the beholder. Any goods or services
being sold at an agreed market price were by definition value-creating.
The swing from value determining price to price determining value
coincided with major social changes at the end of the nineteenth century.
One was the rise of socialism, which partly based its demands for reforms
on the claim that labour was not being rewarded fairly for the value it
created, and the ensuing consolidation of a capitalist class of producers.
The latter group was, unsurprisingly, keen on the alternative theory, that
price determined value, a story which allowed them to defend their
appropriation of a larger share of output, with labour increasingly being
left behind.
In the intellectual world, economists wanted to make their discipline
seem ‘scientific’ – more like physics and less like sociology – with the
result that they dispensed with its earlier political and social connotations.
While Adam Smith’s writings were full of politics and philosophy, as well
as early thinking about how the economy works, by the early twentieth
century the field which for 200 years had been ‘political economy’
emerged cleansed as simply ‘economics’. And economics told a very
different story.
Eventually the debate about different theories of value and the dynamics
of value creation virtually vanished from economics departments, only
showing up in business schools in a very new form: ‘shareholder value’,13
‘shared value’,14 ‘value chains’,15 ‘value for money’, ‘valuation’, ‘adding
value’ and the like. So while economics students used to get a rich and
varied education in the idea of value, learning what different schools of
economic thought had to say about it, today they are taught only that value
is determined by the dynamics of price, due to scarcity and preferences.
This is not presented as a particular theory of value – just as Economics
101, the introduction to the subject. An intellectually impoverished idea of
value is just taken as read, assumed simply to be true. And the
disappearance of the concept of value, this book argues, has paradoxically
made it much easier for this crucial term ‘value’ – a concept that lies at the
heart of economic thought – to be used and abused in whatever way one
might find useful.

MEET THE PRODUCTION BOUNDARY

To understand how different theories of value have evolved over the

centuries, it is useful to consider why and how some activities in the
economy have been called ‘productive’ and some ‘unproductive’, and how
this distinction has influenced ideas about which economic actors deserve
what – how the spoils of value creation are distributed.
For centuries, economists and policymakers – people who set a plan for
an organization such as government or a business – have divided activities
according to whether they produce value or not; that is, whether they are
productive or unproductive. This has essentially created a boundary – the
fence in Figure 1 below – thereby establishing a conceptual boundary –
sometimes referred to as a ‘production boundary’ – between these
activities.16 Inside the boundary are the wealth creators. Outside are the
beneficiaries of that wealth, who benefit either because they can extract it
through rent-seeking activities, as in the case of a monopoly, or because
wealth created in the productive area is redistributed to them, for example
through modern welfare policies. Rents, as understood by the classical
economists, were unearned income and fell squarely outside the
production boundary. Profits were instead the returns earned for
productive activity inside the boundary.
Historically, the boundary fence has not been fixed. Its shape and size
have shifted with social and economic forces. These changes in the
boundary between makers and takers can be seen just as clearly in the past
as in the modern era. In the eighteenth century there was an outcry when
the physiocrats, an early school of economists, called landlords
‘unproductive’. This was an attack on the ruling class of a mainly rural
Europe. The politically explosive question was whether landlords were just
abusing their power to extract part of the wealth created by their tenant
farmers, or whether their contribution of land was essential to the way in
which farmers created value.

Figure 1. Production boundary around the value-producing activities of the economy

A variation of this debate about where to draw the production boundary

continues today with the financial sector. After the 2008 financial crisis,
there were calls from many quarters for a revival of industrial policy to
boost the ‘makers’ in industry, who were seen to be pitted against the
‘takers’ in finance. It was argued that rebalancing was needed to shrink the
size of the financial sector (falling into the dark grey circle of unproductive
activities above) by taxation, for example a tax on financial transactions
such as foreign exchange dealing or securities trading, and by industrial
policies to nurture growth in industries that actually made things instead of
just exchanging them (falling into the light grey circle of productive
activities above).
But things are not so simple. The point is not to blame some as takers
and to label others as makers. The activities of people outside the
boundary may be needed to facilitate production – without their work,
productive activities may not be so valuable. Merchants are necessary to
ensure the goods arrive at the marketplace and are exchanged efficiently.
The financial sector is critical for buyers and sellers to do business with
each other. How these activities can be shaped to actually serve their
purpose of producing value is the real question.
And, most important of all, what about government? On which side of
the production boundary does it lie? Is government inherently
unproductive, as is often claimed, its only earnings being compulsory
transfers in the form of taxes from the productive part of the economy? If
so, how can government make the economy grow? Or can it at best only
set the rules of the game, so that the value creators can operate efficiently?
Indeed, the recurring debate about the optimal size of government and
the supposed perils of high public debt boils down to whether government
spending helps the economy to grow – because government can be
productive and add value – or whether it holds back the economy because
it is unproductive or even destroys value. The issue is politically loaded
and deeply colours current debates, ranging from whether the UK can
afford Trident nuclear weapons to whether there is a ‘magic number’ for
the size of government, defined as government spending as a proportion of
national output, beyond which an economy will inevitably do less well
than it might have done if government spending had been lower. As we
will explore in Chapter 8, this question is more tainted by political views
and ideological positions than informed by deep scientific proofs. Indeed,
it is important to remember that economics is at heart a social science, and
the ‘natural’ size of government will depend on one’s theory of (or simply
‘position’ on) the purpose of government. If it is seen as useless, or at best
a fixer of occasional problems, its optimum size will inevitably be
notionally smaller than if it is viewed as a key engine of growth needed to
steer and invest in the value creation process.
Over time, this conceptual production boundary was expanded to
encompass much more of the economy than before, and more varied
economic activities. As economists, and wider society, came to determine
value by supply and demand – what is bought has value – activities such as
financial transactions were redefined as productive, whereas previously
they had usually been classed as unproductive. Significantly, the only
major part of the economy which is now considered largely to lie outside
the production boundary – and thus to be ‘unproductive’ – remains
government. It is also true that many other services that people provide
throughout society go unpaid, such as care given by parents to children or
by the healthy to the unwell, and are not well accounted for. Fortunately,
issues such as factoring care into the way we measure national output
(GDP) are increasingly coming to the fore. But besides adding new
concepts to GDP – such as care, or the sustainability of the planet – it is
fundamental to understand why we hold the assumptions about value that
we do. And this is impossible if value is not scrutinized.

WHY VALUE THEORY MATTERS

First, the disappearance of value from the economic debate hides what
should be alive, public and actively contested.17 If the assumption that
value is in the eye of the beholder is not questioned, some activities will be
deemed to be value-creating and others will not, simply because someone
– usually someone with a vested interest – says so, perhaps more
eloquently than others. Activities can hop from one side of the production
boundary to the other with a click of the mouse and hardly anyone notices.
If bankers, estate agents and bookmakers claim to create value rather than
extract it, mainstream economics offers no basis on which to challenge
them, even though the public might view their claims with scepticism.
Who can gainsay Lloyd Blankfein when he declares that Goldman Sachs
employees are among the most productive in the world? Or when
pharmaceutical companies argue that the exorbitantly high price of one of
their drugs is due to the value it produces? Government officials can
become convinced (or ‘captured’) by stories about wealth creation, as was
recently evidenced by the US government’s approval of a leukemia drug
treatment at half a million dollars, precisely using the ‘value-based
pricing’ model pitched by the industry – even when the taxpayer
contributed $200 million dollars towards its discovery.18
Second, the lack of analysis of value has massive implications for one
particular area: the distribution of income between different members of
society. When value is determined by price (rather than vice versa), the
level and distribution of income seem justified as long as there is a market
for the goods and services which, when bought and sold, generate that
income. All income, according to this logic, is earned income: gone is any
analysis of activities in terms of whether they are productive or
unproductive.
Yet this reasoning is circular, a closed loop. Incomes are justified by the
production of something that is of value. But how do we measure value?
By whether it earns income. You earn income because you are productive
and you are productive because you earn income. So with a wave of a
wand, the concept of unearned income vanishes. If income means that we
are productive, and we deserve income whenever we are productive, how
can income possibly be unearned? As we shall see in Chapter 3, this
circular reasoning is reflected in how national accounts – which track and
measure production and wealth in the economy – are drawn up. In theory,
no income may be judged too high, because in a market economy
competition prevents anyone from earning more than he or she deserves.
In practice, markets are what economists call imperfect, so prices and
wages are often set by the powerful and paid by the weak.
In the prevailing view, prices are set by supply and demand, and any
deviation from what is considered the competitive price (based on
marginal revenues) must be due to some imperfection which, if removed,
will produce the correct distribution of income between actors. The
possibility that some activities perpetually earn rent because they are
perceived as valuable, while actually blocking the creation of value and/or
destroying existing value, is hardly discussed.
Indeed, for economists there is no longer any story other than that of the
subjective theory of value, with the market driven by supply and demand.
Once impediments to competition are removed, the outcome should
benefit everyone. How different notions of value might affect the
distribution of revenues between workers, public agencies, managers and
shareholders at, say, Google, General Electric or BAE Systems, goes
unquestioned.
Third, in trying to steer the economy in particular directions,
policymakers are – whether they recognize it or not – inevitably influenced
by ideas about value. The rate of GDP growth is obviously important in a
world where billions of people still live in dire poverty. But some of the
most important economic questions today are about how to achieve a
particular type of growth. Today, there is a lot of talk about the need to
make growth ‘smarter’ (led by investments in innovation), more
sustainable (greener) and more inclusive (producing less inequality).19
Contrary to the widespread assumption that policy should be
directionless, simply removing barriers and focusing on ‘levelling the
playing field’ for businesses, an immense amount of policymaking is
needed to reach these particular objectives. Growth will not somehow go
in this direction by itself. Different types of policy are needed to tilt the
playing field in the direction deemed desirable. This is very different from
the usual assumption that policy should be directionless, simply removing
barriers so that businesses can get on with smooth production.
Deciding which activities are more important than others is critical in
setting a direction for the economy: put simply, those activities thought to
be more important in achieving particular objectives have to be increased
and less important ones reduced. We already do this. Certain types of tax
credits, for, say, R&D, try to stimulate more investment in innovation. We
subsidize education and training for students because as a society we want
more young people to go to university or enter the workforce with better
skills. Behind such policies may be economic models that show how
investment in ‘human capital’ – people’s knowledge and capabilities –
benefits a country’s growth by increasing its productive capacity.
Similarly, today’s deepening concern that the financial sector in some
countries is too large – compared, for example, to manufacturing – might
be informed by theories of what kind of economy we want to be living in
and the size and role of finance within it.
But the distinction between productive and unproductive activities has
rarely been the result of ‘scientific’ measurement. Rather, ascribing value,
or the lack of it, has always involved malleable socio-economic arguments
which derive from a particular political perspective – which is sometimes
explicit, sometimes not. The definition of value is always as much about
politics, and about particular views on how society ought to be
constructed, as it is about narrowly defined economics. Measurements are
not neutral: they affect behaviour and vice versa (this is the concept of
performativity which we encountered in the Preface).
So the point is not to create a stark divide, labelling some activities as
productive and categorizing others as unproductive rent-seeking. I believe
we must instead be more forthright in linking our understanding of value
creation to the way in which activities (whether in the financial sector or
the real economy) should be structured, and how this is connected to the
distribution of the rewards generated. Only in this way will the current
narrative about value creation be subject to greater scrutiny, and
statements such as ‘I am a wealth creator’ measured against credible ideas
about where that wealth comes from. A pharmaceutical company’s value-
based pricing might then be scrutinized with a more collective value-
creation process in mind, one in which public money funds a large portion
of pharmaceutical research – from which that company benefits – in the
highest-risk stage. Similarly, the 20 per cent share that venture capitalists
usually get when a high-tech small company goes public on the stock
market may be seen as excessive in light of the actual, not mythological,
risk they have taken in investing in the company’s development. And if an
investment bank makes an enormous profit from the exchange rate
instability that affects a country, that profit can be seen as what it really is:
rent.
In order to arrive at this understanding of value creation, however, we
need to go beyond seemingly scientific categorizations of activities and
look at the socio-economic and political conflicts that underlie them.
Indeed, claims about value creation have always been linked to assertions
about the relative productiveness of certain elements of society, often
related to fundamental shifts in the underlying economy: from agricultural
to industrial, or from a mass-production-based economy to one based on
digital technology.

THE STRUCTURE OF THE BOOK

In Chapters 1 and 2 I look at how economists from the seventeenth century

onwards have thought about steering growth by increasing productive
activities and reducing unproductive ones, something they conceptualized
by means of a theoretical production boundary. The production boundary
debate, and its close relationship to ideas of value, has influenced
government measures of economic growth for centuries; the boundary,
too, has changed, influenced by fluctuating social, economic and political
conditions. Chapter 2 delves into the biggest shift of all. From the second
half of the nineteenth century onwards, value went from being an objective
category to a more subjective one tied to individual preferences. The
implications of this revolution were seismic. The production boundary
itself was blurred, because almost anything that could get a price or could
successfully claim to create value – for example, finance – suddenly
became productive. This opened the way to increased inequality, driven by
particular agents in the economy being able to brag about their
extraordinary ‘productivity’.
As we will see in Chapter 3, which explores the development of national
accounts, the idea of the production boundary continues to influence the
concept of output. There is, however, a fundamental distinction between
this new boundary and its predecessors. Today, decisions about what
constitutes value in the national accounts are made by blending different
elements: anything that can be priced and exchanged legally; politically
pragmatic decisions, such as accommodating technological change in the
computer industry or the embarrassingly large size of the financial sector;
and the practical necessity of keeping the accounting manageable in very
big and complex modern economies. This is all very well, but the fact that
the production boundary debate is no longer explicit, nor linked openly to
ideas about value, means that economic actors can – through sustained
lobbying – quietly place themselves within the boundary. Their value-
extracting activities are then counted in GDP – and very few notice.
Chapters 4, 5 and 6 examine the phenomenon of financialization: the
growth of the financial sector and the spread of financial practices and
attitudes into the real economy. In Chapter 4 I look at the emergence of
finance as a major economic sector and its transition from being
considered largely unproductive to becoming accepted as largely
productive. As late as the 1960s, national accountants viewed financial
activity not as generating value but as simply transferring existing value,
which placed it outside the production boundary. Today, this view has
changed fundamentally. In its current incarnation, finance is seen as
earning profits from services reclassified as productive. I look at how and
why this extraordinary redefinition took place, and ask if financial
intermediation really has undergone a transformation into an inherently
productive activity.
In Chapter 5 I explore the development of ‘asset manager capitalism’:
how the financial sector expanded beyond the banks to incorporate an
increasingly large number of intermediaries dedicated to managing funds
(the asset management industry), and ask whether the role of these
intermediaries, and the actual risks they take on, justify the rewards they
earn. In doing so, I question the extent to which fund management and
private equity have actually contributed to the productive economy. I ask,
too, whether financial reform can be tackled today without a serious debate
over whether activities in the financial sector are properly classified – are
they what should be seen as rents, rather than profits? – and how we can
go about making this distinction. If our national accounting systems are
really rewarding value extraction as though it is value creation, maybe this
can help us understand the dynamics of value destruction that
characterized the financial crisis.
Building on this acceptance of finance as a productive activity, Chapter
6 examines the financialization of the whole economy. In seeking a quick
return, short-term finance has affected industry: companies are run in the
name of maximizing shareholder value (MSV). MSV arose in the 1970s as
an attempt to revitalize corporate performance by invoking what was
claimed to be the main purpose of the company: creating value for
shareholders. I will argue, however, that MSV has been detrimental to
sustained economic growth, not least because it encourages short-term
gain for shareholders at the expense of long-term gains for the company –
a development closely linked to the increasing influence of fund managers
seeking returns for their clients and for themselves. Underlying MSV is the
notion of shareholders as the biggest risk takers, meriting the large rewards
they often obtain.
Risk-taking is often the justification for the rewards investors reap, and
Chapter 7 continues to look at other types of value extraction carried out in
its name. Here I consider the kind of risk-taking required for radical
technological innovation to occur. Innovation is without doubt one of the
most risky and uncertain activities in capitalism: most attempts fail. But
who takes it on? And what sort of incentives must be created? I explore the
biased view of the current innovation narrative: how public-sector risk-
taking is ignored, the state being seen as merely facilitating and ‘de-
risking’ the private sector. The result has been policies, including reforms
to the intellectual property rights (IPR) system, which have strengthened
the power of incumbents, limiting innovation and creating ‘unproductive
entrepreneurship’.20 Building on my previous book The Entrepreneurial
State, I will show how entrepreneurs and venture capitalists have been
hyped up to represent the most dynamic part of modern capitalism –
innovation – and have presented themselves as ‘wealth creators’. I will
unpick the wealth-creating narrative to show how, ultimately, it is false.
Claiming value in innovation, most recently with the concept of
‘platforms’ and the related notion of the sharing economy, is less about
genuine innovation and more to do with facilitating value extraction
through the capture of rents.
Picking up on the false innovation narrative, Chapter 8 will ask why the
public sector is always described as slow, boring, bureaucratic and
unproductive. Where did this depiction come from and who is benefiting
from it? I will argue that, in the same way and at the same time that
finance was made productive, the public sector has been made to appear
unproductive. Modern economic thought has relegated government to just
fixing market failures rather than actively creating and shaping markets.
The value-creating role of the public sector, I contend, has been
underestimated. The dominant view, which originated in the backlash
against government in the 1980s, fundamentally affects how government
sees itself: hesitant, cautious, careful not to overstep in case it should be
accused of crowding out innovation, or accused of favouritism, ‘picking
winners’. In questioning why public-sector activities are ignored in GDP
accounting, I ask why this should matter, and outline what a different view
of public value might look like.
It is, I conclude in Chapter 9, only through an open debate about value –
its sources and the conditions that foster it – that we can help steer our
economies in a direction that will produce more genuine innovation and
less inequality, and which will also transform the financial sector into one
that is truly focused on nurturing value creation in the real economy. It is
not enough to critique speculation and short-term value extraction, and to
argue for a more progressive tax system that targets wealth. We must
ground those critiques in a different conversation about value creation,
otherwise programmes for reform will continue to have little effect and
will be easily lobbied against by the so-called ‘wealth creators’.
This book does not try to argue for one correct theory of value. Rather,
it aims to bring back value theory as a hotly debated area, relevant to the
turbulent economic times in which we find ourselves. Value is not a given
thing, unmistakably either inside or outside the production boundary; it is
shaped and created. In my view, today finance nurtures not the industries
for which it is meant to ‘grease’ the wheels of commerce, but rather other
parts of the financial sector itself. It thus lies outside the boundary, even
though it is formally counted as being inside. But this does not have to be
the case: we can shape financial markets so that they do indeed belong
inside the boundary. This would include both new financial institutions
dedicated to lending to those organizations interested in long-term high-
risk investments that can help foster a more innovative economy, as well
as changing measures in the tax code that reward long-term investments
over short-term ones. Similarly, as I discuss in Chapter 7, changes to the
current unhelpful use of patents could help them stimulate innovation
rather than stifle it.
To create a fairer economy, one where prosperity is more broadly shared
and is therefore more sustainable, we need to reinvigorate a serious
discussion about the nature and origin of value. We must reconsider the
stories we are telling about who the value creators are, and what that says
to us about how we define activities as economically productive and
unproductive. We cannot limit progressive politics to taxing wealth, but
require a new understanding of and debate about wealth creation so that it
is more fiercely and openly contested. Words matter: we need a new
vocabulary for policymaking. Policy is not just about ‘intervening’. It is
about shaping a different future: co-creating markets and value, not just
‘fixing’ markets or redistributing value. It’s about taking risks, not only
‘de-risking’. And it must not be about levelling the playing field but about
tilting it towards the kind of economy we want.
This idea that we can shape markets has important consequences. We
can create a better economy by understanding that markets are outcomes
of decisions that are made – in business, in public organizations and in
civil society. The eight-hour working day has formed markets – and that
was the result of a fight held in labour organizations. And perhaps the
reason there is so much despair across the globe – despair now leading to
populist politics – is that the economy is presented to us simply as ‘made’
by trade rules, technocrats and neoliberal forces. Indeed, as the book will
show, ‘value’ theory itself is presented as a sort of objective force
determined by supply and demand, rather than deeply embedded in
particular ways of seeing the world. The economy can indeed be made and
shaped – but it can be done either in fear or in hope.
The specific challenge I pose here is to move beyond Oscar Wilde’s
cynic, who knows the price of everything but the value of nothing, towards
an economics of hope, where we are better empowered to question the
assumptions of economic theory and how they are presented to us. And to
choose a different path among the many that are available.
 1
A Brief History of Value

There is one sort of labour which adds to the value of the subject upon which it is
bestowed: there is another which has no such effect. The former, as it produces a value,
may be called productive; the latter, unproductive labour.
Adam Smith, The Wealth of Nations (1776)

Today we take increasing prosperity for granted. We assume that by and

large the next generation will be better off than the last. But it was not
always so. For most of human history people had no such expectations
and, partly because living standards improved at best very slowly, few
thinkers devoted much time to asking why some economies grow and
others do not. In the early modern period, the pace of change quickened.
Previously static economies became dynamic. Movement was in the air.
The rise of the nation state in Europe, the need to finance war,
colonization, machinery, factories and coal, combined with expanding
populations to stimulate new thinking across many fields. Governments
and people of all stations in life wanted to know what was causing
unprecedented movement and how it could be managed. What taxes can
we raise? Why are my wages so low compared with the profits of
capitalists? How sure can one be of the future when investing now? What
creates value?
Understanding the nature of production is key to answering such
questions. Once productive activities have been identified, economic
policy can try to steer an economy, devoting a greater share of capital and
effort to productive activities which propel and sustain economic growth.
But the distinction between what is or is not productive has varied
depending on economic, social and political forces. Ever since economists
began to explore the changing conditions of production some 300 years
ago they have struggled to provide a rationale for labelling some activities
productive and others unproductive. After all, economists are creatures of
their time like everyone else; in terms of understanding value, what’s
important is to distinguish durable principles from transitory ones – and
also, as we will see, the way that ideological positions develop.
This chapter explores how theories of value evolved from roughly the
mid-seventeenth century to the mid-nineteenth century. The thinkers of the
seventeenth century focused on how to calculate growth according to the
needs of the time: fighting wars, or increasing competitiveness relative to
another country – for example, England against its commercial and naval
rival, Holland. The mercantilists focus on trade and the needs of merchants
(selling things). From the mid-eighteenth to the late nineteenth century,
economists saw value as arising from the amount of labour that went into
production, at first farm labour (the physiocrats) and then industrial labour
(the classicals). This value, they believed, therefore determined the price
of what was finally sold. Their theories of value – of how wealth was
created – were dynamic, reflecting a world being transformed socially and
politically as well as economically. These economists focused on objective
forces: the effects of changes in technology and the division of labour on
how production and distribution are organized. Later, as we will see in the
next chapter, they were superseded by another perspective – that of the
neoclassicals – focused less on objective forces of production and more on
the subjective nature of the ‘preferences’ of different actors in the
economy.

THE MERCANTILISTS: TRADE AND TREASURE

Since ancient times, humanity has divided its economic activity into two
types: productive and unproductive, virtuous and vile, industrious and
lazy. The touchstone was generally what kind of activity was thought to
further the common good. In the fourth century BC, Aristotle distinguished
a variety of more or less virtuous jobs, depending on the class (citizen or
slave) of the ancient Greek polis dweller.1 In the New Testament, the
apostle Matthew reported that Jesus said it was ‘easier for a camel to go
through the eye of a needle than for a rich man to enter into the Kingdom
of God’.2 During the Middle Ages, the Church disparaged and even
denounced moneylenders and merchants who ‘bought cheap and sold
dear’;3 while they may not have been lazy, they were considered
unproductive and vile.
 Pre-modern definitions of what work was or was not useful were never
clear-cut. With the onset of colonialism in the sixteenth century these
definitions became even more blurred. European colonial conquest and the
protection of trade routes with newly annexed lands were expensive.
Governments had to find the money for armies, bureaucracies and the
purchase of exotic merchandise. But help seemed to be at hand:
extraordinary amounts of gold and silver were discovered in the Americas,
and a vast treasure poured into Europe. As these precious metals
represented wealth and prosperity, it seemed that whoever bought, owned
and controlled the supply of them and the currencies minted from them
was engaged in productive activities.
Scholars and politicians of the time who argued that accumulating
precious metals was the route to national power and prosperity are called
mercantilists (from mercator, the Latin word for merchant), because they
espoused protectionist trade policies and positive trade balances to
stimulate the inflow, and prevent the outflow, of gold and silver. The best-
known English advocate of mercantilism was a merchant and director of
the East India Company called Sir Thomas Mun (1571–1641). In his
influential book England’s Treasure by Forraign Trade, Mun summed up
the mercantilist doctrine: we must, he said, ‘sell more to strangers yearly
than wee consume of theirs in value’.4
Mercantilists also defended the growth of national government as
necessary to fund wars and expeditions to keep trade routes open and to
control colonial markets. In England, Holland and France, mercantilists
advocated shipping Acts, such as England’s Navigation Act of 1651,
which forced their countries’ and colonies’ trade exclusively into ships
flying the national flag.
As mercantilist thinking developed, and people started to conceive of
wealth production in national terms, the first estimates of national income
– the total amount everyone in the country earned – started to appear.
Seventeenth-century Britain saw two groundbreaking attempts to quantify
national income. One was by Sir William Petty (1623–87), an adventurer,
anatomist, physician and Member of Parliament, who was a tax
administrator in Ireland under Oliver Cromwell’s Commonwealth
government.5 The other was by the herald Gregory King (1648–1712), a
genealogist, engraver and statistician whose work on enacting a new tax on
marriages, births and burials provoked his interest in national accounting.
Petty and King were ingenious in their use of incomplete and messy
data to generate surprisingly detailed income estimates. They had to work
with rudimentary government tax figures, estimates of population and
patchy statistics on the consumption of basic commodities such as corn,
wheat and beer. What their estimates lacked, however, was a clear value
theory: Petty and King were concerned only with calculating the nation’s
output, not with how that output came about. Nevertheless, their attempts
at national accounting were unprecedented and laid the foundations for
modern national accounts.
In the 1660s, as Petty worked on his income studies, England was
emerging from its experiment with republicanism, and was struggling with
Holland and France for supremacy at sea. Petty wanted to find out whether
England had the resources to survive these threats to its security: as he put
it, to ‘prove mathematically that the [English] State could raise a much
larger revenue from taxes to finance its peace and wartime needs’,6
because he believed the country was richer than commonly thought.
Petty made a decisive breakthrough. He realized that income and
expenditure at the national level should be the same. He understood that, if
you treat a country as a closed system, each pound one person spends in it
is another person’s income of one pound. It was the first time anyone had
grasped and worked with this fundamental insight. To make up for the lack
of available statistics, Petty worked on the assumption that a nation’s
income is equal to its expenditure (omitting savings in good times,
although he was aware of the potential discrepancy).7 That meant he could
use expenditure per person, multiplied by population, to arrive at the
nation’s income. In so doing he started, implicitly, to impose a production
boundary, including within it only money spent on the production of
‘Food, Housing, Cloaths, and all other necessaries’.8 All other
‘unnecessary expenses’, as defined by Petty, were omitted.
In this way, by extension, Petty came to see any branch of the economy
that did not produce those necessities as unproductive, adding nothing to
national income. As he worked, his idea of the production boundary began
to crystallize further, with ‘Husbandmen, Seamen, Soldiers, Artizans and
Merchants … the very Pillars of any Common-Wealth’ on one side; and
‘all the other great Professions’ which ‘do rise out of the infirmities and
miscarriages of these’ on the other.9 By ‘great professions’ Petty meant
lawyers, clergymen, civil servants, lords and the like. In other words, for
Petty some ‘great professions’ were merely a necessary evil – needed
simply for facilitating production and for maintaining the status quo – but
not really essential to production or exchange. Although Petty did not
believe that policy should be focused on controlling imports and exports,
the mercantilists influenced him heavily. ‘Merchandise’, he argued, was
more productive than manufacture and husbandry; the Dutch, he noted
approvingly, outsourced their husbandry to Poland and Denmark, enabling
them to focus on more productive ‘Trades and curious Arts’.10 England, he
concluded, would also benefit if more husbandmen became merchants.11
In the late 1690s, after the first publication of Petty’s work Political
Arithmetick, Gregory King made more detailed estimates of England’s
income. Like Petty, King was concerned with England’s war-making
potential and compared the country’s income with those of France and
Holland. Drawing on a wide variety of sources, he meticulously calculated
the income and expenditure of some twenty different occupation groups in
the country, from the aristocracy to lawyers, merchants to paupers. He
even made forecasts, for example of population, predating the arrival of
the forecasting ‘science’ some 250 years later, and estimated the crop yield
of important agricultural items.
As in Petty’s work, an implicit production boundary began to emerge
when King assessed productivity, which he defined as income being
greater than expenditure. King thought merchant traders were the most
productive group, their income being a quarter more than their
expenditure, followed by the ‘temporal and spiritual lords’, then by a
variety of prestigious professions. On the boundary were farmers, who
earned almost no more than they spent. Firmly on the ‘unproductive’ side
were seamen, labourers, servants, cottagers, paupers and ‘common
soldiers’.12 In King’s view, the unproductive masses, representing slightly
more than half the total population, were leeches on the public wealth
because they consumed more than they produced.
Figure 2 shows that there were discrepancies between the ‘productive’
professions Petty and King identified. Almost all the professions Petty
deemed unproductive King later saw as productive, while several of those
producing value for Petty – seamen, soldiers and unskilled labourers – did
not make the cut in King’s analysis. Their different views may have
stemmed from their backgrounds. A man of humble origins and republican
instincts, Petty started out serving Oliver Cromwell; moving in aristocratic
and court circles, King was perhaps less inclined to think that Petty’s
‘great professions’ were unproductive. Both, however, classed ‘vagrants’
as unproductive, an analysis that has parallels today with people receiving
welfare from governments financed by taxes on the productive sectors.
Some of Petty’s and King’s ideas have proved remarkably durable.13
Perhaps most importantly, in what they both called ‘Political Arithmetick’
they laid the basis for what we today call the ‘national accounts’ to
calculate GDP, the compass by which countries attempt to steer their
national economic ships.
 Figure 2. The production boundary in the 1600s

Mercantilist ideas still resonate in current economic practices. Modern

‘management’ of exchange rates by governments, trying to steal a
competitive advantage for exports and accumulate foreign exchange
reserves, harks back to mercantilist notions of boosting exports to
accumulate gold and silver. Tariffs, import quotas and other measures to
control trade and support domestic enterprises are also reminiscent of these
early ideas about how value is created. There is basically nothing new in
the calls to protect Western steel producers from Chinese imports or to
subsidize domestic low-carbon energy generation to substitute for imports
of oil, gas and coal. The emphasis by populist politicians on the negative
effect of free trade, and the need to put up different types of walls to
prevent the free movement of goods and labour, also gestures back to the
mercantilist era, with emphasis more on getting the prices right (including
exchange rates and wages) than on making the investments needed to
create long-run growth and higher per capita income.
Petty and King were seminal figures in these early forays into the
question of how and where value is created. Yet, ultimately, both could
label productive and unproductive occupations however they chose. Their
work was purely descriptive. It did not attempt to quantify or model
relations between different groups and individuals in the economy,14 or to
quantify how the system reproduced itself and maintained the conditions
for future production. In short, their work was not linked to an underlying
theory of what constitutes wealth and where it comes from: a value theory.
Any policy for economic growth was therefore idiosyncratic because it
was unclear what generated it. But during the following century, this
would start to change.
As the study of economics developed during the course of the
eighteenth century, thinkers became increasingly concerned with finding a
theory to explain why some nations grew and prospered while others
declined. Although the economists of the time did not use the term
‘production boundary’, the idea was at the heart of their work. Their search
for the source of value led them to locate it in production, first in land –
understandably so, in predominantly agrarian societies – and then, as
economies became more industrialized, in labour. The labour theory of
value reached its apogee with Karl Marx in the mid-nineteenth century,
when the Industrial Revolution was in full swing.

THE PHYSIOCRATS: THE ANSWER LIES IN THE SOIL

The first efforts to find a formal theory of value came in the mid-
eighteenth century from the court of Louis XV of France, in the twilight –
so it turned out – of that country’s absolute monarchy. There, François
Quesnay (1694–1774), often described as the ‘father of economics’, was
the king’s physician and adviser. He used his medical training to
understand the economy as a ‘metabolic’ system. Crucially, in metabolism,
everything must come from somewhere and go somewhere – and that, for
Quesnay, included wealth. Quesnay’s approach led him to formulate the
first systematic theory of value that classified who is and is not productive
in an economy, and to model how the entire economy could reproduce
itself from the value generated by a small group of its members. In his
seminal work Tableau Économique, published in 1758, he constructed an
‘economic table’ which showed how new value was created and circulated
in the economy. In it he continued the metabolic analogy: pumps were
drawn to signify the ways in which new value was introduced, and
outgoing tubes illustrated how value left the system.
At the time Quesnay wrote, French society was already facing the
problems that would lead to the French Revolution fifteen years after his
death. French agriculture was in a bad state. Farmers were choked by high
taxes, imposed by their usually noble landlords to fund their lavish
lifestyles and by central government to finance war and trade. Adding to
this burden, the French government’s mercantilist policy, faced with a now
aggressively expanding Britain, kept the prices of agricultural produce low
to provide cheap subsistence to domestic manufactures, which could in
turn be cheaply made and exported in exchange for the highly coveted
gold, still generally believed to be a measure of national wealth. Faced
with this situation, Quesnay and his followers built a powerful argument in
favour of the farmers and against the mercantilists. Though they came to
be known as the physiocrats, after one of Quesnay’s publications, they
called themselves something else: ‘Les Économistes’.
Contrasting sharply with the prevailing mercantilist thinking that gave
gold a privileged place, Quesnay believed that land was the source of all
value. Figure 3 illustrates how for him, in the end, everything that
nourished humans came from the earth. He pointed out that, unlike
humans, Nature actually produced new things: grain out of small seeds for
food, trees out of saplings and mineral ores from the earth from which
houses and ships and machinery were built. By contrast, humans could not
produce value. They could only transform it: bread from seeds, timber
from wood, steel from iron. Since agriculture, husbandry, fishing, hunting
and mining (all in the darker blob in Figure 3) bring Nature’s bounty to
society, Quesnay called them the ‘productive class’. By contrast, he
thought that nearly all other sectors of the economy – households,
government, services and even industry, lumped together in the lighter
blob – were unproductive.
Quesnay’s classification was revolutionary. Breaking away from the
mercantilists, who placed exchange and what was gained from it – gold –
at the centre of value creation, he now linked value creation inextricably
with production. Developing his classification of productive and
unproductive work, Quesnay grouped society into three classes. First came
farmers and related occupations working on the land and water; according
to Quesnay, this was the only productive class. Next were manufacturers,
artisans and related workers who transform the materials they receive from
the productive class: wood and stone for furniture and houses, sheep’s
wool for clothing and metals from the mines for tools.15 Yet, argued
Quesnay, this class did not add value; rather, their work merely
recirculated existing value. The third class was the unproductive
‘proprietor’, ‘distributive’ or ‘sterile’ class, which was made up of
landlords, nobility and clergy. Here, ‘distributive’ was meant pejoratively:
this class redistributes value, but only to itself, for the sole reason that it
owns the land and does not give anything in return.16
 Figure 3. The production boundary in the 1700s

In Quesnay’s table, the productive part of the system is entirely based

on the farmers, but others also have a useful role in ensuring that the
system reproduces itself. Figure 4 shows in detail the process of
production, income and consumption of each class or economic sector, and
how they interact. Perhaps the world’s first spreadsheet, it is also the first
consistent abstract model of economic growth.
 Figure 4. Example of the Tableau Économique

A Numerical Example for the Tableau Économique

The logic of Quesnay’s model is illustrated in Figure 4. The most
important thing is where the initial wealth comes from, how it is
circulated, and what percentage is reinvested into production (in
nature) in the next round, creating more value – the latter being the
essence of the growth process. In the simplest case of a non-
expanding economy, the productive class has an initial amount of
‘products of the earth’ (translated from ‘produits de la terre’), valued
here for the sake of argument as 5 billion livres’ worth. These are
divided 4/5 food (for the farmers to subsist on) and 1/5 in material for
the sterile class. The proprietors hold 2 billion in cash that they have
 collected in taxes from the productive class, and the sterile class has
an inventory of 2 billion livres’ worth of tools and other
manufactured goods.
From this, a process of circulation takes place, each step of which
corresponds to a move from one row to the next. In every step, an
equal amount of value changes hands, to prepare for the next round of
production. But no new value is created. An exception is the step
from period 5 to 6 in the circulation process, at which a transfer rather
than exchange of 2 billion livres takes place. Only money flows, not
products.17 At the end, production takes place, with 2 billion surplus
products in the productive sector, while 2 billion have been
unproductively consumed in the proprietor class, starting a new round
of circulation. Obviously, if the surplus is bigger than consumption,
the economy will grow from round to round.
(All units are in billions of French livres; solid arrows indicate
product flows, dashed arrows indicate money flows.)18

Most significant is how the table neatly shows, from row to row, that as
long as what is produced is greater than what is consumed, an amount will
be left over at the end to be reinvested, thereby allowing the economy to
continue reproducing itself. If any of the unproductive members of society
take too much, reducing the amount the farmer can reinvest in production,
the economy will grind to a halt. In other words, if value extraction by the
unproductive members exceeds value creation by the productive members,
growth stops.
Though he himself did not use the term, Quesnay’s theory of value
incorporates a very clear production boundary, the first to be drawn with
such precision, which makes it clear that the surplus the ‘productive’
sectors generate enables everyone else to live.
Other economists quickly weighed in with analysis and criticism of
Quesnay’s classification. Their attack centred on Quesnay’s labelling of
artisans and workers as ‘sterile’: a term that served Quesnay’s political
ends of defending the existing agrarian social order, but contradicted the
everyday experience of a great number of people. Refining Quesnay’s
thinking, his contemporary A. R. J. Turgot retained the notion that all
value came from the land, but noted the important role of artisans in
keeping society afloat. He also recognized that there were other ‘general
needs’ that some people had to fulfil – such as judges to administer justice
– and that these functions were essential for value creation. Accordingly,
he re-labelled Quesnay’s ‘sterile’ class as the ‘stipendiary’, or waged,
class. And, since rich landowners could decide whether to carry out work
themselves or hire others to do so using revenues from the land, Turgot
labelled them the ‘disposable class’. He also added the refinement that
some farmers or artisans would employ others and make a profit. As
farmers move from tilling the land to employing others, he argued, they
remain productive and receive profits on their enterprise. It is only when
they give up on overseeing farming altogether and simply live on their rent
that they become ‘disposable’ rent collectors. Turgot’s more refined
analysis therefore placed emphasis on the character of the work being
done, rather than the category of work itself.
Turgot’s refinements were highly significant. In them, we see the
emergent categories of wages, profits and rents: an explicit reference to the
distribution of wealth and income that would become one of the
cornerstones of economic thought in the centuries to come, and which is
still used in national income accounting today. Yet, for Turgot, land
remained the source of value: those who did not work it could not be
included in the production boundary.19
Quesnay and Turgot’s almost complete identification of productivity
with the agricultural sector had an overriding aim. Their restrictive
production boundary gave the landed aristocracy ammunition to use
against mercantilism, which favoured the merchant class, and fitted an
agricultural society better than an industrial one. Given the physiocrats’
disregard for industry, it is hardly surprising that the most significant
critique of their ideas came from the nation where it was already clear that
value was not just produced in agriculture, but in other emerging sectors: a
rapidly industrializing Britain. The most influential critic of all was
Quesnay’s contemporary, a man who had travelled in France and talked at
length with him: Adam Smith.

CLASSICAL ECONOMICS: VALUE IN LABOUR

As industry developed rapidly through the eighteenth and nineteenth

centuries, so too did the ideas of a succession of outstanding thinkers like
Adam Smith (1723–90), David Ricardo (1772–1823) and Karl Marx
(1818–83), a German who did much of his greatest work in England.
Economists started to measure the market value of a product in terms of
the amount of work, or labour, that had gone into its production.
Accordingly, they paid close attention to how labour and working
conditions were changing and to the adoption of new technologies and
ways of organizing production.
 In The Wealth of Nations, first published in 1776 and widely regarded as
the founding work of economics, Smith’s famous description of the
division of labour in pin factories showed his understanding of how
changes in the organization of work could affect productivity and therefore
economic growth and wealth. Another enormously influential book,
Ricardo’s On the Principles of Political Economy and Taxation, first
published in 1817, contained a famous chapter called ‘On Machinery’, in
which he argued that mechanization was reducing demand for skilled
labour and would depress wages. And in Marx’s Capital, Volume 1 of
which was first published in 1867, the chapter called ‘The Working Day’,
which dealt with the development of the English Factory Acts governing
working conditions, showed his fascination with production as the field on
which the battle for workers’ rights, higher wages and better conditions
was being fought.
Smith, Ricardo and others of the time became known as the ‘classical’
economists. Marx, a late outrider, stands somewhat apart from this
collective description. The word ‘classical’ was a conscious echo of the
status given to writers and thinkers of the ancient Greek and Roman
worlds, whose works were still the bedrock of education when the term
‘classical economics’ began to be used in the later nineteenth century. The
classical economists redrew the production boundary in a way that made
more sense for the period they lived in: one which saw the artisan-craft
production of the guilds still prominent in Smith’s time give way to the
large-scale industry with huge numbers of urban workers – the proletariat
– that Marx wrote about in the third quarter of the nineteenth century. Not
for nothing was their emerging discipline called ‘political economy’. It did
not seem odd to contemporaries that economics was intimately part of
studying society: they would have found odd the idea, widespread today,
that economics is a neutral technical discipline which can be pursued in
isolation of the prevailing social and political context. Although their
theories differed in many respects, the classical economists shared two
basic ideas: that value derived from the costs of production, principally
labour; and that therefore activity subsequent to value created by labour,
such as finance, did not in itself create value. Marx, we will see, was more
subtle in his understanding of this distinction.

Adam Smith: The Birth of the Labour Theory of Value

Born in 1723 into a family of customs officials in Kirkcaldy, in the county
of Fife, Scotland, Adam Smith became Professor of Moral Philosophy at
the University of Glasgow before turning his mind to what we now call
economic questions, although at the time such questions were deeply
influenced by philosophy and political thought.
With Britain well on the path to industrial capitalism, Smith’s The
Wealth of Nations highlighted the role of the division of labour in
manufacturing. His account of pin-manufacturing continues to be cited
today as one of the first examples of organizational and technological
change at the centre of the economic growth process. Explaining the
immense increase in productivity that occurred when one worker was no
longer responsible for producing an entire pin, but only for a small part of
it, Smith related how the division of labour allowed an increase in
specialization and hence productivity:
I have seen a small manufactory of this kind where ten men only were employed, and
where some of them consequently performed two or three distinct operations. But
though they were very poor, and therefore but indifferently accommodated with the
necessary machinery, they could, when they exerted themselves, make among them
about twelve pounds of pins in a day. There are in a pound upwards of four thousand
pins of a middling size. Those ten persons, therefore, could make among them upwards
of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of
forty-eight thousand pins, might be considered as making four thousand eight hundred
pins in a day. But if they had all wrought separately and independently, and without any
of them having been educated to this peculiar business, they certainly could not each of
them have made twenty, perhaps not one pin in a day; that is, certainly, not the two
hundred and fortieth, perhaps not the four thousand eight hundredth part of what they
are at present capable of performing, in consequence of a proper division and
combination of their different operations.20

These insights were original and profound. Smith was writing while the
Industrial Revolution introduced machines into factories on a large scale.
When harnessed to the division of labour, mechanization would radically
increase productivity – the principal engine of economic growth. But even
the simple reorganization of labour, without machinery, by which each
worker specialized and developed skills in a specific area, enabled Smith
to make this critical point.
Equally significant was Smith’s analysis of how the ‘market’ determines
the way in which consumers and producers interact. Such interaction, he
contended, was not down to ‘benevolence’ or central planning.21 Rather, it
was due to the ‘invisible hand’ of the market:
Every individual is continually exerting himself to find out the most advantageous
employment for whatever capital he can command. It is his own advantage, indeed, and
not that of the society which he has in view. But the study of his own advantage
naturally, or rather necessarily, leads him to prefer that employment which is most
advantageous to society … He intends only his own gain, and he is in this, as in many
other cases, led by an invisible hand to promote an end which was not part of his
intention.22
Like Quesnay, Smith launched a more general attack on mercantilist
policies which, he argued, restricted competition and trade. He also argued
strongly for policies that would increase savings, and hence the amount of
capital available for investment rather than unproductive consumption
(say, on luxuries). But for Smith, industrial workers – not, as for Quesnay,
farmers – were at the heart of the productive economy. Manufacturing
labour, not land, was the source of value.23 The labour theory of value was
born.
Smith has become the figurehead of much modern economic theory
because of his ideas about how capitalism is founded on supposedly
immutable human behaviour, notably self-interest, and competition in a
market economy. His metaphor of the ‘invisible hand’ has been cited ad
nauseam to support the current orthodoxy that markets, left to themselves,
may lead to a socially optimal outcome – indeed, more beneficial than if
the state intervenes.
Smith’s book is actually a collection of recipes for politicians and
policymakers. Far from leaving everything to the market, he thinks of
himself as giving guidance to ‘statesmen’ on how to act to ‘enrich both the
people and the sovereign’24 – how to increase the wealth of nations. This is
where Smith’s value theory enters the picture. He was convinced that
growth depended on increasing the relative share of ‘manufactures’ –
factories employing formerly independent artisans or agricultural workers
as dependent wage labourers – in the overall make-up of industry and
believed that free trade was essential to bring this about. He felt that the
enemies of growth were, first, the protectionist policies of mercantilists;
second, the guilds protecting artisans’ privileges; and third, a nobility that
squandered its money on unproductive labour and lavish consumption. For
Smith (as for Quesnay), employing an overly large portion of labour for
unproductive purposes – such as the hoarding of cash, a practice that still
afflicts our modern economies – prevents a nation from accumulating
wealth.
Value, Smith believed, was proportional to the time spent by workers on
production. For the purposes of his theory, Smith assumed a worker of
average speed. Figure 5 shows how he drew a clear line (the production
boundary) between productive and unproductive labour. For him, the
boundary lay between material production – agriculture, manufacturing,
mining in the figure’s darker blob – and immaterial production in the
lighter blob. The latter included all types of services (lawyers, carters,
officials and so on) that were useful to manufactures, but were not actually
involved in production itself. Smith said as much: labour, he suggested, is
productive when it is ‘realized’ in a permanent object.25 His positioning of
government on the ‘unproductive’ side of the boundary set the tone for
much subsequent analysis and is a recurring theme in today’s debates
about government’s role in the economy, epitomized by the Thatcher–
Reagan reassertion in the 1980s of the primacy of markets in solving
economic and social issues.

Figure 5. The production boundary according to Adam Smith

In Smith’s view, ‘how honourable, how useful, or how necessary

soever’ a service may be, it simply does not reproduce the value used in
maintaining (feeding, clothing, housing) unproductive labourers. Smith
finds that even ‘the sovereign’, together with ‘all the officers both of
justice and war who serve under him, the whole army and navy, are
unproductive labourers’.26 Priests, lawyers, doctors and performing artists
are all lumped together as unproductive too.
What informs Smith’s classification is his conviction that some types of
labour do not ‘reproduce’ the value needed to keep those workers alive at a
subsistence level. In other words, if all the subsistence that was needed to
keep a person alive was a certain amount of grain, then anyone who does
not produce as much value as that amount of grain is by definition
unproductive.
How, then, are those that do not produce this unit of value kept alive?
Smith’s answer lay in the concept of a ‘surplus’. Many productive
workers produce the equivalent of more grain than they need to feed
themselves to survive. A manufacturer makes things that, when
exchanged, will yield more grain than needed to keep the productive
workers alive. The surplus then sustains unproductive labourers, including
the entourages of aristocrats, who kept ‘a profuse and sumptuous table’
with ‘a great number of menial servants, and a multitude of dogs and
horses’.
This is where Smith addressed head-on how the wealth of nations could
grow. It was in effect his policy advice. Instead of ‘wasting’ the surplus on
paying for unproductive labour, he argued, it should be saved and invested
in more production so that the whole nation could become richer.27 Smith
was not criticizing the wealthy per se. But he was criticizing those who
wasted their wealth on lavish consumption – ‘collecting books, statues,
pictures’, or ‘more frivolous, jewels, baubles, ingenious trinkets’ – instead
of productive investment. (This, after all, was the age of the Grand Tour,
when young aristocrats travelled to the Continent to improve their
education and returned laden with ancient artefacts.) Smith was
particularly attracted to the prospect of investment in machines, then just
beginning to be used in factories, because they improved workers’
productivity.
His emphasis on investment linked directly to his ideas about rent.
Smith believed that there were three kinds of income: wages for labour in
capitalist enterprises; profits for capitalists who owned the means of
production; and rents from ownership of land. When these three sources of
income are paid at their competitive level, together they determine what he
called the ‘competitive price’.28 Since land was necessary, rent from land
was a ‘natural’ part of the economy. But that did not mean rent was
productive: ‘the landlords, like all other men, love to reap where they
never sowed and demand a rent [from the earth] even for its natural
produce’.29 Indeed, Smith asserted, the principle of rent from land could be
extended to other monopolies, such as the right to import a particular
commodity or the right to plead at the bar. Smith was well aware of the
damage monopolies could do. In the seventeenth century, a government
desperate for revenue had granted – often to well-placed courtiers – an
extraordinary range of monopolies, from daily necessities such as beer and
salt to mousetraps and spectacles. In 1621 there were said to be 700
monopolies, and by the late 1630s they were bringing in £100,000 a year
to the Exchequer.30 But this epidemic of rent-seeking was deeply
unpopular and was choking the economy: more than that, it was one of the
proximate causes of the Civil War, which led to the execution of Charles I.
Many Englishmen understood what Smith meant when he said that a free
market was one free of rent.
Smith’s penetrating analysis of how advanced capitalist economies
functioned won him many followers. Equally, his staunch advocacy of free
trade, in an era in which mercantilist policies were beginning to be seen as
old-fashioned (Smith, indeed, believed that merchants were unproductive
because they only provided the ephemeral service of moving goods
around, rather than producing anything of value), made his book a hit
among the ‘free traders’ who eventually overturned England’s Corn Laws,
which imposed heavy tariffs on imported corn to protect domestic
landowners, and other protectionist measures. Armed with Smith’s ideas,
free traders showed that nations could get richer even if there was no trade
surplus and no gold accumulation. Amassing gold was unnecessary and
insufficient for growth. Huge amounts of gold flowed to Spain from its
colonies, but the kingdom did not become more productive.
The victory of the free traders over the mercantilists is better understood
in terms of their rival conceptions of value. Mercantilists thought gold had
inherent worth and that everything else could be valued in terms of how
much gold it was exchanged for. Following Smith, free traders could trace
value to labour, and the logic of value was thereby inverted. Gold, like all
other things, was valued by how much labour it took to produce.31
Smith’s theory was not immune to criticism. He had actually put
forward at least two theories of value, which created confusion about both
the production boundary and precisely who was productive – in particular,
whether the provision of services in themselves created value.32
In essence, Smith was confused about the distinction between material
and immaterial production. For Smith, as we have seen, a servant ‘adds’
no value that could be used by the master on something other than,
literally, keeping the servant alive. But he also argued that if a
manufacturing worker earns £1 in turning a quantity of cotton, whose other
inputs also cost £1, into a piece of cloth that sells for £3, then the worker
will have repaid his service and the master has made a profit of £1. Here a
definition of productivity, irrespective of whether what is produced is a
solid product or a service, emerges. Adding value in any branch of
production is productive; not adding value is unproductive. Following this
definition, services such as cleaning or vehicle repair can be productive –
thereby invalidating Smith’s own material–immaterial division of the
production boundary. The debates about Smith’s theories of value rumbled
on for centuries. Other of Smith’s ideas, such as free trade and the
unproductive nature of government, have also left an enduring legacy.
But he is often misconstrued. His understanding of politics and
philosophy was never sidelined in his economic reasoning. His Theory of
Moral Sentiments and The Wealth of Nations were not contradictory but
part of his deep analysis of what drives human behaviour and how
societies organize themselves, and why some societies might grow in
wealth more than others. Smith’s analysis of ‘free markets’ was closely
tied to his understanding of production, and the need to limit rent-seeking
behaviour.

David Ricardo: Grounding Smith’s Value Theory

In the 1810s, another towering figure of the English classical economic
school used the labour theory of value and productiveness to explain how
society maintains the conditions which enable it to reproduce itself. David
Ricardo came from a Sephardic Jewish family which originated in
Portugal and moved to Holland before settling in England. Ricardo
followed his father as a London stockbroker, although he was later
estranged from his family after becoming a Unitarian. He grew fabulously
rich from his speculative activities, most notoriously by profiting from
inaccurate information that was circulating on the Battle of Waterloo in
1815. He was said to have made £1 million (in 1815 value) from holding
on to bonds while everyone else was selling (due to the false rumours that
Wellington was losing against Napoleon), an almost unimaginable sum at
the time, after which he promptly and wisely retired to the country, well
away from London.
Ricardo was drawn to economics by reading Smith’s The Wealth of
Nations, but was concerned with something that he felt was glaringly
absent from Smith’s theory of value: how that value was distributed
throughout society – or what we would today call income distribution. It
need hardly be said that, in today’s world of growing inequality of income
and wealth, this question remains profoundly relevant.
Smith had observed that the value produced by labour, when sold, is
redistributed as wages, profits and rent; he had also seen that labour’s
exact share of this value – wages – would vary.33 However, Smith had no
coherent explanation for the way in which wages were apportioned, or
why they differed between professions and countries or over time.34
Ricardo, by contrast, felt that the distribution of wages was, as he stressed
in his magnum opus On the Principles of Political Economy and Taxation,
the ‘principle problem’ in economics and ultimately regulates the growth
and wealth of a nation.
Ricardo actually believed in the labour theory of value, and, unlike
Smith, was at pains to point out that the value of a commodity was strictly
proportional to the amount of labour time needed to produce it. Ricardo
emphasized agriculture for a different reason from Quesnay. He wanted to
explain the distribution of income, and for him productivity in agriculture
was the hinge upon which that distribution turned. Workers, Ricardo
believed, were paid a subsistence wage: in essence, they earned enough to
pay for food and shelter. But food comes from agriculture, so the price of
food regulates wages: a low price of food (or ‘corn’, as Ricardo wrote in
the language of the day) will permit lower wages and therefore higher
profits and incentives to invest in future production (for example in
manufacturing) and promote economic growth. A high wage due to low
productivity in agriculture will mean lower profits, and hence little
investment in future production, which in turn leads to slower economic
growth.
Ricardo inherited this ‘dismal theory’ of wages from his contemporary
Thomas Malthus (1766–1834), another English writer on political
economy, who proposed that whenever real wages are above subsistence
level, the population will grow until it is so large that the demand for food
will push up food prices enough to bring wages back to subsistence level.35
In Ricardo’s view, then, wages depended heavily on the productivity of
agriculture: if productivity rose and food became cheaper, wages would
fall. And in manufacturing and the other branches of the economy,
whatever did not have to be paid to the worker would flow to the capitalist
as profit. Profits are the residual from the value that workers produce and
do not need to consume for their own ‘maintenance’, as Ricardo put it, ‘to
subsist and perpetuate their race’.36
This in turn leads to Ricardo’s theory of growth and accumulation –
increasing the stock of capital or wealth to help fuel subsequent further
increases in wealth. As profits grow, so capitalists invest and expand
production, which in turn creates more jobs and raises wages, thereby
increasing the population, whose wages finally go back to subsistence
level, and so on. The economy is a perpetual growth machine, with more
and more people earning the subsistence wage.
But Ricardo’s theoretical genius really came to the fore in tackling his
third class of society: landlords. Production in agriculture depends on two
types of input: goods and services needed for production. One type can be
scaled – increased in proportion to requirements. It includes labour,
machinery, seeds and water. The other type cannot be scaled: good arable
land. As Mark Twain is supposed to have said, ‘Buy land, they’re not
making it any more.’
Since the population will grow thanks to investment and rising wages,
and more and more food will need to be produced to feed everyone, at
some point all the best land for corn production will be spoken for. Less
fertile or productive land will then be cultivated. However, since all the
corn is sold at one price to the workers, who are on subsistence wages, the
more productive land already in use yields a higher profit than the less
productive land. Here Ricardo developed his celebrated theory of rent.
Ricardo defined rent as a transfer of profit to landlords simply because
they had a monopoly of a scarce asset. There was no assumption, as in
modern neoclassical theory (reviewed in Chapter 2), that these rents would
be competed away. They remained due to power relationships inherent in
the capitalist system. In Ricardo’s time much of the arable land was owned
by aristocrats and landed gentry but worked by tenant farmers or labourers.
Ricardo proposed that the rent from more productive land always goes to
the landlord because of competition between tenants. If the capitalist
farmer – the tenant – wants to hang on to the largest possible profit by
paying less rent, the landlord can give the lease to a competing farmer who
will pay a higher rent and therefore be willing to work the land for only the
standard profit. As this process goes on, land of increasingly poor quality
will be brought into production, and a greater portion of the income will go
to the landlords. Ricardo predicted that rents would rise.
More significantly, rising rents were the flipside of rising food prices,
caused by lack of good-quality agricultural land. More costly food
increased the wages workers needed for subsistence. This growing wage
share, Ricardo believed, put a squeeze on profits in other sectors such as
manufacturing. As economic development proceeded, the profit rate –
basically the manufacturing capitalist’s return on capital – would fall. The
profit share – the part of the national income going to capitalists – would
also fall. Correspondingly, the wage share going to manufacturing workers
would rise. But the extra wages would have to be spent on food, which
was more expensive because landlords were charging higher rents. As a
result, much of the nation’s income would ultimately go to landlords. This
would halt further economic growth and investment in, say, manufacturing
because the low returns would not justify the risks.37
By highlighting the different types of incomes earned, such as rent,
profits and wages, Ricardo drew attention to an important question. When
goods are sold, how are the proceeds of that sale divided? Does everyone
involved get their ‘just share’ for the amount of effort they put into
production? Ricardo’s answer was an emphatic ‘No’.
If some input into production – such as good arable land – is scarce, the
cost of producing the same output – a given quantity of corn – will vary
according to availability of the input. The cost is likely to be lower with
good land, higher with inferior land. Profits, instead, are likely to be higher
with good land and lower with inferior land. The owner of good land will
pocket the difference in profit between the good land and inferior land
simply because he or she has a monopoly of that asset.38 Ricardo’s theory
was so convincing that it is, in essence, still used today in economics to
explain how rents work.39 Rents in this sense could mean a patent on a
drug, control of a rare mineral such as diamonds, or rents in the everyday
sense of what you pay a landlord to live in a flat. In the modern world, oil
producers like those of the Organization of Petroleum Exporting Countries
(OPEC) collect rents from their control of an essential resource.
Ricardo’s gloomy picture of economic stagnation is relevant to a
modern debate: how the rise of the financial sector in recent decades and
the massive rents it earned from speculative activity have created
disincentives for industrial production. Some heterodox economists today
argue that growth will fall if finance becomes too big relative to the rest of
the economy (industry) because real profits come from the production of
new goods and services rather than from simple transfers of money earned
from those goods and services.40 To ‘rebalance’ the economy, the
argument runs, we must allow genuine profits from production to win over
rents – which, as we can see here, is exactly the argument Ricardo made
200 years ago, and John Maynard Keynes was to make 100 years later.41
Indeed, as is also argued today, Ricardo believed that the pool of
(mainly unskilled) workers held the losing ticket. In Ricardo’s day,
agricultural labour flocked to the fast-growing cities and the supply of
unskilled labour exceeded demand for it. Without bargaining power, these
workers were paid a meagre subsistence wage. Ricardo’s portrayal of rents
dominating production also had a political impact. It helped to persuade
Britain to abolish the Corn Laws in 1846 and embrace free trade, which
diminished the power of big vested interests and allowed production costs,
rather than embedded monopoly and the privileges that went with it, to
govern production. The ensuing decades saw Britain become the
‘workshop of the world’. But the abolition of the Corn Laws brought about
a political transformation as well as an economic one: it tipped the balance
of power away from aristocratic landlords and towards manufacturing as
the nineteenth century wore on. Value theory influenced political
behaviour, and vice versa – the performativity referred to in the Preface.
Other lessons about the sources of value and who generates it can be
drawn from Ricardo’s model of accumulation. Like Smith, Ricardo was
concerned with understanding how the economy reproduces itself. Like
Smith, he focused on the difference between investment in durable capital
and consumption: ‘When the annual productions of a country more than
replace its annual consumption, it is said to increase its capital; when its
annual consumption is not at least replaced by its annual production, it is
said to diminish its capital.’42 Ricardo hastened to add, though, that all
goods produced – from clothes to carts – must be consumed or used;
otherwise they would depreciate just like inventory.
Here Ricardo made a fundamental point about consumption, by which
he means consumption by capitalists, not just households. As with
production, consumption can be productive or unproductive. The
productive kind might be a capitalist who ‘consumes’ his capital to buy
labour, which in turn reproduces that capital and turns a profit. The
alternative – unproductive consumption – is capital spent on luxuries that
do not lead to reproduction of that capital expenditure. On this matter,
Ricardo is absolutely clear: ‘It makes the greatest difference imaginable
whether they are consumed by those who reproduce, or by those who do
not reproduce another value.’43
So Ricardo’s heroes are the industrial capitalists, ‘those who reproduce’,
who can ensure that workers subsist and generate a surplus that is free for
the capitalist to use as he or she sees fit. His villains are those ‘who do not
reproduce’ – the landed nobility, the owners of scarce land who charge
very high rents and appropriate the surplus.44 For Ricardo, capitalists
would put that surplus to productive use, but landlords – including the
nobility – would waste it on lavish lifestyles. Ricardo echoes Smith here.
Both had seen with their own eyes the extravagance of the aristocracy, a
class which often seemed better at spending money than making it and was
addicted to that ultimate unproductive activity – gambling. But Ricardo
parted company from Smith because he was not concerned about whether
production activities were ‘material’ (making cloth) or ‘immaterial’
(selling cloth). To Ricardo, it was more important that, if a surplus was
produced, it was consumed productively.
Significantly for our discussion, Ricardo singled out government as the
ultimate example of unproductive consumption. Government, in his view,
is a dangerous leech on the surplus. Most of government spending comes
from taxes, and if it consumes – by spending on armies, for example – too
large a share of the national income, ‘the resources of the people and the
state will fall away with increasing rapidity, and distress and ruin will
follow’.45 Ricardo believed that government is by nature unproductive.
At the time Ricardo was writing, such issues were uppermost. Only a
few years earlier, the British government had had to raise unprecedented
amounts of money from taxes and issuing bonds to wage the war against
Napoleon, from which the nation emerged heavily in debt. Could it afford
the immense military expenditure which Ricardo’s theory deemed
unproductive? He found to his relief that the increase in value production
by private companies more than compensated for the increase in
unproductive government consumption. Unlike Smith, Ricardo did not
write about that part of government expenditure which creates the
conditions for productivity in the first place: infrastructure (bridges, roads,
ports and so on), national defence and the rule of law. By omitting to
discuss the role of government in productivity, he paved the way for
generations of economists to be equally oblivious – with hugely significant
consequences that we will look at in Chapter 8.
In essence, Ricardo’s theory of value and growth led to a production
boundary that does not depend on a job or profession itself (manufacturer,
farmer or vicar) or on whether the activity is material or immaterial. He
believed that industrial production in general leads to surpluses, but for
him the real question is how those surpluses are used. If the surpluses
finance productive consumption, they are productive; if not, they are
unproductive.
Ricardo focused on the ‘plight’ of capitalists and their struggle against
landlords. However, he never addressed the awkward fact that labour
creates value but the capitalists get the spoils – the surplus over and above
the subsistence wages paid to labourers. In the course of the nineteenth
century, as England industrialized, inequalities and injustices multiplied.
The labour theory of value was to interpret production in a way that cast
capitalists in a much less favourable light.

Karl Marx on ‘Production’ Labour

Ricardo’s appreciation of the dynamism of capitalism compared with past
eras prefigures the emphasis Marx placed a generation later on the
system’s unprecedented power to transform societies. Born in 1818, Marx
grew up in the German city of Trier, one of nine children of Jewish
parents, both lawyers. In his own legal studies at university, Marx was
drawn to a critical version of Hegel’s philosophy of dialectics, propounded
by Hegel’s disciples, which set out how intellectual thought proceeds via
negation and contradiction, through a thesis, its antithesis, and then a
synthesis. Marx was particularly interested in how history is shaped by
contradictions between material forces – such as capital and labour – and
by the resolution or synthesis of those contradictions. After being barred
from taking a professorship at the University of Jena because of his radical
political leanings, he became editor of a progressive newspaper,
Rheinische Zeitung. Then in 1843 he moved to Paris, where he met
Friedrich Engels, his future co-author and collaborator. Two years later
Marx was expelled from France because of his socialist political activities
and settled in Brussels. There in 1848 he published with Engels the
Communist Manifesto. Marx wrote voluminously on politics for the rest of
his life but it is remarkable that, despite being opposed to capitalism, he
analysed it objectively in order to understand where it was taking
humankind and what the alternatives might be.
Marx developed his own version of the labour theory of value. He
emphasized how definitions of ‘productive’ activity depend on historical
circumstances – the society of any given time. He also focused on the
nature of productive activity within the capitalist system. Under
capitalism, firms produce commodities – a general term for anything from
nuts and bolts to complete machines. If commodities are exchanged – sold
– they are said to have an exchange value. If you produce a commodity
which you consume yourself it does not have an exchange value.
Exchange value crystallizes the value inherent in commodities.
The source of that inherent value is the one special commodity workers
own: their labour power, or – put another way – their capacity to work.
Capitalists buy labour power with their capital. In exchange, they pay
workers a wage. Workers’ wages buy the commodities such as food and
housing needed to restore a worker’s strength to work. In this way, wages
express the value of the goods that restore labour power.
This description of the source of value largely followed Ricardo. But
Ricardo had tried unsuccessfully to find an external commodity that could
serve as an ‘invariable standard of value’ by which the value of all other
products could be determined. Marx solved this problem by locating this
invariable measure in workers themselves. He was careful to distinguish
labour expended in production from labour power, which is the capacity to
work. Workers expend labour, not labour power. And in this distinction
lies the secret of Marx’s theory of value. Humans can create more value
than they need to restore their labour power. For instance, if a worker has
to work five hours to produce the value needed to restore labour power per
day, the labour power’s value is equivalent to the five hours of work.
However, if the working day lasts ten hours, the additional five hours’
work will create value over and above that needed to restore labour power.
Labour power creates surplus value.
The ingenuity of capitalism, according to Marx, is that it can organize
production to make workers generate unprecedented amounts of this
surplus value. In early societies of hunter-gatherers and subsistence
farmers, people worked enough to create the value that would allow them
to survive, but no surplus over and above that. Later, under feudalism, they
could be forced to produce enough surplus to satisfy the (unproductive)
consumption of the feudal lord, which, as Smith and Ricardo knew, could
be substantial. But after the means of production were taken away from
independent producers – mostly by violence and expropriation through
property rights legislation, such as enclosures of common land in England
by big landowners – they became workers, ‘free’ and without property.
Capitalists were able to purchase the workers’ labour power because
workers lost their independent means of subsistence and needed a wage to
survive. The trick is to get them to work longer than needed to produce
value (wages) that they spend on their subsistence needs – again, food and
housing.46 Workers, in other words, are exploited because capitalists
pocket the surplus value workers produce over and above their subsistence
requirements. And, unlike the feudal lords, capitalists will not squander all
of the surplus on consumption, but will have incentives to reinvest part of
it in expanding production to make yet more profits. However, Marx noted
that there was a contradiction in the system. The drive to increase
productivity would increase mechanization, which, in displacing labour
(machines taking over human work), would then eventually reduce the key
source of profits: labour power. He also foresaw the problem of growing
financialization, which could potentially undermine industrial production.
Throughout his analysis, his focus was on change, and the effects of
change on the creation of value.
Indeed, the extraordinary aspect of Marx’s theory is his fundamental
insight that capitalism is dynamic and constantly changing. But it was not
just economically dynamic. Marx was struck by the social upheavals he
could see all around him, such as the mass movement of rural workers into
cities, which created an urban proletariat. He saw that capitalist society,
not just the capitalist economy, was utterly different from preceding
societies and was in permanent flux – a very evident phenomenon today as
we struggle to come to terms with the massive changes brought by digital,
nano, biological and other technologies.
Economists had previously thought of ‘capital’ as purely physical –
machinery and buildings, for example – and surplus as solely positive,
helping the economy to reproduce itself and grow. But Marx gives capital
a social dimension and surplus a negative connotation. Labour produces
surplus value, which fuels capital accumulation and economic growth. But
capital accumulation is not just due to productive labour. It is also deeply
social. Because workers do not own the means of production they are
‘alienated’ from their work. The surplus they produce is taken away from
them. Work is necessary for earning the wages they receive to buy the
food, shelter and clothes they need to survive.47 Moreover, in a capitalist
market society, relations between people are mediated by commodity
exchange. In a specialized society with division of labour, humans produce
the social product – net national income – together and depend on other
humans. But precisely because the division of labour, which Smith
extolled, left most workers overly specializing in discrete aspects of the
production process, he believed that social relations became relations
between commodities (things).48
Marx was so fascinated by the dynamics of capitalism that he produced
his own theory of value to explain how it works. Unlike earlier
economists, who tended to define production by sector or occupation
(agriculture or manufacturing, merchant or clergyman), Marx defined the
production boundary in terms of how profits are made. Marx asked how,
by owning the means of production, the capitalist could appropriate
surplus value while the workers who provided the labour received barely
enough to live on – exactly the question Big Bill Heywood posed. By
placing this distinction at the heart of value theory, Marx generated a new
and unprecedented production boundary. Marx’s value theory changed
economics – at least for a time.
Marx argued that workers are productive if they create surplus value
which the capitalist class then retains. For Marx, while workers in
capitalist production are productive, the key questions when drawing his
production boundary are: who participates in capitalist production? And
who receives the surplus that is produced?
Figure 6 gives a graphical answer to these questions. The production
sphere, the light grey blob, includes three basic sectors: primary,
comprising essential materials such as food and minerals (the only source
of value for Quesnay); secondary, which is industry, the basis of value
creation in Smith and Ricardo; and tertiary, the services considered by
Smith to be ‘immaterial’. The darker blob within, called the ‘circulation
sphere’, reflects Marx’s analysis, which we will discuss later, that some
aspects of finance are essential to production and deserve to be placed on
that side of the production boundary. On the other side of the boundary,
Marx followed Smith and Ricardo in regarding government and
households as unproductive.
 Figure 6. The production boundary according to Karl Marx

At any moment in a capitalist economy, there is a ratio of surplus value

to value used for workers’ subsistence – what Marx calls simply the rate of
surplus value. It determines what share of the economic product can
potentially be used for accumulation and growth. Marx referred to capital
that is used to hire labour as ‘variable’ capital: the workers produce more
capital than is invested in them, so the capital that hires them ‘varies’ in
relation to the capitalist’s total capital. Capital not used to hire workers is
invested in other means of production that are ‘constant’ capital –
including machinery, land, buildings and raw materials – whose value is
preserved but not increased during production.49
The value used for workers’ subsistence, the ‘wage share’, could not be
less than was needed to restore labour power or workers would perish,
leaving the capitalist unable to produce surplus value. Historically, the
wages of the poor had tended to be at subsistence level. But here Marx
introduces a powerful new idea which has informed thinking ever since:
class struggle. Workers’ wages were set by class struggle. The side with
more power could force through a wage rate favourable to itself. Which
class had more power was related to what we would call today the
tightness of the labour market. If wages increased because workers had a
lot of bargaining power in a tight labour market, capitalists would
substitute more machines for labour, creating more unemployment and
competition among workers for jobs. Marx thought that capitalists would
try to keep a ‘reserve army’ of the unemployed to hold down wages and
maintain or increase their own share of the value workers created.
 The value of labour power is expressed to workers as wages, to
capitalists as profits. The rate of profit for an enterprise is the surplus value
divided by variable and constant capital – roughly what today we call the
rate of return on a company’s assets. The average profit rate of the
economy as a whole is total surplus value divided by total variable and
constant capital. But the size of the average profit rate depends on the
composition of capital (how much variable and constant capital) and on
class struggle – effectively, the size of workers’ wages relative to value
produced. The average profit rate is also affected by economies of scale as
the productivity of workers rises with a growing market and the increasing
specialization of workers.50 In particular, Marx believed that increasing
agricultural production would not lead to Ricardo’s stationary, food-
constrained world.51 He was right: broadly speaking, food production has
kept pace with population increase. Marx was also acute in his
understanding of the capacity of technology to transform society. He
would not have been surprised by the extent to which automation has
replaced people, nor perhaps by the possibility of machines more
intelligent than their human creators.
Marx’s analysis of who got what in capitalism did not stop there. He
also distinguished between different functions of various capitalist actors
in the economy. In doing so he used his value theory shrewdly to identify
those who produce value and those who do not.
Like economists before him, Marx believed that competition would tend
to equalize rates of profits across the economy.52 But at this point Marx
introduced a distinction that is critically important for his and for
subsequent theories of value: the way in which different kinds of
capitalists came by their profits. The first two categories Marx identified
were production (or industrial) capital and commercial capital. The first
produces commodities; the second circulates commodities by selling them,
making the money received available to production capital for buying the
means of production (the dark grey sphere in the lighter blob in Figure 6).
As Marx explained, the first creates surplus value, the second ‘realizes’ it.
Any unsold commodity will therefore be of no use to a capitalist,
regardless of how much he or she exploits his or her workers, because no
surplus value is realized. Commercial capital, Marx noted, had existed for
millennia: international merchants such as the Phoenicians and the Hanse
bought cheap and sold dear. What they did not do was to add value by
capitalist production. Under capitalism, the commercial capitalists realize
the value produced by the production capitalists. To apply Marx’s theory
to a modern-world example, Amazon is a commercial capitalist because it
is a means by which production capitalists sell their goods and realize
surplus value. Banks’ money transfer services are also an example of
commercial capital.53
Marx suggested that, initially, production enterprises might also carry
out commercial capital activities. As production expands, however,
separate capitalist enterprises will probably emerge to carry out these
functions as commodity or money capitalists. Crucially, these capitalists
and the labour they employ are purely concerned with the ‘circulation’ of
capital; they do not produce commodities which generate surplus value
and therefore they are unproductive.54 However, because they are also
capitalist firms, they require the same rate of profit as does production
capital. Consequently, some surplus value is diverted to become their
income, diminishing the average profit rate in the economy.55 Although
labour in firms engaged in the circulation of capital does not create surplus
value, it is seen by the commercial capitalist as productive because it
secures the capitalist’s share in existing surplus value and becomes a
profit.56 The emergence of distinct commercial capital enterprises alters the
structure of the whole economy and the amount of surplus value available
to production capitalists.
Marx then identified ‘interest-bearing’ capital – capitalists such as banks
who earned interest on loans that production capitalists took out to expand
production. The generation of interest is possible because, in capitalism,
money represents not just purchasing power – buying commodities for
consumption – but also the potential to generate more profit in the future
through investment as capital.57 The interest is deducted from the
production capitalist’s profit rate. Interest-bearing capital, unlike
commercial capital, does not lower the general rate of profit; it just
subdivides it between recipients of interest and earners of profit.
The relationship between these two types of capital has distinct
advantages. It can increase the scale and speed of capitalist production by
making it easier to obtain capital and reduce the turnover time (the time it
takes for capital to produce, sell and buy new means of production – one
‘period’ of production). Interest-bearing capital and the credit system it
supplies also reduce the importance of commercial capital, for example by
shortening the time the production capitalist has to wait for the merchant to
return with the proceeds from sales. However, since interest-bearing
capital does not produce any surplus value, it is not directly productive.58
Finally, in addition to these types of capitalists, Marx identified another:
owners of scarce things like land, coal, a patent, a licence to practise law,
and so on. Such scarce things can improve productivity above the general
productivity level – the same product can be produced in less labour time
or with fewer means of production. That in turn creates ‘surplus profits’ –
what Smith and Ricardo might have thought of as ‘rent’ – for capitalists, or
landlords and proprietors, who can exploit these advantageous production
conditions. Marx thus outlined a theory of ‘monopoly’ gain.
The key, in Marx’s view, is that labour is productive if – and only if – it
produces a surplus value for production capital, the engine of the capitalist
system; that is, value above and beyond the value of labour power. For
Marx, then, the production boundary is defined not by sectors or
occupations but by how profits are generated – more specifically, whether
an occupation is carried out in a capitalist production context. Only the
capitalist enterprise will accumulate the surplus value that can lead to an
expansion of production. In this way, the capitalist economy reproduces
itself.
Participating in ‘circulation’ or earning interest is not a judgement on
such activities’ ‘usefulness’. It was simply necessary, Marx argued, for
capital to transform itself from commodity form into money form and back
again.59 In fact, Marx thought that a well-functioning sphere of circulation
could raise the profit rate by reducing turnover time for capital. If the
‘circulation sphere’ was not functioning properly – for example, the
system of credit that fuelled it was inefficient – it risked absorbing too
large a chunk of the surplus value that capitalists hoped to generate by
selling their goods and as a result impeding growth.
Marx refined Adam Smith’s distinction between productive (industry)
and unproductive (services) sectors into something much more subtle. As
can be seen in Figure 6, in Marx’s theory of value every privately
organized enterprise that falls within the sphere of production is
productive, whether it is a service or anything else. Here, Marx’s
achievement was to move beyond the simple categorization of occupations
and map them onto the landscape of capitalist reproduction.60 Marx’s
production boundary now runs between goods and services production on
one side and all those functions of capital that were not creating additional
surplus value, such as interest charged by moneylenders or speculative
trading in shares and bonds, on the other. Functions lying outside the
production boundary take a chunk of surplus value in exchange for
circulating capital, providing money or making possible surplus
(monopoly) profits.
What is more, in distinguishing between different types of capitalist
activity – production, circulation, interest-bearing capital and rent – Marx
offers the economist an additional diagnostic tool with which to examine
the state of the economy. Is the sphere of circulation working well
enough? Is there enough capacity to bring capital to the market, so that it
can be exchanged and realize its value and be reinvested in production?
What proportion of profits pays for interest, and is it the same for all
capitalists? Do scarce resources, such as ‘intellectual’ ones like patents on
inventions, create advantageous conditions for producers with access to
them and generate ‘surplus profits’ or rents for those producers?
Ricardo and Marx refined the theory of rent to make it clear that rent is
income from redistributing value and not from creating it. Landlords do
not create the soil but they can generate income from their right to exclude
from the land others (capitalists) who might use it to produce value. Rent
of any kind is basically a claim on the total of social surplus value and
therefore lowers productive capitalists’ profits. As we will see in the next
chapter, neoclassical (mainstream) economics has fundamentally changed
this idea of rent into one of imperfections and impediments – which can be
competed away.
All these issues have come to the fore again since the 2008 financial
crisis. At their heart is how finance has been self-serving, and not actually
serving what the American economist Hyman Minsky (1919–96) called
the ‘capital development of the economy’.61 In other words, instead of
facilitating industrial production, finance has simply degenerated into a
casino, aiming to appropriate as much of the existing surplus as possible
for itself.62 But whether that casino is seen as a mere imperfection or as a
stable source of unearned income (whereby activities that are not creating
value are somehow allowed to be presented a such) makes all the
difference in policies that aim to reform the system.
Marx’s attempt to define the production boundary was more rigorous
than those of Smith and Ricardo and was certainly a long way from those
of Petty and King. He introduced the idea of labour power as an objective
and invariable standard of value, building on the essential premise shared
by earlier economists that value derived from labour. He also shared with
them the belief that government was unproductive. The early and classical
economists left a legacy of ideas about value – on currencies and
protection, free trade, rent, government and technology – which have
reverberated down the centuries and remain alive today.
The next chapter explores how, even as the ink was drying on Marx’s
writing in the British Museum Reading Room, the intellectual world of the
classical economists was about to be turned upside down.
 2
Value in the Eye of the Beholder: The Rise of the
Marginalists

… the distribution of the income of society is controlled by a natural law … this law, if it
worked without friction, would give to every agent of production the amount of wealth
which that agent creates.
J. B. Clark, The Distribution of Wealth: A Theory of Wages, Interest and Profits1

In Marx’s hands, value theory became a powerful tool for analysing

society. While Smith had praised the merits of individual pursuit of
happiness and profit, and Ricardo had made the capitalist entrepreneur the
hero of the economy, Marx was much more critical of both. As the
Industrial Revolution progressed and threw masses of labourers in Europe
into urban poverty, his labour theory of value was not just a set of abstract
ideas, but an active critique of the system that he saw developing around
him. If labour produced value, why was labour continuing to live in
poverty and misery? If financiers did not create value, how did they
become so rich?
However, the labour theory of value’s days were numbered. This
chapter is about the emergence of a new set of ideas that inverted the
earlier argument that value was nested in objective conditions of
production, and that all other economic categories, such as the price of
goods and services, were subsumed to it. The classical economists lost
their crown to a new dynasty, the neoclassicals.

NEW TIMES, NEW THEORY

Socialist critiques of value theory were multiplying even before Marx
wrote Capital. A group called the ‘Ricardian socialists’ used Ricardo’s
labour theory of value to demand that workers get better wages. They
included the Irishman William Thompson (1775–1833), Thomas Hodgskin
(1787–1869) and John Gray (1799–1883), both British, and John Bray
(1809–97), who was born in the US but worked for part of his life in
Britain. Together, they made the obvious argument that if the value of
commodities derives from labour, the revenue from their sale should go to
workers. This idea underlay the co-operativism of the textile manufacturer
Robert Owen (1771–1858), for whom the solution was that workers should
also participate in ownership, of both factories and publicly created
infrastructure. Marx and Engels were friendly with some of these groups,
but very unfriendly towards others whom they thought had no proper
analysis of why things were going wrong. The pair collaborated with the
groups to whom they were well disposed to produce critiques of
capitalism.
Intellectual opposition to capitalism had its practical counterpart in a
growing array of radical and socialist political organizations which
connected the often dire conditions of working people with programmes of
action to remedy them. In Britain, the Chartists (1837–54) demanded
reforms to the political system. Trade unionism began to gain a significant
following. The Amalgamated Society of Engineers was formed in 1851
and the Trades Union Congress in 1868. During the recession of the 1880s,
socialism became more widespread, culminating in the founding of the
Labour Party in 1900. Here, Britain was a relative latecomer: the Socialist
Workers’ Party of Germany was founded in 1875 and the Federation of the
Socialist Workers of France four years later.
Faced with these threats to the status quo, the powers that be needed a
new theory of value that cast them in a more favourable light. Other
influences also encouraged the search for a new analysis of how capitalism
works and the troubling question of where value comes from. Malthus’s
pessimism about the dangers of population growth was an affront to the
later-nineteenth-century belief in progress – and the facts did not appear to
support him, because the food shortages he predicted had not materialized.
Non-conformism offered a moral basis on which to argue that the
immiseration of the masses that Marx and others feared was neither
inevitable nor desirable. The development of natural sciences and
mathematics encouraged attempts to place economics on a similar
‘scientific’ footing, as opposed to what was becoming seen as the more
‘literary’ endeavours of the political economists. Above all, perhaps, the
rising power of capitalists in a society long dominated by aristocratic
landowners and local gentry meant that a new analysis of capitalism was
required to justify their standing.

THE ECLIPSE OF THE CLASSICALS

A series of thinkers and economists who were roughly contemporaneous

with Marx began to lay the foundations for what has become modern
mainstream economics. Landlords were defended as productive by Lord
Lauderdale (1784–1860), a Scottish earl, and profits by Nassau Senior
(1790–1864), an English lawyer and economist, as abstinence from
consumption. Linking profits to a notion of sacrifice allowed a useful
moral justification for the large income inequality between capitalists and
workers.2 Furthermore, as scarce capital could be either invested or saved,
profits were no longer linked to theories of exploitation but came to be
seen as simply a return for saving and not consuming.
But to put the classicals to bed properly, a new theory of value had to be
invented. Two of the principal architects of what became known as
neoclassical economics were Léon Walras (1834–1910) and William
Stanley Jevons (1835–82). Walras was a professor of economics in
Lausanne, Switzerland. For him, ‘the characteristic of a science properly
speaking is the complete indifference to any consequences, advantageous
or undesirable, of its attachment to the pursuit of pure truth’.3 Walras was
keen to show that economics was a real science, less fuzzy than sociology
or philosophy, so set out to discover ‘pure truths’ in the science of
theoretical economics rather than focus on applications. Jevons, a
Professor of Political Economy at University College, London, began his
1871 The Theory of Political Economy with the assertion that economics,
‘if it is to be a science at all, must be a mathematical science’. He justified
this statement by stating that economics deals with quantities: there were,
he continued, ‘laws’ in economics, which could become like other ‘exact’
sciences if sufficient commercial statistics were available. Jevons called
his economic theory ‘the mechanics of utility and self-interest’.
Another economist who linked value to utility was Carl Menger (1840–
1921), one of the founders of the ‘Austrian school’ of economics. As we
shall see later, utility is a broad concept, combining ideas about a product’s
efficiency – is the car reliable? – with vaguer notions of satisfaction and
even happiness – does the new car impress the neighbours? For Menger,
the value arising from utility set the cost of production; the cost of
production, including the cost of labour, did not determine value. Although
original, Menger’s ideas did not fit comfortably into the new narrative that
economics had to be much more abstract, expressed neatly in
mathematical equations based on Newtonian physics.

FROM OBJECTIVE TO SUBJECTIVE: A NEW THEORY OF VALUE BASED ON

PREFERENCES

Walras, Jevons and Menger provided a positive and ‘scientific’ view of

reproduction, exchange and income distribution. They used the construct
which later came to be called ‘marginal utility’, and their propagation of a
new view on value theory is now referred to as a ‘marginal revolution’4 –
it was, however, a slow one.
The marginal utility theory of value states that all income is reward for a
productive undertaking. Given the large investments being made in
factories and the edifices of the Industrial Revolution, it suited the
changing circumstances of the second half of the nineteenth century. But it
did not come out of nowhere; indeed, it has a long history. In medieval
times, thinkers argued that ‘just prices’ were those that reflected an
object’s utility. In his Summa Theologica, the thirteenth century
philosopher-theologian Thomas Aquinas discussed the concept of the just
price in a section of the book called ‘Of Cheating, Which Is Committed in
Buying and Selling’. Just price was a normative concept, against what was
seen as the wrong price resulting from morally evil greed. The medieval
Church inveighed against the sin of greed and avarice, which broadly
meant profiteering by middlemen and moneylenders. In Dante’s Inferno,
usurers are consigned to the hottest part of hell (circle 7) because they are
making money not from the productive sources, which for Dante were
Nature or Art, but from speculative changes in interest rates. Indeed, he is
so disgusted by usury that he puts usurers just below the circle of hell
housing the sodomites.
This normative and moral view of price, linked to cheating or criminal
behaviour, began to fade after the seventeenth century – the time of Petty
and King – but lingered on until firmly supplanted by the concept of
individual utility, which held that it was not about good or bad but how
common goals could be reached through each individual trying to
maximize the benefit to him- or herself. In 1776 – the year that Adam
Smith published The Wealth of Nations – the Englishman Jeremy Bentham
argued that ‘the greatest happiness of the greatest number’ should be the
‘measure of right and wrong’.5 In other words, an action should be
evaluated according to its consequences in a particular context: killing may
be justified if it prevents more killing. This ‘utilitarian’ theory of ethics
spilled over into ideas about production. In France, Jean-Baptiste Say
(1767–1832), Smith’s contemporary and a hostile critic of Quesnay,
argued in his 1803 book Treatise on Political Economy that the value of a
commodity resides in its utility to a buyer and, therefore, that productive
labour is labour which produces utility. In Say’s view, labour in services –
which classical economists thought fell squarely into the ‘unproductive’
category, because they failed to produce ‘things’ – could in fact be
reclassified as productive, so long as those services fetched a price and
labour got paid a wage.6
The most influential person in developing utility theory was the late-
nineteenth-/early-twentieth-century British economist Alfred Marshall
(1842–1924), Professor of Political Economy (as it was still called) at
Cambridge. Significantly, he was trained as a mathematician. Marshall’s
1890 Principles of Economics diffused the new ideas to generations of
students. The economics library in Cambridge is known simply as the
Marshall Library; introductory economics textbooks still include diagrams
he developed in the nineteenth century.
In many respects Marshall was a natural heir to the classical tradition.
He accepted that the cost of production was important in determining a
commodity’s value. But he and his followers shifted thinking about value
from the study of broad quantities of capital, labour and technology inputs
and their returns to that of small incremental quantities. Using
mathematical calculus, they focused on how a small – or ‘marginal’ –
change in one variable causes a change in another: for instance, how a
small change in price affects the quantity of product demanded or
supplied.
So what was the new value theory, marginalism, about? First, it is based
on the notions of utility and scarcity and is subjective: the value of things
is measured by their usefulness to the consumer. There is, therefore, no
‘objective’ standard of value, since utility may vary between individuals
and at different times. Second, this utility decreases as the amount of a
thing that is held or consumed increases. The first Mars Bar you eat in a
day may provide a lot of utility or satisfaction and even happiness. It is
enjoyable and maybe staves off hunger pangs. But as you go on eating
Mars Bars they cease to be so enjoyable and may even make you feel ill.
At some point the utility gained from eating them will decrease.7 In this
way, the utility of the last bar is less, possibly much less, than that of
earlier bars. This is ‘marginal utility’ – in the case of a Mars Bar, worth
less to you than the previous one, ‘decreasing marginal utility’. By the
same token, the scarcer a thing is, the more utility it gives you –
‘increasing marginal utility’. One Mars Bar on a desert island can give you
more happiness than any number of bars bought from your corner shop.

THE RISE OF THE ‘NEOCLASSICALS’

Prices, then, reflect the utility that buyers get from things. The scarcer they
are – the higher their marginal utility – the more consumers will be willing
to pay for them. These changes in the marginal utility of a product came to
be known as consumer ‘preference’. The same principle applies to
producers. ‘Marginal productivity’ is the effect that an extra unit of
produced goods would have on the costs of production. The marginal cost
of each extra Mars Bar that rolls off the production line is lower than the
cost of the previous one.
This concept of marginalism lies at the heart of what is known today as
‘neoclassical’ theory – the set of ideas that followed the classical theory
developed by Smith and Ricardo and was extended by Marx. The term
neoclassical reflected how the new theorists stood on the shoulders of
giants but then took the theory in new directions. Microeconomic theory,
the theory of how firms, workers and consumers make choices, is based on
the neoclassical theory of production and consumption which rests on the
maximization of profits (firms), and utility (consumers and workers).
As a mathematician, Marshall used mathematical calculus, borrowed
from Newtonian physics, to develop his theory of how an economy
worked. In his model, the point at which a consumer’s money is worth
more to him or her than the additional (marginal) unit of a commodity
(that next Mars Bar) that their money would purchase, is where the system
is in ‘equilibrium’, an idea reminiscent of Newton’s description of how
gravity held the universe together. The smooth, continuous curves of these
equilibrating and evolutionary forces depict a system that is peaceful and
potentially ‘optimal’. The inclusion of concepts like equilibria in the
neoclassical model had the effect of portraying capitalism as a peaceful
system driven by self-equilibrating competitive mechanisms – a stark
contrast to the ways in which the system was depicted by Marx, as a battle
between classes, full of disequilibria and far from optimal, whose resulting
revolutions would have been better described by Erwin Schrödinger’s
concept of quantum leaps and wave mechanics.
So keen was Marshall to emphasize the equilibrating and evolutionary
forces in economics, with their smooth, continuous curves that could be
described by mathematical calculus, that the epigraph of his 1890
Principles of Economics was the Latin tag Natura non facit saltum, a nod
to its use by Darwin in his 1859 On the Origin of Species to make the point
that Nature, rather than progressing in leaps and bounds, evolves in
incremental steps, building on previous changes.
The equilibrium concept had a lot of appeal at the start of the twentieth
century, when the rise of socialism and trade unions in Europe threatened
the old, often autocratic, order and the conventional wisdom was that
capitalism was largely self-regulating and government involvement was
unnecessary or even dangerous.
Equilibrium was predicated on the notion of scarcity, and the effect of
scarcity on diminishing returns: the more you consume, the less you enjoy
each unit of consumption after a certain amount (the maximum
enjoyment); and the more you produce, the less you profit from each
marginal unit produced (the maximum profit). It is this concept of
diminishing returns that allows economists today to draw smooth curves in
diagrams, using mathematical calculus, so that maxima and minima points
(e.g., the bottom of a U-shaped curve showing how costs change with
increased production) provide the equilibrium targets and utility
maximization.
Nineteenth-century economists liked to illustrate the importance of
scarcity to value by using the water and diamond paradox. Why is water
cheap, even though it is necessary for human life, and diamonds are
expensive and therefore of high value, even though humans can quite
easily get by without them? Marx’s labour theory of value – naïvely
applied – would argue that diamonds simply take a lot more time and
effort to produce. But the new utility theory of value, as the marginalists
defined it, explained the difference in price through the scarcity of
diamonds. Where there is an abundance of water, it is cheap. Where there
is a scarcity (as in a desert), its value can become very high. For the
marginalists, this scarcity theory of value became the rationale for the
price of everything, from diamonds, to water, to workers’ wages.
The idea of scarcity became so important to economists that in the early
1930s it prompted one influential British economist, Lionel Robbins
(1898–1984), Professor of Economics at the London School of Economics,
to define the study of economics itself in terms of scarcity; his description
of it as ‘the study of the allocation of resources, under conditions of
scarcity’ is still widely used.8 The emergence of marginalism was a pivotal
moment in the history of economic thought, one that laid the foundations
for today’s dominant economic theory.

The Marginal Revolution

The ‘marginal revolutionaries’, as they have been called, used marginal
utility and scarcity to determine prices and the size of the market. In their
view, the supply and demand of scarce resources regulates value expressed
in money. Because things exchanged in a monetary market economy have
prices, price is ultimately the measure of value. This powerful new theory
explained how prices were arrived at and how much of a particular thing
was produced.9 Competition ensures that the ‘marginal utility’ of the last
item sold determines the price of that commodity. The size of the market
in a particular commodity – that is, the number of items that need to be
sold before marginal utility no longer covers the costs of production – is
explained by the scarcity, and hence price, of the inputs into production.
Price is a direct measure of value.10 We are, then, a long way from the
labour theory of value.
But what this model gains in versatility – the notion that the preferences
of millions of individuals determine prices, and hence value – it loses in its
ability, or, rather, lack of ability, to measure what Smith called ‘the wealth
of nations’, the total production of an economy in terms of value. As value
is now merely a relative concept – we can compare the value of two things
through their prices and how the prices may change – we can no longer
measure the labour that produced the goods in the economy and by this
means assess how much wealth was created.
Marginal utility and scarcity need a couple of additional assumptions for
price determination to work as intended. First, all humans have to be one-
dimensional utility calculators who know what’s best for themselves, what
price to pay for what commodity and how to make an economically
‘rational’ choice.11 Second, there must be no interference, for example by
monopolies, in price-setting. ‘Equilibrium’ with ‘perfect competition’ – in
which supply and demand are exactly balanced, an idea Jean-Baptiste Say
developed back in the early nineteenth century – became a necessary and
central concept in economics. These assumptions, as we will see, bear
heavily on today’s discussion of value creation.

The Production Boundary Becomes Malleable

The consequences of marginal thinking for the production boundary are
dramatic. As we have seen, classical thinkers differed in their definition of
who was and was not productive. For Quesnay only farmers were
productive; Smith put services in the ‘unproductive’ bracket; and even
Marx defined productive workers as those who were working in capitalist
production. In marginal thinking, however, such classification was swept
aside. What replaced it was the notion that it is only whatever fetches a
price in the market (legally) that can be termed productive activity.
Moreover, productivity will fluctuate with prices, because prices determine
value, not vice versa. The utility theory therefore completely changes the
concept of productive and unproductive labour. In fact, the distinction
effectively falls away, since every sector that produces for the market
exchanges its products – which means there are now few definitively
unproductive sectors. The only part of the economy which clearly lies
outside the production boundary and is unproductive, as in Figure 7,
consists of those who receive income not earned in the market: the
government by collecting taxes and the beneficiaries of government
subsidies such as social security payments, and state entities like the armed
forces.
In Marshall’s state of ‘equilibrium’, where prices are not distorted,
everyone gets paid what they are worth – which may change if consumers
alter their tastes or if technology advances. This has important
consequences for how incomes are assessed and justified. What workers
earn is reflected in their marginal productivity and their revealed
preferences (marginal utility) for leisure versus work. There is no longer
any room for the analytical distinctions that Ricardo or Marx made about a
worker’s contribution to production, let alone the exploitation of that
worker. You are valuable because what you provide is scarce. Because we
are rational utility calculators in the face of scarcity, we don’t let things go
to waste. Workers might choose unemployment because that gives them
more marginal utility than working for that or a given wage. The corollary
of this logic is that unemployment is voluntary. Voluntary unemployment
arises from viewing economic agents as rationally choosing between work
and leisure (i.e. ‘intertemporal maximization’ in modern theory). In other
words, Marx’s concept of the ‘reserve army of labour’ disappears into thin
air.
 Figure 7. The marginalist revolution

As Lionel Robbins neatly put it,

In the first place, isolated man wants both real income and leisure. Secondly, he has not
enough of either fully to satisfy his want of each. Thirdly, he can spend his time in
augmenting his real income or he can spend it in taking more leisure. Fourthly, it may
be presumed that, save in most exceptional cases, his want for the different constituents
of real income and leisure will be different. Therefore he has to choose. He has to
economize.12

Inherent in equilibrium is the idea that everything is in everyone’s interest.

In the 1940s the Russian-born British economist Abba Lerner (1903–82)
formulated what he called the ‘first fundamental welfare theorem’,13 which
basically states that competitive markets lead to ‘optimal’ outcomes for all.
Once market exchange at equilibrium prices has taken place, no one can be
made better off, or, in economic parlance, have their ‘welfare’ increased
(for example, by accepting more work) without making someone else
worse off.
Today, competitive markets where no one can be made better off
without someone being made worse off are known as ‘Pareto-optimal’ –
named after Walras’s successor in Lausanne, Vilfredo Pareto (1848–1923),
who was the first to introduce the term ‘welfare maximization’. In his
Manual of Political Economy (1906), Pareto studied economic equilibrium
in terms of solutions to individual problems of ‘objectives and constraints’,
and was the first economist to argue that utility maximization did not need
to be cardinal (i.e., the exact amount that someone wanted something) just
the ordinal amount (how much they wanted it more than something else –
X versus Y). This made mathematical calculus even easier to use, and
many welfare properties in economics today bear his name. He used his
theories to argue for free trade in Italy, which did not make him popular
with the Fascist government of the time, which was more protectionist.
But to get to these ‘optimal’ outcomes, we must ensure that equilibrium
holds: all obstacles to equilibrium, such as an interfering government,
monopolies, other rents arising from scarcity and so on, must be
obliterated. Our problems, marginalism holds, derive solely from
imperfections in, and inhibitions on, the smooth working of the capitalist
machine. Rent is no longer seen as ‘unearned income’, as it was by the
classical economists, but as an imperfection that can be competed away.
Left to itself, capitalism can thus create maximal value for everyone,
which is conveniently what everyone ‘deserves’ based on their marginal
product. The contrast with the classical economists is glaring. For Marx,
capitalists appropriate surplus value by paying a wage less than the value
of labour. Smith and Ricardo held that value was created by effort that
directly added up to the wealth of nations. But with marginal utility there
are no longer classes, only individuals, and there is no objective
measurement of value.
This approach has a very important consequence. It suggests that
government should never intervene in the economy unless there are market
failures. Market failure theory uses the first fundamental theorem (FFT) of
welfare economics as its starting point. The FFT holds that markets are the
most efficient allocators of resources under three specific conditions: first,
that there exists a complete set of markets, so that all goods and services
which are demanded and supplied are traded at publicly known prices; that
all consumers and producers behave competitively; and that an equilibrium
exists.
Violations of any of these three assumptions leads to the inefficient
allocation of resources by markets, or what marginalists term ‘market
failures’. Market failures might arise when there are ‘positive
externalities’, benefits to society such as basic science research from
which it is hard for individual firms to profit; or ‘negative externalities’,
bad things like pollution, which harm society but are not included in firms’
costs. If markets are not ‘Pareto-optimal’, then everyone could be better
off as a result of public policies that correct the market failure in
question.14 However, as we will see in Chapter 8, a body of economics
referred to as Public Choice theory, advocated by Nobel Prize winner
James Buchanan (1919–2013), later argued that as government failures are
even worse than market failures (due to corruption and capture), so the
correction of market failures by bureaucrats might make things even
worse.

From the Class Struggle to Profits and Wages in ‘Equilibrium’

Defining everything that commands a price as valuable led to the
marginalists’ conclusion that what you get is what you are worth. Profits
are not determined by exploitation but by technology and the ‘marginal
product of capital’. Capital and labour are seen as the two main inputs into
production, and so just as labour earns wages for its productive
contribution (marginal product of labour), capital earns a profit (marginal
product of capital). John Bates Clark (1847–1938), a former critic of
capitalism who converted to become one of the most ardent contributors to
the marginalist revolution, argued strongly against the idea that labour was
exploited. Capital could not exploit labour, he reasoned, because labour
and capital were simply earning their ‘just rewards’ – their marginal
products. In Clark’s view, capital goods themselves were the rewards for
capitalist self-restraint. Instead of consuming their profits, they had saved
them – saving that would eventually result in higher investment in more
capital goods (we will come back to this in Chapter 8).
The equilibrium view diverted attention from the tensions between
capital and labour, and ultimately from alternative theories on the sources
and distribution of value – which almost faded into oblivion from the late
nineteenth century onwards, except in expressly Marxist circles and in the
thinking of economists such as Joan Robinson (1903–1983), Professor of
Economics at Cambridge, and Piero Sraffa (1898–1983), an Italian who
also studied and worked in Cambridge. Both were dedicated critics of the
neoclassical view of production, believing that the concept of the
‘marginal’ product of labour and capital was ideologically based, and was
also subject to a ‘fallacy of composition’: the neoclassical theory of
production could not apply to the entire system. They engaged actively in
what was later called the Cambridge Capital Critique – a debate between
the Cambridge, UK-based Robinson and Sraffa, and Solow and
Samuelson, who were at MIT in Cambridge, Massachusetts.
 Sraffa and Robinson argued that ‘capital’ is heterogeneous and so
cannot be used as an aggregate concept. That is, it cannot be aggregated
since it would be like adding apples to oranges. In 1952 Robinson,
influenced by the writings of Sraffa, argued that the idea of profits as the
value measurement of capital is a tautology: there is no way to know the
value of capital without knowledge of equilibrium prices, and these require
an equilibrium rate of profit that cannot be obtained unless we have
estimated the value of capital. Furthermore, following the ideas of Marx,
Robinson and Sraffa argued that the rate of profit was not the reward for
productive contribution of ‘capital’; it derived from social relations, that’s
to say, who owned the means of production and who was forced to work
for them. The circularity of the logic of neoclassical theory was partly
accepted by Samuelson in a well-known 1966 article in the prestigious
Quarterly Journal of Economics, where he admitted the logical validity of
the points being made by Robinson and Sraffa. Solow, on the other hand,
claimed that neoclassical economics should not be distracted by such
critiques; and indeed, the debate between the ‘classicals’ and the
‘neoclassicals’ would later disappear, so that most students of economics
today don’t even know it happened.
Remarkably, the neoclassical theory of value has not changed much in
the last hundred years. The maximization of utility has been extended
beyond the economic sphere to explain human behaviour, including crime,
drug addiction and, infamously, models of divorce. This particular idea
originated with Gary Becker (1930–2014), an American who was
Professor of Economics and Sociology at the University of Chicago and
won the Nobel Prize in Economics in 1992. In essence, Becker postulated
that two individuals marry when there is a positive surplus from their
union in contrast to remaining single. These gains may come from, for
example, economies of scale, provision of insurance and general risk-
sharing. Becker’s ideas encouraged many others to pursue similar
investigations.
Attempts have also been made to forge stronger links between
macroeconomic patterns (the whole economy, for instance inflation,
unemployment and business cycles) and microeconomic decisions made
by people and firms. And, as we will see, other work has looked at the
need to include non-priced goods (such as care) into GDP.
But despite the critiques, marginal utility theory prevails and is highly
influential. The narrow equilibrium view that we will all benefit from
perfect competition has influenced – and continues to influence –
government policies and those of powerful multilateral bodies such as the
International Monetary Fund and the World Bank: how, with perfect
competition, individuals will supposedly maximize their preferences and
companies their profits so we will all benefit. On the basis of
contemporary economic assumptions, we can no longer reliably say who
creates value and who extracts it and therefore how the proceeds of
production – income – should reasonably be distributed. In the next
chapter we will see how this subjective approach to value has also had a
strong impact on the ways we measure national wealth and income
through the concept of GDP.

THE DISAPPEARANCE OF RENT AND WHY IT MATTERS

When students learn about microeconomics in the classroom (e.g. how

prices are determined, including wages), they are not told that this is only
one of many different approaches to thinking about value. It is, as far as
they are concerned, the only one – and, as a result, there is no need to refer
to the word ‘value’. The term essentially disappears from the discourse. It
is simply Microeconomics 101.
In concluding our history of economic thought, we should ask: is this
only an academic exercise, or does it matter? Why it does matter is the
subject of this book: it is crucial to our understanding of value extraction –
and hence the ability to limit it.
The concept of ‘rent’ has changed in economic thought over the
centuries, because rent is the principal means by which value is extracted.
The eighteenth-century economists described rent as unearned income,
which they thought of as income derived from simply moving existing
resources from one hand to another. Their disapproval of unearned income
partly came, as we have seen, from medieval strictures on usury – the
charging of interest. But it was also practical. Adam Smith believed that a
genuinely free market was a market free of rent, and so policymakers had
to do their best to eliminate it. His follower David Ricardo considered
landowners who collected rent without contributing to the productivity of
land to be economic parasites; he denied vehemently that there was any
value in the income or rent received from owning land. Rents were
unearned income and fell squarely outside the production boundary. Both
Smith and Ricardo realized that freeing the economy from rent called for
strong intervention – in practice by government – to prevent value
extraction. Neoclassical economists too; they see rent as an impediment to
‘free competition’ (free entry and exit of different types of producers and
consumers). Once those impediments are removed, competition will
benefit everyone.
 In the subjective marginalist’s approach, wages, profits and rent, along
with wages and profits, all arise from ‘maximizing’: individuals
maximizing utility and firms maximizing profits. Thus labour, capital and
land are input factors on the same footing. The distinction between social
classes, including who owns what, is obliterated, since whether one lends
out capital or works for wages depends on an unexplained initial
endowment of resources.15
Wages are determined by the worker equalizing the (diminishing)
marginal utility of the money obtained from working with the ‘disutility’
of working, for example less leisure time. At the prevailing wage rate, the
amount of time spent on work determines the income. This assumes that
the amount of employment can be flexibly adjusted. If this is not the case,
the marginal utility of taking a job might become less than the utility
derived from an equivalent time of leisure; someone chooses not to work.
As we have seen, this means that unemployment is therefore voluntary.
Profits and rent are thus determined analogously: the owners of capital
(money) will lend it until the marginal utility from doing so is lower than
that of consuming their capital. Landlords do the same with their land. For
instance, the owner of a house might rent it out and then decide to let her
daughter live there for nothing, effectively consuming capital because rent
earnings are forgone. The justification for any profits is thus related to
individual choices (based on psychology) and the psychological
assumption that people derive less utility from future consumption
(discounting). So the return on capital and land is seen as compensation for
future marginal utility at a level which could be enjoyed today if the
capital were consumed instead of lent.
In classical economics, therefore, rents are part of the ‘normal’ process
of reproduction. In neoclassical economics, rents are an equilibrium below
that which is theoretically possible – ‘abnormal’ profits. The main
similarity is that both theories see rent as a type of monopoly income. But
rent has a very different status in the two approaches. Why? Chiefly
because of the divergent value theories: classical economics fairly clearly
defines rent as income from non-produced scarce assets. This includes, for
example, patents on new technologies which – once produced – need not
be reproduced any more; the right to issue credit money, which is
restricted to organizations with a banking licence; and the right to
represent clients in court, which is restricted to members of a Bar
association.16 Essentially, it is a claim on what Marx called the pool of
social surplus value – which is enormous compared to any individual
production capitalist, circulation capitalist, landowner, patent holder and
so on.
By contrast, in neoclassical economics – in general equilibrium –
incomes must by definition reflect productivity. There is no space for
rents, in the sense of people getting something for nothing. Tellingly,
Walras wrote that the entrepreneur neither adds nor subtracts from value
produced.17 General equilibrium is static; neither rents nor innovation are
allowed. A relatively recent refinement, the more flexible partial
equilibrium analysis, allows us to disregard interactions with other sectors
and introduce quasi-rents, and has since the 1970s led to the idea of ‘rent-
seeking’ by creating artificial monopolies, for example tariffs on trade.
The problem is that there is no hard-and-fast criterion with which to assess
whether the entrepreneur creates ‘good’ new things or is imposing
artificial barriers in order to seek rents.
The neoclassical approach to rent, which largely prevails today, lies at
the heart of the rest of this book. If value derives from price, as
neoclassical theory holds, income from rent must be productive. Today,
the concept of unearned income has therefore disappeared. From being
seen by Smith, Ricardo and their successors as semi-parasitic behaviour –
extracting value from value-creating activity – it has in mainstream
economic discourse become just a ‘barrier’ on the way to ‘perfect
competition’. Banks which are judged ‘too big to fail’ and therefore enjoy
implicit government subsidy – a form of monopoly – contribute to GDP,
as do the high earnings of their executives.
Our understanding of rent and value profoundly affects how we measure
GDP, how we view finance and the ‘financialization’ of the economy, how
we treat innovation, how we see government’s role in the economy, and
how we can steer the economy in a direction that is propelled by more
investment and innovation, sustainable and inclusive. We begin by
exploring in the next chapter what goes into – and what is omitted from –
that totemic category, GDP, and the consequences of this selection for our
assessment of value.
 3
Measuring the Wealth of Nations

What we measure affects what we do; and if our measurements are flawed, decisions
may be distorted.
Joseph Stiglitz, Amartya Sen and Jean-Paul Fitoussi, Mismeasuring Our Lives (2010)

Scarcely a day goes by without politicians, the media or experts opining on

the state of a country’s GDP – the measure used to calculate the growth of
goods and services in an economy: the ‘wealth of nations’. Success or
failure – real or imagined – in managing GDP can make or break
governments and careers. If GDP falls for more than two consecutive
quarters, there are cries of ‘recession’. If the fall is sustained over a year,
it’s a depression. But where does this measure come from? And how is it
influenced by the way value is understood?
Marginal utility is today a major influence on the measurement of
economic activity and growth. It has an effect on the rationale for the kinds
of economic activities that are considered productive – which, as we saw
in Chapter 2, is basically anything that fetches a (legal) price in the market.
According to marginalists, because value derives from price, somebody
earning a very high salary is indicative of their productivity and worth. At
the same time, anybody holding down a job at all is supposed to reflect
their preference for work: the utility of work against that of leisure. GDP
can be measured as the total amount of products produced, the total
amount demanded, or the total income earned (with adjustments reviewed
below). But if income is not necessarily a sign of productivity but of
something else – for example the classicals’ notion of rent as ‘unearned
income’ – what are the implications for GDP as a reliable measure of an
economy’s productiveness?
 A rise in incomes in the financial sector, for example, would have an
effect on GDP. So how sectors are valued influences our calculations of
growth rates, and this may in turn influence how we decide to steer the
economy. In other words, how we measure GDP is determined by how we
value things, and the resulting GDP figure may determine how much of a
thing we decide to produce. Performativity!
But if there are problems with the way in which we measure GDP,
policymakers can receive misleading signals about what is productive and
how to steer the economy. Discussion about which parts of society are
productive and which non-productive has been much less explicit since the
arrival of marginal utility theory. As long as products and services fetch a
price on the market, they are worthy of being included in GDP; whether
they contribute to value or extract it is ignored. The result is that the
distinction between profits and rents is confused and value extraction
(rent) can masquerade as value creation.
This chapter will look at the ways in which governments have
calculated growth through national accounting methods, the relationship
between these methods and value theory, and the very strange results that
have ensued, including the undervaluation of certain activities (like caring
for our children), and the overvaluation of others (such as polluting
businesses). In Chapter 4 we will see how marginal utility theory has also
failed to account for one of the key problems in modern capitalism: the
extractive activities of the financial sector.

GDP: A SOCIAL CONVENTION

It is crucial to remember that all types of accounting methods are evolving

social conventions, defined not by physical laws and definite ‘realities’ but
reflecting the ideas, theories and ideologies of the age in which they are
devised.1 The way in which a spreadsheet is constructed in itself reflects
values. An interesting example is the Jesuit Order. Back in the 1500s, the
newly founded Order devised an innovative accounting system which
blended vision with finance. In order to align finance with the values of
their order, they made sure that the cash box could only be opened with
two keys: one operated by the person in charge of the finances (the
procurator, today’s CFO) and another by the person in charge of the
strategy (the rector, today’s CEO).2 As this instance shows, accounting is
not neutral, nor is it set in stone; it can be moulded to fit the purpose of an
organization and in so doing affect that organization’s evolution.
In this same way, the modern accounting concept of GDP is affected by
the underlying theory of value that is used to calculate it. GDP is based on
the ‘value added’ of a national economy’s industries. Value added is the
monetary value of what those industries produce, minus the costs of
material inputs or ‘intermediate consumption’: basically, revenue minus
material input cost. Accountants call the intermediate inputs a ‘balancing’
item because they balance the production account: cost and value added
equal the value of production. Value added, however, is a figure
specifically calculated for national accounting: the residual difference
(residual) between the resource side (output) and the use side
(consumption).
The sum of all industry value-added residuals in the economy leads to
‘gross value added’, a figure equal to GDP, with some minor corrections
for taxes. GDP can be calculated either through the production side, or
through the income side, the latter by adding up the incomes paid in all the
value-adding industries: all profits, rents, interest and royalties. As we will
see below, there is a third way to calculate GDP: by adding up expenditure
(demand) on final goods, whose price is equal to the sum of the value
added along the entire production chain. So GDP can be looked at through
production (all goods and services produced), income (all incomes
generated), or demand (all goods and services consumed, including those
in inventory).
So which industries add value? Following marginalist thinking, the
national accounts today include in GDP all goods and services that fetch a
price in the market. This is known as the ‘comprehensive boundary’. As
we saw in Chapter 2, according to marginalism the only economic sectors
outside the production boundary are government – which depends on taxes
paid by the productive sectors – and most recipients of welfare, which is
financed from taxation. Adopting this principle to calculate GDP might
seem logical. But in fact it throws up some real oddities which call into
question the rigour of the national accounting system and the way in which
value is allocated across the economy. These oddities include how
government services are valued; how investments in future capacity, such
as R&D, are measured; how jobs earning high incomes, as in the financial
sector, are treated; and how important services with no price (such as care)
or no legal price (such as the black market) are dealt with. In order to
explain how these oddities have arisen, and why the system seems to be so
idiosyncratic, we need briefly to look at the way in which national
accounting and the idea of ‘value added’ has developed over the centuries.

A Brief History of National Accounts

Value theory has been at the heart of national accounting for a very long
time. The most significant early initiatives took place in late-eighteenth-
century France, when there were at least eight attempts by different
thinkers to estimate France’s national product based on Quesnay’s land
theory of value. Because, as we have seen, for Quesnay the production
boundary encompassed only agricultural output – everyone else being
classed as living off transfers from the agricultural sector – manufacturing
was placed on the unproductive side of the boundary, in the process
ignoring dissenting voices such as that of Say, who, taking a broadly
utilitarian approach, argued that productive labour is simply labour which
produces utility. If the product is something people want to buy – has
utility for them – then making it is productive.
Excluding manufacturing from the national product seemed as obvious
to Quesnay’s followers as it is for us today to include everything that
fetches a price. These early French estimators were illustrious figures.
They included the writer Voltaire (1694–1778); Antoine Laurent Lavoisier
(1743–94), one of the founders of modern chemistry; and his friend the
mathematician Joseph Louis Lagrange (1736–1813), better known today
for his work on mechanics and mathematical techniques which is still used
by economists. Quesnay’s ideas proved remarkably durable: as late as
1878, one French estimate of national product was based on his reasoning.3
Similarly influential were Adam Smith’s ideas of value production. His
national income estimates defined only the production or income of
agricultural and industrial labour, which produced material goods – actual
stuff – and excluded all services, whether government or banking ones.
Smith’s ideas even underpinned the first account of national product in
revolutionary France when, in 1789, Napoleon commissioned Smith’s
disciple Charles Ganilh (1758–1836) to provide an up-to-date and accurate
picture of French national income.4
In the late nineteenth century, marginal utility theory predominated.
Although radically different from the thinking of earlier economists, it
continued to underscore the importance of value theory in national
accounting. Increasingly, under its influence, national accountants
included everything bought with income: for them, the sum of revenue
from market activity, irrespective of sector, added up to the national
income. As income tax statistics became more readily available, it was
easier to construct estimates based on income data and to analyse the
personal distribution of income.
Alfred Marshall, the father of marginal utility theory in Britain, was the
driving force behind its application to national income estimates.5 In his
highly influential Principles of Economics he wrote explicitly about how
the national product could be estimated. An earlier book, The Economics
of Industry, co-authored with his wife Mary Paley Marshall (1850–1944),
was clear on the utility basis of national income: ‘everything that is
produced, in the course of a year, every service rendered, every fresh
utility brought about is a part of the national income’.6
Meanwhile, the labour theory of value which, fully developed by Marx,
rooted productivity firmly in the concept of the production of ‘surplus
value’, was either disputed or, increasingly, ignored altogether in
assessments of national income. By the early twentieth century it was
associated with a revolutionary programme and therefore could not, by
definition, sit easily with official statistics in the very nations of which
Marxists were so critical. Things were of course different in the countries
where Communists came to power: first in the Soviet Union after the 1917
Bolshevik Revolution and later in Eastern Europe after the Second World
War (though in justifying their construction of a ‘material product system’
that valued only material goods they should technically have been
invoking Smith, not Marx). With the exception of these socialist states, the
idea that assessments of national income should be based on the sum total
of all incomes, thus forming a ‘comprehensive’ production boundary,
spread rapidly to many countries.7
In the first half of the twentieth century marginalists had become aware
of their theory’s limitations, and began to debate the inclusion of non-
market activities in national income accounting. One of Alfred Marshall’s
students, the British economist Arthur Cecil Pigou (1877–1959), who
succeeded him as Professor of Political Economy at Cambridge, argued
that since market prices merely indicated the satisfaction (utility) gained
from exchange, national income should in fact go further: it should
measure welfare. Welfare, Pigou argued, is a measure of the utility that
people can gain through money – in other words, the material standard of
living. In his influential 1920 book The Economics of Welfare, Pigou
further defined ‘the range of our inquiry’ as being ‘restricted to that part of
social welfare that can be brought directly or indirectly into relation with
the measuring-rod of money’.8 On the one hand, Pigou was saying that all
activities which do not really improve welfare (recall the discussion of
welfare principles from Pareto discussed in Chapter 2), should be excluded
from national income, even if they cost money. On the other hand, he
stressed, activities which do generate welfare should be included – even if
they are not paid for. In these, he included free or subsidized government
services.
 One of Pigou’s most prominent disciples was the first person to provide
an estimate of the fall in national income of the United States during the
Great Depression. The Belarusian-born Simon Kuznets (1901–85), a
Professor of Economics at Harvard, won the Nobel Prize in Economics in
1971 for his work on national accounts. Believing that they incurred costs
without adding to final economic output, Kuznets, unlike Pigou, excluded
from the production boundary all government activities that did not
immediately result in a flow of goods or services to households – public
administration, defence, justice, international relations, provision of
infrastructure and so on.9
Kuznets also believed that some household expenditure did not increase
the material standard of living, but simply paid for the cost of modern life
– in particular the ‘inflated costs of urban civilization’, such as having to
maintain a bank account, pay trade union dues or the social obligation to
be a member of a club. Kuznets estimated that between 20 and 30 per cent
of consumer expenditure went on such services.10 However, he did argue
that unpaid housework should be included, because it clearly improves
economic welfare. Kuznets, then, drew the production boundary according
to what he believed improved the material standard of living and what did
not.
Perhaps Kuznets’s view would have had more traction in a peaceful
world. But the exigencies of the Second World War, which forced
governments to focus on the war effort, took economists down a different
path: estimating output rather than concerning themselves with welfare. As
a result, economists who believed that national product is the sum total of
market prices prevailed.
The resulting ways in which estimates of output were used to calculate
GDP appeared to follow marginal utility theory, but were in fact doubly
out of sync with it. First, they ignored the idea of value as utility – the
benefit it provided to the consumer – and included items that the Pigou–
Kuznets welfare concept would have seen as ‘necessary’ for the creation
of value. Rather than assess whether final consumption increased utility,
they added any final consumption to national income. In Kuznets’s own
words: ‘Many foods and drugs are worthless by scientific standards of
nutrition and medication; many household appurtenances are irrelevant to
any scientifically established needs for shelter and comfort; many service
activities as well as commodities are desired for the sake of impressing
foreigners or our fellow countrymen and could hardly measure up to
ethical principles of behaviour in relation to the rest of mankind.’11 From
that perspective, the new national accounts overstated welfare.
 Second, competition in economies is generally imperfect – a reality that
has proven distinctively uncomfortable for national accountants trained in
the neoclassical ideas of perfect competition and ‘equilibria’. By simply
adding up market prices they ignored the fact that those prices would not
always produce an equilibrium and be compatible with ‘perfect
competition’; prices could therefore be higher or lower than if equilibrium
prevailed, thereby giving a distorted impression of value creation. In short,
during the war years practice became significantly detached from the
prevailing theory – or, seen another way, the utility theory of value did not
solve the urgent war-related problems of the time.
In many ways, the national accounts as we know them today stem from
the trauma of the Great Depression of the 1930s, and the needs of the
Second World War war effort. In this, as in so much else, the British
economist John Maynard Keynes (1883–1946) was a pivotal figure. In his
1936 masterpiece The General Theory of Employment, Interest and
Money, written during the Great Depression, Keynes assumed that workers
would underestimate the purchasing power of their wages, and would
therefore be willing to produce more than they needed to. In this way,
workers’ involuntary overproduction would in turn create involuntary
unemployment – fewer workers being needed to do the same amount of
work – and the economy could find itself in a low-output equilibrium. This
is a state in which forces in the economy, such as supply and demand, are
in balance and there is no incentive to change them, even though the total
output of the economy is low and wages and employment are depressed.
Keynes used this idea to develop a theory of the macroeconomy – the
economy as a whole – in which government spending could stabilize the
business cycle when business was investing too little, and even raise the
economy’s output.
In order to lift the economy out of the depression, governments needed
information to measure how their policies were working. Up until then,
they had flown mostly blind: they had no need for detailed statistics
because the economy was supposed to be self-regulating. Keynes’s book
How to Pay for the War, published in 1940, introduced the idea of
recording national income in a set of accounts and completely changed the
way in which governments used that data.
In the late 1930s and the 1940s national accountants took up Keynes’s
ideas about how government could invigorate an economy, and came to
view government spending as directly increasing output. For the first time
in the history of modern economic thought, government spending became
important – in stark contrast to Kuznets’s omission of many government
services from the national income. This redefinition of government as a
contributor to national product was a decisive development in value
theory. Keynes’s ideas quickly gained acceptance and were among the
main influences behind the publication of the first handbook to calculate
GDP, the United Nations’ System of National Accounts (SNA): a
monumental work that in its fourth edition now runs to 662 pages.

THE SYSTEM OF NATIONAL ACCOUNTS COMES INTO BEING

After the Second World War, formal international rules were drawn up,
standardizing national accounting for production, income and expenditure.
The first version of the SNA, compiled by the United Nations, appeared in
1953.12 The SNA describes itself as ‘a statistical framework that provides a
comprehensive, consistent and flexible set of macroeconomic accounts for
policymaking, analysis and research purposes’.13 It defines national
accounting as measuring ‘what takes place in the economy, between which
agents, and for what purpose’; at its heart ‘is the production of goods and
services’.14 GDP is ‘[i]n simple terms, the amount of value added
generated by production’.15 It is defined explicitly as a measure of value
creation. It can therefore be said that the national accounts, too, have a
production boundary.
The SNA’s emergence in the early post-war years owed much to recent
economic, political and intellectual developments. The experience of
depression and war weighed heavily on policymakers’ minds. Many
countries saw wartime planning, which was based on unprecedented
amounts of economic information, as a success. Political pressures were
important too. In the US, the New Deal of the 1930s and full employment
during the war led many voters to believe that government could intervene
benignly and progressively in the economy. In Europe, the strength of left-
wing parties after the war – exemplified by the Labour Party’s 1945
election victory in the UK – also changed, and marked a change in,
people’s attitudes, and made fuller and more accurate national accounts
essential. The crucial question was, and remains: on what theory of value
were they based?
‘Simple’ national income estimates had to add up the price of
production (minus intermediate goods) in the economy, or incomes, or the
expenditure of all economic actors on final goods: National Production =
National Income = National Expenditure. In order to carry out this
estimate, we might have expected the SNA’s authors to use as their
methodology the prevailing economic theory of value, marginal utility.
But they didn’t – or, at least, not fully. In fact, the resulting model was,
and is, a strange muddle in which utility is the major, but not the only,
ingredient.
The SNA brings together various different ways of assessing the
national income that had developed over centuries of economic thinking.
Decisions about what gets included in the production boundary have been
described as ‘ad hoc’,16 while national accountants admit that the SNA
rules on production are ‘a mix of convention, judgment about data
adequacy, and consensus about economic theory’.17 These include devising
solutions based on ‘common sense’; making assumptions in the name of
‘computational convenience’ – which has important consequences for the
actual numbers we come up with when assessing economic growth; and
lobbying by particular economic interests.
In fairness, there have always been practical reasons for this ad hoc
approach. Aspects of the economy, from R&D and housework to the
environment and the black economy, proved difficult to assess using
marginal utility. It was clear that a comprehensive national accounting
system would have to include incomes from both market exchange and
non-market exchange – in particular, government. With market-mediated
activity lying at the heart of the marginalist concept of value, most
estimators of national income wanted to adopt a broader approach.18

National Income Accounting Gets it All Together

National income accounting, then, incorporates many different accounting
methods. The system simultaneously allows an integrated view of the
different aspects of the economy – both production (output) and
distribution of income – and obliges national income accountants to link
each commodity produced with someone’s income, thereby ensuring
consistency. To maintain consistency between production, income and
expenditure, the national accounts must record all value produced, income
received, money paid for intermediate and finished goods and so on as
transactions between actors in the economy – the government, or
households or a particular sector – in which each actor has an account.
This helps provide a detailed picture of the economy as a whole.
Expenditure on final goods must add up to GDP (as the price of
intermediate goods goes into the price of the final goods). So it is possible
to compute GDP from the expenditure side and, as we saw in Chapter 1,
Petty used this method to estimate national output as early as the
seventeenth century. Modern national accounts divide expenditure into the
following categories:
 GDP = Consumption by households (C) + Investment by companies and by residential
investment in housing (I) + Government spending (G).
This can be expressed as: GDP = C + I + G.

For simplicity’s sake we will ignore the contribution of net exports. Two
observations are in order: first, on the expenditure side, companies only
appear as investors (demanding final investment goods from other
companies). The remainder of spending (aggregate demand) is split
between households and the government. Government expenditure is only
what it spends itself; that is, excluding the transfers it makes to households
(such as pensions or unemployment benefits). It is its collective
consumption expenditure on behalf of the community. By focusing on
government only in terms of the spending, it is by definition assumed to be
‘unproductive’ – outside the production boundary.

MEASURING GOVERNMENT VALUE ADDED IN GDP

In Chapter 8 we will see that government is rarely acknowledged as a
creator of value – indeed, quite the reverse. Yet national accounting
conventions have in fact been quietly tracking its value-added contribution
for the last half century—and it’s not small! While Chapter 8 is fully
dedicated to looking at the various ways in which economists, and those
they advise, have considered government – as a value-creating entity or
just a strain on the economy – in this chapter we focus on the relevance of
this discussion to how GDP is calculated. The most striking thing to
emerge from these analyses is that, contrary to the views of most
economists, government certainly does add value to the economy,
Figure 8 below tracks US government value added and expenditure
since 1930. During the Second World War the government bought an
astonishing half of national output. In this figure we can see that
government value added has hovered between 11 and 15 per cent of GDP
for the post-war period. As a comparison, the finance industry adds some 4
per cent of GDP in the US and 8 per cent in the UK. But the chart reveals
what looks like a strange discrepancy. It shows that government
expenditure has been consistently higher than government value added, at
between 20 and 25 per cent of GDP.
It is important to stress, however, that the difference between value
added and final expenditure is not the government’s budget deficit. Rather,
the deficit is government revenue (mainly taxes) minus expenses,
including transfers of funds from the government to households, such as
pensions and unemployment benefit – which, since households spend the
money from pensions and benefits, are defined in national accounting as
household, rather than government, spending (it’s the final expenditure
that matters, remember). It is that household spending that counts towards
final demand for the whole economy. So, what is going on?

Figure 8. US government expenditure and value added as a share of GDP, 1930–201419

Spending and Value

Before answering this question, we have to recognize that government
value added cannot be computed in the same way as that of other
industries and, as a result, is a complicated issue for national statistical
institutes. A lot of government activities are not sold at market prices: that
is, prices that pay for all production costs (including wages, rent, interest,
royalties as well as inputs into production) and yield a profit for a private-
sector business. Instead, government activities are provided at lower, ‘non-
market’ prices – or even for free. Consider schools, state-funded
universities, public healthcare, public transport, parks, recreation and the
arts, police and fire services, the law courts, environmental protection such
as flood prevention and so on. These goods are largely financed by taxes
or debt.
Given these lower prices, the usual way of calculating value added for a
business doesn’t work with government activities. Let’s recall that value
added is normally the value of output minus costs of intermediate inputs
used in production. The value added by a business is basically workers’
wages plus the business’s operating surplus, the latter broadly similar to
gross operating profit in business accounting terms. So adding up the non-
market prices of government activities is likely to show less value added,
because they are set with a different, non-commercial objective: to provide
a service to the public. If the non-market prices of the output are lower
than the total costs of intermediate inputs, value added would even show
up as negative – indeed, government activities would ‘subtract’ value.
However, it makes no sense to say that teachers, nurses, policewomen,
firefighters and so on destroy value in the economy. Clearly, a different
measurement is needed. As the British economist Charles Bean, a former
Deputy Governor for Economic Policy at the Bank of England, argues in
his Independent Review of UK Economic Statistics (2016),20 the
contribution to the economy by public-sector services has to be measured
in terms of ‘delivering value’.21 But if this value is not profit, what is it?
National accountants have therefore long adopted the so-called ‘inputs =
outputs’ approach. Once the output is defined, value added can be
computed because the costs of intermediate inputs, such as the computers
that employees use, are known. But since government’s output is basically
intermediate inputs plus labour costs, its value added is simply equal to its
employees’ salaries. One significant consequence of this is that the
estimate of government value added – unlike that of businesses – assumes
no ‘profit’ or operating surplus on top of wages. (In Figure 8 above, the
dark-grey line shows the value added of government; it is equal – with
slight adjustments – to the share of government employment income in
GDP.) In a capitalist system in which earning a profit is deemed the
outcome of being productive, this is important because it makes
government, whose activities tend to be non-profit, seem unproductive.
But then what about the light-grey line, which represents government
final consumption expenditure? We have already seen that pensions and
unemployment benefits paid by government are part of household final
consumption, not government spending. More broadly, it is not obvious
why government should have any final consumption expenditure in the
way that households do. After all, companies are not classed as being final
consumers; their consumption is seen as intermediate, on the way to
producing final goods for households. So why isn’t government spending
likewise classed as intermediate expenditure? After all, there are, for
example, billions of school students or medical patients who are
consumers of government services.
Indeed, following this logic, government is also a producer of
intermediate inputs for businesses. Surely education, roads, or the police,
or courts of law can be seen as necessary inputs into the production of a
variety of goods? But herein lies is a twist. If government spending were to
increase, this would mean that government was producing more
intermediate goods. Businesses would buy at least some of those goods
(e.g. some public services cost money) with a fee; but because they were
spending more on them (than if government was not producing anything,
and therefore not buying supplies from businesses), their operating surplus
and value added would inevitably fall. Government’s share of GDP would
rise, but the absolute size of GDP would stay the same. This does, of
course, run counter to Keynesian attempts to show how increases in
government demand could lift GDP.
Many economists made exactly this argument in the 1930s and 1940s –
in particular Simon Kuznets, who suggested that only government non-
market and free goods provided to households should be allowed to
increase GDP. Nevertheless, the convention that all government spending
counts as final consumption arose during the Great Depression and the
Second World War, when the US needed to justify its enormous
government spending (the spike in the light-grey line in Figure 8 in the
early 1940s). The spending was presented as adding to GDP, and the
national accounts were modified accordingly.22
Later in the twentieth century there were repeated attempts to clear up
the confusion over whether certain kinds of government spending counted
as intermediate or final consumption. This was done by identifying which
government activities provided non-market and free services for
households (for example, schools), as opposed to intermediate services for
businesses (for example, banking regulation). The distinction is not easy to
make. Governments build roads. But how much of their value accrues to
families going on holiday and how much to a trucking company moving
essential spare parts from factory to user? Neither family nor trucking
company can build the road. But the family on holiday adds to total final
demand; the trucking company is an intermediate cost for businesses.
In 1982, national accountants estimated that some 3 to 4 per cent of
Swedish, German and UK GDP was government expenditure that,
previously categorized as final consumption expenditure, should be
reclassified as (intermediate) inputs for businesses. This had the effect of
lowering government’s overall value added by between 15 to 20 per cent.23
To take an example of such reclassification, in 2017 the UK
telecommunications regulator, Ofcom, compelled British Telecom (a
private firm) to turn its broadband network operation Openreach into a
separate company following repeated complaints from customers and other
broadband providers that progress in rolling out broadband around the
country had been too slow and that the service was inadequate. At least
part of the cost of Ofcom could be seen as beneficial to the private
telecommunications sector. Yet the convention that all government
spending should count as final consumption has proved remarkably
resistant to change.
Now we can see why government final consumption expenditure is
bigger than its value added in Figure 8. The government’s value added
only includes salaries. However, the government also purchases a lot of
goods and services from businesses, from coffee to cars, from pencils to
plane tickets, to the office rentals for regulating bodies such as Ofcom. The
producers of these goods and services, not the government, take credit for
the value added. Since government is treated as a final consumer, the
purchase of goods and services increases its spending. Clearly,
government expenditure can be higher than what it charges (e.g. fees for
services) because it raises taxes to cover the difference. But need the value
of government be undermined because of the way prices are set? By not
having a way to capture the production of value created by government –
and by focusing more on its ‘spending’ role – the national accounts
contribute to the myth that government is only facilitating the creation of
value rather than being a lead player. As we will see in Chapter 8, this in
turn affects how we view government, how it behaves and how it can get
‘captured’ easily by those who confidently see themselves as wealth
creators.

SOMETHING ODD ABOUT THE NATIONAL ACCOUNTS: GDP FACIT SALTUS!

Apart from this curious view of government, the national accounts expose
a number of other accounting oddities. GDP, for instance, does not clearly
distinguish a cost from an investment in future capacity, such as R&D;
services valuable to the economy such as ‘care’ may be exchanged without
any payment, making them invisible to GDP calculators; likewise, illegal
black-market activities may constitute a large part of an economy. A
resource that is destroyed by pollution may not be counted as a subtraction
from GDP – but when pollution is cleaned up by marketed services, GDP
increases. And then there’s the biggest oddity of all: the financial sector.
Does the financial sector simply facilitate the exchange of existing
value, or does it create new value? As we will see in Chapters 4 and 5, this
is the billion-dollar question: if it’s answered wrongly, it may be that the
growing size of the financial sector reflects not an increase of growth, but
rent being captured by some actors in the economy. First, however, there
are some other inconsistencies to be considered.
 Investment in Future Capacity
First, let’s look at how R&D is dealt with in the national accounts. Before
2008, the SNA considered in-house R&D to be an input into production24
– in other words, a company’s spending on R&D (research equipment,
laboratories, staff and the like) was treated as a cost and subtracted from
the company’s final output. However, in the 2008 version of the SNA, in-
house R&D was reclassified as an investment in the company’s stock of
knowledge, to be valued ‘on the basis of the total production costs
including the costs of fixed assets used in production’.25 It became a final
productive activity rather than just an intermediate cost towards that
activity.
The SNA’s decision to reclassify R&D was justified less by value
theory than by ‘common-sense’ reasoning: the contribution of ‘knowledge’
to production seemed to be significant, and should therefore be recognized.
R&D was made productive because it was considered important.
As a result, since 2008 GDP has been enlarged by the annual cost of
R&D, including the depreciation of fixed assets used. When in 2013 the
US implemented this change, the value from R&D added $400 billion –
2.5 per cent of US GDP – to national income overnight.26 Of course, those
sectors with the largest R&D contributions improved their share of GDP,
making them look more important than others.

The Value of Housework … and the House

Then there’s housework. Feminists in particular have long objected to the
lack of recognition given to housework’s contribution to the economy. The
national accounts exclude all housework, and therefore a large part of
women’s work, from production. The architect of the first and second
editions of the SNA (1953 and 1968), the Nobel Prize-winning British
economist Sir Richard Stone (1913–91) – sometimes called ‘the father of
national income accounting’ – had decided views on the matter. Writing
for the UN committee that drafted the first SNA evaluation of household
production, Stone commented that it ‘is unnecessary to impute an income
to family services or to the services of household equipment and may even
prove an embarrassment to do so, since, not only are there very little data
in this field, but the principles on which such imputations should be made
are obscure’.27 He simply thought it was impossible to know how to do it –
and even if a solution could be devised, doing so would be socially
awkward.
 Now, seventy years later, since there is still no theory – beyond
ignorance or shame – that explains why housewives (and house husbands)
should not be included in GDP, the SNA architects have come up with a
different defence. They have expressed a ‘reluctance’ to include such work
because, although it is equivalent to work done by servants, ‘By
convention … only the wages of the domestic staff are treated as the value
of output.’28 The ‘convention’ here is ironically close to Marx’s value
theory that only someone who produces a surplus for a capitalist generates
surplus value. But Marx’s point was linked to his value theory and
understanding of how capitalism works (or does not work), whereas in this
instance the convention has been cherry-picked because it is convenient
for the current system.
In explaining why housework is accounted as unproductive, national
accountants are forced constantly to fall back on their ‘comprehensive’
production boundary, and are at pains to invoke ‘common sense’. Their
explanations include: ‘the relative isolation and independence of these
activities from markets, the extreme difficulty of making economically
meaningful estimates of their values, and the adverse effects it would have
on the usefulness of the accounts for policy purposes and the analysis of
markets and market disequilibria’.29
According to this awkward logic, a nation would increase its GDP if we
paid our neighbours to look after our children and do our laundry, and they
paid us to do theirs.30 Underlying this ‘common-sense’ approach to
household work is the utility theory of value: what is valuable is what is
exchanged on the market. The implicit production boundary is determined
by whether money changes hands for the service. Therefore, there is
‘extreme difficulty’ in giving a value to work done by women (or men)
who do not receive a wage in exchange for it.
By contrast, it is remarkable how national accountants go to great
lengths to include inside the production boundary the house itself, the
property in which the supposedly unproductive household work is done. In
the national accounts, houses owned by their occupants generate services
that are included in GDP. In the US, such ‘work’ contributes 6 per cent of
GDP – that is, a cool $1 trillion – even though none of these dollars
actually exist.
How do the statisticians come up with such an absurdity? They impute a
rent to everyone who lives in their own home. A market rent is estimated
for a property which the owner-occupier then pays herself as lessor for the
services the house provides. Since the imputed rent is regarded as income,
it is also recorded in the national accounts as production. Accountants
justify this with the argument that ‘both international and inter-temporal
comparisons of the production and consumption of housing services could
be distorted if no imputation were made for the value of own-account
housing services’.31
How might this work? Let’s contrast two countries. In one, there are
only renters paying owners such as real-estate companies (in Switzerland
in 2014 more people lived in rented homes than in owner-occupied
homes). In the other, all houses are owned (in the US and UK a larger
percentage of people own than rent). Since real estate adds value and
income (rent) from the actual rent charged (as opposed to the ‘imputed
rent’ calculated), the first country would have an unfairly high GDP
compared to the other, at least in terms of the percentage of GDP deriving
from property.
From a different perspective – one that sees no greater value in renting
over owning a house, especially when there is no rent control – we could
equally well ask why real-estate rents should add value in the first place.
Another valid question is why a hike in rent should increase the value
produced by real-estate agencies, especially if the quality of the rental
service is not improving. London and New York City tenants, for example,
know only too well that property management services do not improve
even though rents rise – in London’s case, rapidly in recent years.32
It’s also worth noting that the national accounts treat property and real
estate (both residential and commercial) as comparable to a firm. Buying a
house or factory building is called an ‘investment’. It is assumed that the
owner goes on ‘servicing’ the building, investing in its upkeep or
improvement, so their income is ‘payment for a service’ and not just rent.
Capital gains on buying and selling property are treated like those that
apply to a business or a financial asset – although the extent to which a
building is ‘productive’ is debatable. Capital gains from holding property
arise out of increases in land value, which itself are determined by
collective investment (in roads, schools, etc.) – little to do with the effort
of the property owner.
As with the absurdity of neighbours paying each other to do their
housework, it is as if the statisticians are saying that a nation of owner-
occupiers could artificially amplify GDP by swapping homes with their
neighbours and paying rent to one another. Statisticians have fiercely
defended their treatment of income from property. But when real-estate
prices appreciate rapidly, as in the US and the UK before 2007 and in hot-
spots such as London even after the financial crisis, there are alarming
implications for measuring. Rising house prices mean rising implicit
rentals, and hence rising incomes when the implicit rental is included. The
paradoxical result is that a house price bubble, perhaps caused by low
interest rates or relaxed lending conditions, will show up as an acceleration
of GDP growth. Why? Because households’ services to themselves – as
their own landlords, charging themselves implicit rentals – are suddenly
rising in value, and that is counted as income which adds to GDP. By the
same token, if you strip out those imputed rentals, GDP can be shown to
have risen more slowly in the years before the financial crash than after
2009.33

Prostitution, Pollution and Production

So national accountants’ approach to valuation affects the production
boundary, sometimes in intriguing ways. In the Netherlands, where
prostitution is legal and regulated, the tax authorities have asked sex
workers to declare their earnings, which count towards national income. In
other countries, such as the UK, earnings from prostitution are not
included in national income, except perhaps in estimates of the black
economy.
Equally importantly, the boundary loops around the issue of the
environment. Consider a river polluted by industrial waste. When the
polluter pays to clean it up, the expenditure is treated as a cost which
reduces profits and GDP. But when the government pays another company
to clean up the river, the expenditure adds to GDP because paying workers
adds value. If the cost of cleaning up pollution is borne by someone other
than the polluter it is called an externality – the cost is ‘outside’ the
polluter’s profit-and-loss account – and increases GDP. Kuznets argued
that such a calculation should be balanced by the ‘disservice’ that has been
created by pollution, and therefore that the cost of that ‘disservice’ be
taken out of the ‘net’ calculation of value added. But national accounts do
not do that: instead, they state that it is not ‘appropriate’ or ‘analytically
useful’ for ‘economic accounts to try to correct for presumed institutional
failures of this kind by attributing costs to producers that society does not
choose to recognize’.34
National accountants present this question of whether something is
‘analytically useful’ or not as a vague argument, without reference to
value. To be fair, they also rightly caution that it would be extremely
difficult comprehensively to cost such externalities – negative or positive
‘side effects’ of production – which are not priced. All of which just
highlights the difficulties of being consistent and drawing a clear
production boundary.
So while Marshall claimed that Nature does not make jumps (recall the
discussion of natura non facit saltus in Chapter 2), national income, it
appears, can do so! If self-employment (referred to as own-account
production for small farming or sex workers, for example) grows in
importance, or if a way can be found to cost externalities, national income
will jump when the statisticians decide to include it.

The Black Economy Gets into the SNA

Something similar happens with the black or – to use the official
euphemism – ‘informal’ economy when countries decide that it has grown
so large that they must start to include estimates of it in national
accounting. Consider Italy, a ‘developed’ country. The Group of 7 (G7),
the international club of the biggest economies, estimates that in 2015 the
informal economy made up 12.6 per cent of Italy’s GDP.35 That
calculation excludes illegal activities, which Italian statisticians decided to
leave out of their GDP measures. Since the Great Recession which began
in 2008, many more unemployed Italians have taken up informal
production. The Organization for Economic Cooperation and Development
(OECD), the grouping of mainly high-income countries, estimated that in
2013 Italy’s black market (including illegal activities – around 1 per cent
of GDP) was a massive 21 per cent of GDP.36 The same study found that,
across other European countries, informal activities comprised between 7
per cent and 28 per cent of GDP – activities which were incorporated in
the national accounts upon the recommendation of the 1993 and 2008
SNA.
All this begs the question: where does one start and stop? What is, or is
not, to be included in the national accounts? The very fact that these
questions are so difficult to answer illustrates the idiosyncrasies and
vagaries of the accounting system. And the biggest oddity of all has turned
out to be the so-called ‘banking problem’: how to estimate the
productiveness of finance.
More than any other sector, finance highlights the arbitrary way in
which modern national accounting decides where to draw the production
boundary. When the financial sector was small (before its boom in the
1970s), there was little difficulty in excluding it; interest was as much a
question of morality (positions against usury) as of economics. But as the
size of the financial sector grew it became more awkward to exclude it
from national output. The tension between economists’ – and indeed
society’s – long-held views of banks as unproductive and the steady post-
war growth of the sector gave rise to what is known as the banking
problem.
Until the 1970s, one of the principal sources of banks’ profits – net
interest payments, which are the difference between the interest that banks
charge for loans they make and the interest they pay on deposits – was
excluded from output in the national accounts. The only part of banks’
income which was included was fees for services people actually paid for,
such as the cost of opening or closing a bank account or getting mortgage
advice.
Yet next came an extraordinary change. From being perceived as
transferring existing value and ‘rent’ in the sense of ‘unearned income’,
finance was transformed into a producer of new value. This seismic shift
was justified by labelling commercial bank activities as ‘financial
intermediation’, and investment bank activities as ‘risk-taking’. It was a
change that co-evolved with the deregulation of the sector, which also
swelled its size even further. As this part of the story – how finance has
been ‘accounted’ for – is too big to treat in this chapter, the next two will
be devoted to it.

Profits versus Rents

As we saw in Chapter 2, the discussion about which parts of society were
productive or unproductive was much less explicit before the arrival of
marginal utility theory. And as we have seen in this chapter, moreover, as
long as products and services fetch a price on the market, they are deemed
worthy of being included in GDP; whether they contribute to value or
extract it is ignored. The result is that the distinction between profits and
rents is confused and value extraction (rent) can masquerade as value
creation.
The complexity of assessing government value added pales in
comparison with this glaring weakness in the SNA: a confusion between
profits and rents. Disentangling the two is fundamental to understanding
value. As we saw earlier, classical value theory held that income from
activities outside the production boundary was unearned. Rent – which
was regarded as unearned income – was classified as a transfer from the
productive to the unproductive sector, and was therefore excluded from
GDP. But if, as marginal utility holds, the ‘services’ of a landlord or hedge
fund manager are treated as productive, they magically become part of
GDP.
The SNA generally links what people earn with the industries which pay
them. Steel workers are paid by steel makers, shop workers are paid by
retailers, insurance workers are paid by insurance companies, and so on.
But income from property, dividends and lending, for example, is different
because the people receiving it are not necessarily directly linked to its
source (rent, dividends, loan interest etc.). If a steel firm rents an office,
the rent it pays could go to firms in other sectors, to the government or
even to households. A rich investor can derive income from dividends paid
by any number of productive companies. A creditor – such as a bank – can
lend money to several businesses or households and receive income as
interest from them. All these types of income cannot be pinned down
easily in the product account.
Although the SNA 2008 tried to deal with this difficulty, it did not state
that, for example, property income is a reward for production, merely that
‘Property income accrues when the owners of financial assets and natural
resources put them at the disposal of other institutional units.’37

PATCHING UP THE NATIONAL ACCOUNTS ISN’T ENOUGH

So while, in theory, balancing the national accounts between income and

expenditure requires a clear sense of where the production boundary lies –
where value is created – in practice the boundary is far from clear.
National accounts as they stand are certainly much better than nothing and,
among their merits, do permit consistent comparison between countries
and over time. But despite all the effort that has gone into developing it,
the SNA lacks a coherent and rigorous underlying value theory.
Government agencies such as the Bureau of Economic Analysis (BEA)
in the United States and the Office of National Statistics (ONS) in the
United Kingdom employ armies of people to estimate GDP, making
decisions about what is producing new value that enlarges the wealth of a
country. We are mesmerized into seeing this as the domain of a highly
specialized profession that uses sophisticated modern statistical methods to
provide precise parameters for the value that our society produces. The
growth rate of our economies is forecast years in advance using
complicated mathematics, with potential ‘outputs’ measured and GDP
estimated to a tenth of a percentage every quarter.
In reality, the national accounts have been subjected to repeated
attempts to patch them up and make them more relevant to changing needs
and economies. Accounting for environmental damage has been
mentioned. Accounting for happiness is another case. Lest the idea seems
impossible, or at least nothing to do with economics, it’s worth recalling
something basic: there is no point to the economy unless it helps people to
lead better lives – and that quite reasonably means, at least in part, happier
lives. The American economist James Tobin (1918–2002), who won the
Nobel Prize in Economics in 1981 and was a Professor of Economics at
Yale University for many years, wrote:
The whole purpose of the economy is the production of goods and services for
consumption now or in the future. I think the burden of proof should always be on those
who would produce less, rather than more, on those who would leave idle men or
machines or land that could be used. It is amazing how many reasons can be found to
justify such waste: fear of inflation, balance-of-payments deficits, unbalanced budgets,
excessive national debt, loss of confidence in the dollar.38

Making decisions about which goods and services to include in GDP

involves returning to the concept of the production boundary at the centre
of classical economic thought – distinguishing productive from
unproductive activities – and the theory of value that justifies such a
distinction. Is a theory just assumed, as in the work of Petty and King? Or
is it spelled out, as in Marx? And how can national accountants be
persuaded that an activity that was previously seen as a transfer of existing
value is actually creating new value? And above all, what do we mean by
growth?
The way we define and measure growth is of course affected by our
theory of value. And the resulting growth figures may guide the activities
that are deemed important. And in the process possibly distort the
economy.
GDP is worrying citizens and politicians everywhere: is it going up?
Falling? And by how much? Understanding how GDP is constructed is
thus crucial.
Unlike statisticians at the time of Smith or Marshall, modern
governments have a wealth of data and a sophisticated system of national
accounts that tracks the economy and the growth of each of its sectors. On
the one hand, this makes it possible to see in great detail who does what in
the economy – who is a ‘value creator’ and just how much everyone
contributes to the national product. On the other hand, because of the way
in which these accounts are set up, they are no more an objective metric of
value than Quesnay’s categorizations, or Smith’s, or Marx’s.
In essence, we behave as economic actors according to the vision of the
world of those who devise the accounting conventions. The marginalist
theory of value underlying contemporary national accounting systems
leads to an indiscriminate attribution of productivity to anyone grabbing a
large income, and downplays the productivity of the less fortunate. In so
doing, it justifies excessive inequalities of income and wealth and turns
value extraction into value creation.
Put bluntly, any activity that can be exchanged for a price counts as
adding to GDP. The accountants determine what falls into this category.
But what criteria do they use? The answer is a hodge-podge which
combines marginal utility with statistical feasibility and some sort of
common sense that invites lobbying rather than reasoning about value. It is
this that determines where the production boundary is drawn in the
national accounts.
The next chapter focuses on the most egregious case of boundary-
hopping: that of the financial sector, formerly seen as unproductive, now a
creator of value.
 4
Finance: A Colossus is Born

If the UK financial system thrives in the post-Brexit world, which is the plan, it will not
be ten times GDP, it will be fifteen to twenty times GDP in another quarter of a century.
Mark Carney, Governor of the Bank of England, 3 August 2017

A large and growing financial sector has long been presented as a sign of
UK and US success, credited with mobilizing capital to drive their
economic development and generating exports at a time when
manufacturing and farming had declined into net import. In the 1990s,
comparable financial-sector expansion became an ambition for other
countries seeking to follow the development path of these early
industrializers, and to lessen dependence on the import of capital and
services from the world’s ‘financial centres’ located in the UK and the US.
Underpinning this expansion is the belief that a country benefits from an
ever-growing financial sector, in terms of its growing contribution to GDP
and exports, and as total financial-sector assets (bank loans, equities,
bonds and derivatives) become an ever-larger multiple of GDP.
The celebration of finance by political leaders and expert bankers is,
however, not universally shared among economists. It clashes with the
common experience of business investors and households, for whom
financial institutions’ control of the flow of money seems to guarantee the
institutions’ own prosperity far more readily than that of their customers.
For those without large fortunes and for many with ‘assets under
management’, the notion of finance adding value has rung increasingly
hollow in the long shadow of the global financial crisis that began in 2008.
This required governments around the world to rescue major banks whose
‘net worth’ had turned out to be fictitious; with the bailouts continuing to
impose heavy social costs, ten years on, in the form of squeezed public
budgets, heavy household debt and negative real returns for savers.
But for much of recent human history, in stark contrast to the current
enthusiasm for financial-sector growth as a sign of (and spur to)
prosperity, banks and financial markets were long regarded as a cost of
doing business. Their profits reflected added value only to the extent that
they improved the allocation of a country’s resources, and cross-subsidized
a reliable payments system. Recurrent financial crises exposed the
regularity with which they threw resources in unproductive directions
(basically to other parts of the financial sector itself), ultimately disrupting
the flow of money and goods in the real economy. The fastest-growing
financial activities in 1980–2008 were asset management (making more
money by investing in liquid financial assets and property, for the segment
of the population earning enough to save) and lending to households,
rather than to businesses. Finance also diverted many highly trained
scientists and engineers away from work in direct production, by offering
them on average 70 per cent more pay than other sectors could afford. The
improbable level to which financial-sector profits rose, before and after the
latest crisis, reflects a deliberate decision during the twentieth century to
redraw the production boundary, so that previously excluded financial
institutions were now included within it – and, having redesignated finance
as productive, to strip away the regulations that had previously kept its
charging and risk-taking under control.
The current chapter looks at the expansion of banking, and the way in
which political decisions to recognize its value in national accounts
(although based on economically contentious assumptions) helped to drive
a deregulation which fuelled its ultimately over-reaching growth. In the
next two chapters I explore the relationship between this growth and the
financialization of the rest of the economy.

BANKS AND FINANCIAL MARKETS BECOME ALLIES

Policymakers’ faith in the value of finance was undiminished by its 2008

implosion. Indeed, their reaction to the global financial crisis was to insist
that more of each economy’s ‘capital’ should be assigned to private-sector
banks, and to support them with an ultra-relaxed monetary policy, in
which near-zero interest rates were supplemented by central banks’
buying-up of government or even corporate bonds to keep their prices
high. This massively increased the ‘asset’ side of the world’s main central
banks.
 Countries aspiring to achieve US levels of prosperity have long been
advised, especially by their multilateral creditors, to make ‘financial
deepening’ – the expansion and deregulation of banks and financial
markets – a central part of their development strategy. At the same time,
these creditors termed policies that restricted banks’ growth – such as
capping interest rates, or restricting cross-border lending – ‘financial
repression’, with the implication that financial liberalization was part of
wider liberation. After 2008, as after previous regional financial crises
(such as those that hit much of Latin America in 1982–3 and East Asia in
1997), the economists who had urged this liberalization asked themselves
whether the unleashing of financial sectors had gone too far. But they
invariably concluded that the crises were mere stumbles on a road
travelled faster when financial growth was unblocked. So in 2015, the IMF
concluded an exhaustive study ‘rethinking’ financial deepening by
concluding that while the positive effects of the sector’s expansion might
weaken at high levels of per-capita GDP, and/or if it grew too fast, ‘there
is very little or no conflict between promoting financial stability and
financial development’, and ‘most emerging markets are still in the
relatively safe and growth-enhancing region of financial development’.1
Yet the belief that economic progress requires a growing financial
sector, with banks at the heart of it, is counter-intuitive on a number of
counts. If financial intermediaries promote economic growth by
mobilizing capital and giving it better uses, national output (GDP) could
be expected to grow faster than financial-sector output, thus diminishing
its share of GDP. This must indeed be the case for many of the most
successful ‘newly industrializing countries’, if – as they claim – the US
and UK financial sectors have outgrown their home economies through the
export of capital and services to the rest of the world. If banks and
financial markets become more efficient, firms should make increased use
of their services over time, losing their early preference for internal
financing of investment out of retained profit. In practice, numerous
studies find that firms continue to finance most of their investment (in
production and new product development) internally through retentions,
because external financers know less about their activities and offset their
greater risk by demanding a higher return.2 And over time, financial
markets should, by gaining efficiency, be able to expand at the expense of
banks, which are usually explained as an alternative mechanism for
channelling funds from savers to borrowers when equity and bond markets
are insufficiently developed and information isn’t flowing freely.3 Yet
even in modern capitalist economies banks have entrenched their role at
the centre of the financial universe, to the extent of commanding wholesale
rescue when their solvency and liquidity drained away in 2008.

THE BANKING PROBLEM

As we’ve seen, problems arise in national accounting with activities that

appear to add value to the economy but whose output isn’t priced. Many of
the services provided by government and voluntary-sector organizations
fall into this category, as do private-sector products that are made freely
available, such as Google’s search engine and Mozilla’s browser. National
accounts conventionally ascribe a value to these, notwithstanding the free-
market critics’ objection that non-marketed goods and services are cross-
subsidized by (and constitute a drain on) the marketed-sector producers,
thus subtracting from national productivity.4
But an equally serious problem arises when prices are charged for (and
profits made from) a product or service that doesn’t obviously confer any
value. In most parts of the economy, this is classified and condemned as
monopoly rent-extraction. The trader who ‘corners the market’ in a
product and resells it at a premium by withholding supplies, or stands
between buyer and seller for no other purpose than to charge a commission
before the two can connect, is condemned for the same unproductive
profiteering as the highwayman who relieves travellers of cash before
allowing them to pass. Until the 1970s, the financial sector was perceived
as a distributor, not a creator, of wealth, engaging in activities that were
sterile and unproductive. At that point, through a combination of economic
reappraisal of the sector and political pressure applied by it, finance was
moved from outside to inside the production boundary – and in the process
wreaked havoc.
Governments across nineteenth-century Europe were convinced that
banks added value, and were vital for the achievement of industrial
modernization and economic growth. They were especially keen to
promote investment banks, which were viewed as essential both to channel
funds into productive investment and to co-ordinate firms and industries to
raise the efficiency and rates of return on this investment. Investment
banks’ importance in channelling professional investors’ funds into
productive industry rose up the political agenda because early savings
banks, which took deposits from households, often lost them to fraudulent
or excessively risky money-making schemes and so were steered by
regulation into buying mainly government bonds.5 By licensing only a few
investment banks, governments granted them the monopoly power needed
to co-ordinate expansion of related industries, and to achieve the profit
required to absorb high risks.6 The banks’ unique role in development was
recognized by some mid-twentieth-century economists, notably Joseph
Schumpeter (1934) and Alexander Gerschenkron (1962).7
The ‘banking problem’ arose because, as the twentieth century
progressed, banks’ role in fuelling economic development steadily
diminished in theory and practice – while their success in generating
revenue and profit, through operations paid for by households, firms and
governments, steadily increased. A fast-expanding part of the economy in
the middle of the twentieth century was not being accounted for. The
economists (like Schumpeter and Gerschenkron) who had ascribed banks a
key role in development were nevertheless clear that they achieved this
through exercising a degree of monopoly power, collecting rent as well as
profit. Mainstream opinion, meanwhile, continued to view banks as
intermediaries which, in charging to connect buyers and sellers (or
borrowers and savers), made their income by capturing value from others
rather than creating it themselves. Indeed today, if we use the value-added
formula, we find that the financial sector, far from contributing 7.2 per
cent of GDP to the UK economy and 7.3 per cent to the US (as the 2016
national accounts showed), in fact makes a contribution to output that is
zero, or even negative. By this yardstick it is profoundly, fundamentally
unproductive to society.
The ‘banking problem’, therefore, presented an oddity for national
accountants. Traditionally, commercial banks and most investment banks
make much of their income from interest differentials: they receive higher
interest on the loans they make to customers than the interest they pay on
funds they borrow. The charging of interest is justified in several
complementary ways. It is said, for instance, to be a ‘reward for waiting’,
compensating lenders for not being able to enjoy their money immediately
because they’re allowing someone else to use it. It may also be a reward
for taking risk. If money is not spent right now, it might yield less
satisfaction later: if, for instance, those who use it in the meantime should
lose all or part of it, or if its purchasing power is eroded by rising prices or
a falling exchange rate. Unless kept in a sock, all unspent money tends to
be lent to others, with no guarantee that money lent now will be repaid in
full and on time. Borrowers might lose it on a failed business venture, or
simply steal it and refuse to repay. Far from being ‘usurious’, therefore,
the payment of interest can be interpreted as the lender’s reward for
running the risk of never seeing their money again. The greater this risk,
the higher the interest they are justified in charging.
 Giving interest an economic function does not in itself explain how
banks create value. Economists have traditionally resolved the ‘banking
problem’ by assuming that banks create value in other ways, and use their
interest differential (the difference between borrowing and lending rates)
as an indirect way to capture this value, because it comes from delivering
services that cannot be directly priced. Banking, it is argued, provides
three main ‘services’: ‘maturity transformation’ (the conversion of short-
term deposits into mortgages and business loans); liquidity (the instant
availability of cash through a short-term loan or overdraft for businesses
and households that need to pay for something); and, perhaps most
importantly, credit assessment (vetting loan applications to decide who is
creditworthy and what the terms of the loan should be). As well as
channelling funds from lenders to borrowers, banks run the various
payments systems linking buyers to sellers. These activities, especially the
transformation of short-term deposits into long-term loans and the
guarantee of liquidity to customers with overdrafts, also mean a transfer of
risk to banks from other private-sector firms. This bundle of services
collectively constitutes ‘financial intermediation’. It is assumed that,
instead of directly charging for these services, banks impose an indirect
charge by lending at higher interest rates than they borrow at.
The cost of ‘financial intermediation services, indirectly measured’
(FISIM) is calculated by the extent to which banks can mark up their
customers’ borrowing rates over the lowest available interest rate. National
statisticians assume a ‘reference rate’ of interest that borrowers and lenders
would be happy to pay and receive (the ‘pure’ cost of borrowing). They
measure FISIM as the extent to which banks can push lenders’ rates below
and/or borrowers’ rates above this reference rate, multiplied by the
outstanding stock of loans.
The persistence of this interest differential is, according to the
economists who invented FISIM, a sign that banks are doing a useful job.
If the gap between their lending rates and borrowing rates goes up, they
must be getting better at that job. That’s especially true given that, since
the late 1990s, major banks have succeeded in imposing more direct
charges for their services as well as maintaining their ‘indirect’ charge
through the interest-rate gap.8
According to this reasoning, banks make a positive contribution to
national output, and their ability to raise the cost of borrowing above the
cost of lending is a principal measure of that contribution. The addition of
FISIM to the national accounts was first proposed in 1953, but until the
1990s the services it represented were assumed to be fully consumed by
financial and non-financial companies, so none made it through into final
output. The 1993 SNA revision, however, began the process of counting
FISIM as value added, so that it contributed to GDP. This turned what had
previously been viewed as a deadweight cost into a source of added value
overnight. The change was formally floated at the International
Association of Official Statistics conference in 2002, and incorporated into
most national accounts just in time for the 2008 financial crisis.9
Banking services are of course necessary to keep the economy’s wheels
turning. But it does not follow that interest and other charges on the users
of financial services are a productive ‘output’. If all firms could finance
their business investments through retained earnings (the profits they don’t
distribute to shareholders), and all households could pay for theirs through
savings, the private sector would not need to borrow, no interest would be
paid and bank loans would be redundant.
National accounting conventions recognize this incongruity by treating
the cost of financial services (FISIM plus direct fees and charges) as a cost
of production for firms or governments. This ‘production’ from financial
institutions that funds the activities of firms and governments immediately
disappears into ‘intermediate consumption’ by the public and non-financial
private sectors. It is only the flow of goods and services from non-financial
firms (and government) that counts as final production. But exceptions are
made for financial services provided to a country’s households and non-
resident businesses; these services, as well as direct fees and charges
imposed by financial institutions, are treated as a final output, counting
towards GDP alongside everything else that households and non-residents
consume. The steady growth in household borrowing in the UK, US and
most other OECD countries since the 1990s has automatically boosted
banks’ measured contribution to GDP, through the rising flow of interest
payments they collect from households. The increasingly hazardous nature
of lending to subprime and already indebted households further boosted
this measured contribution, since it resulted in a higher premium of
borrowers’ rates over the reference rate with inadequate adjustment for the
increased risks.10 The alleged under-reporting of key interbank lending
rates, commonly used as the reference rate, may have worsened the
exaggeration during 2008.
FISIM has ensured that the financial sector’s contribution to GDP has
kept growing since the financial turbulence of 2008–9, especially in the
US and UK. But if an intermediation service becomes more efficient, it
should absorb less of its clients’ output rather than more; it should make a
smaller contribution to GDP the more efficient it gets. Estate agents or
realtors, for example, generate income through commission on each
property sale. If they become more efficient, competition will drive down
commission rates and the remaining players will survive on lower
commission by reducing costs – making a smaller contribution to GDP.
The rules are different for finance. National accounts now state that we
are better off when more of our income flows to people who ‘manage’ our
money, or who gamble with their own. If professional investors profit by
investing in property during a boom, new ways of accounting will register
the profit as a rise in their GDP contribution. Short-selling (or ‘shorting’),
which involves borrowing an asset and selling it in the expectation of
buying it back after its price has fallen,11 is another speculative activity
whose growth contributes to GDP under the new form of measurement. If
money is made by shorting property-related investments before a slump, as
investors such as the hedge fund manager John Paulson famously did
before the 2008 crash, the profit increases GDP. But surely if, for example,
bus fares kept rising in real terms, we’d demand to know why bus
companies were becoming less efficient, and take action against operators
who used monopoly power to push up their prices? But when the cost of
financial intermediation keeps rising in real terms, we celebrate the
emergence of a vibrant and successful banking and insurance sector.
According to theories that view the financial sector as productive, ever-
expanding finance does not harm the economy; indeed, it actually
facilitates the circulation of goods and services. Yet all too often
investment funds and banks act to increase their profits rather than channel
the proceeds into other forms of investment, such as green technology.
Macquarie, the Australian bank which used post-privatization acquisitions
to become one of the world’s largest infrastructure investors, quickly
became known for securing additional debts against these assets so that
more of their revenues were channelled into interest payments, alongside
distributions to shareholders. After acquiring Thames Water in 2006, it
used securitization to raise the company’s debt from £3.2 billion to £7.8
billion by 2012, while avoiding major infrastructure investment,12 The
strategy raised alarm among environmentalists when, in 2017, Macquarie
acquired the Green Investment Bank, a major financer of renewable
energy and conservation projects set up by the UK government five years
earlier. Moreover, once financiers realize that very little value stands
behind their liabilities, they try to issue even more debt to refinance
themselves. When they cannot continue to do so, a debt deflation occurs,
such as the one that began in the US and Europe in 2007–8 and was still
depressing global growth rates ten years later. Society at large then bears
the costs of the speculative mania: unemployment rises and wages are held
down, especially for those left behind during the previous economic
expansion. In other words, value is extracted from labour’s share of
earnings in order to restore corporate profits.
It is, then, difficult to think about the financial sector as anything but a
rentier: a value extractor. This, indeed, was the economic verdict on
finance before the 1970s, incorporated into national accounts, until a
decision was taken to ascribe ‘value added’ to banks and their financial-
market activities. That decision redesignated, as results of productive
activity, financial profits that economists previously had little problem
ascribing to banks’ monopoly power, associated with economies of scale
and governments’ recognition that the biggest were ‘too big to fail’. The
redrawing of the production boundary to include finance was in part a
response to banks’ lobbying, which was itself a feature of their market
power and influence. By showing finance as a large and growing source of
national output, it overthrew the logic of previous financial regulation.
Where beforehand such regulation had been seen as a safeguard against
reckless and rent-seeking behaviour, it was now portrayed as a shackle
suppressing a valuable trade in money and risk.

DEREGULATION AND THE SEEDS OF THE CRASH

Financial sectors were heavily regulated in the early 1970s, even in

countries with large international financial centres such as the US and UK.
Governments viewed regulation as essential, because a long international
history of bank crashes and failed or fraudulent investment schemes
showed how, left to themselves, financial firms could easily lose
depositors’ money and, in so doing, disrupt real economic activity and
even cause social unrest. When banks competed, they tended to offer ever
more improbably high returns to savers by funding ever more risky
investment projects, until disaster (and bankruptcy) struck. But while such
competitive instability was averted by restricting entry, and giving banks
some monopoly power, they still inflicted damage on the rest of the
economy in other ways – by artificially inflating the price of loans, and co-
ordinating their buying and selling to cause artificial boom and bust in the
prices of key commodities. Small banks were especially vulnerable
because their (and clients’) activities were insufficiently spread across
different industries and geographical regions. But big banks quickly
became ‘too big to fail’, assured of expensive government rescue when
overextended because their collapse would do too much economic
damage. Such assurances only led them to behave even more recklessly.
 Governments’ appetite for financial regulation increased after the global
depression of the 1930s, heralded by the collapse of insufficiently
regulated stock markets and banks, and the world war to which this
indirectly contributed. In 1933, following the Wall Street Crash, the US
had separated commercial banks (financial institutions which took
deposits) from investment banks (financial firms raising money for
companies through debt and equity issues, corporate mergers and
acquisitions, and trading in securities for their own account) under the
Glass–Steagall Act. The Act’s regulations were in some respects
strengthened by the Bretton Woods Agreement of 1944. In line with the
so-called ‘Keynes Plan’, the Bretton Woods system imposed tight curbs on
international capital movements in order to preserve a system of fixed
exchange rates – thereby ruling out most of the cross-border investments
and currency trades which had previously been major sources of instability
and speculative profits. The Bretton Woods Agreement also required
governments to maintain tight restrictions on their domestic financial
sectors – including high minimum ratios of capital to assets and liquid
reserves to total bank assets, interest rate caps and, in the US, strict legal
separation of commercial and investment banking. The cornerstone of the
Bretton Woods currency system was the gold standard, under which the
dollar was convertible into gold at $35 an ounce.
Such measures made it hard for financial institutions to shift their
business to low-tax or low-regulation jurisdictions. The rules reflected
policymakers’ consensus that financial institutions acted at best like a
lubricant for the ‘real’ motors of the economy – agriculture, manufacturing
and business services – and were not significantly productive in
themselves. It was feared that a deregulated financial sector could become
excessively speculative, causing disruption domestically and to the
external value of currencies. But in the 1960s, as the idea of ‘light-touch’
regulation became increasingly attractive, such measures were increasingly
viewed on both sides of the Atlantic as an obstacle to circumvent.
During this time, banks never ceased to lobby against the regulations
that deprived them of significant markets, and others (like the Glass–
Steagall Act) which restricted their scope to combine operations in
different markets. As well as pushing for an end to regulations, banks
proved adept at persuading politicians that restrictive regulations were
unworkable, by finding ways to work around them. Bans on speculative
derivatives trading, enacted in the US in the 1930s because of its role in
magnifying the 1929 Crash and Great Depression, were effectively
sidestepped by the growth of unregulated over-the-counter derivatives
trading, which grew explosively in the 1980s and defied subsequent efforts
at re-regulation.13 Banks’ invention of ‘offshore’ currencies, to sidestep
cross-border capital controls, was especially effective. In 1944, the Bretton
Woods system had pegged the value of the dollar to gold. But when the
post-war boom, based on manufacturing, tailed off around 1970, ‘light-
touch’ financial regulation increasingly appealed to policymakers on both
sides of the Atlantic. The financial sector reacted to this interest by
developing a new currency, the Eurodollar.
As non-US companies, mainly in Europe, accumulated dollars from
exports to the US and from oil sales, financiers realized they could borrow
and lend in these dollars, which would be outside the control of European
governments because they had not issued the currency. UK banks were
keen as early as 1957 to mobilize their dollar-denominated deposits, as the
chronic balance-of-payments deficit forced the government to impose
controls on their use of sterling for foreign transactions.14 Russian banks
stepped up their use of Eurodollars in fear of financial sanctions from the
US, and were joined by US banks as they correctly anticipated the
suspension of convertibility by the US in response to its worsening US
external deficit. London became the centre of the Eurodollar market,
which grew into a global one. Rather than being reinvested in the US
economy to build new factories or research laboratories, Eurodollars were
siphoned off to developing countries in search of a higher yield than was
available in developed economies at the time. The result was what has
been called the ‘dollar shortage’, meaning that the currency was
insufficient even for the country that issued it – the US.15 In 1971, faced
also with the cost of the Vietnam War and mounting inflation, President
Richard M. Nixon stepped in to avert a vacuum in the vaults of the US
Bullion Depository at Fort Knox by suspending the dollar’s convertibility
into gold. It was a dramatic move which signalled the end of the Bretton
Woods system and the start of a search for a new way to manage
international trade and payments, which was far more market-driven.
There followed a period of zero growth and high inflation (‘stagflation’),
exacerbated by OPEC quadrupling the oil price in the 1970s. By 1980, the
gold price had reached $850 an ounce.
The economic difficulties industrial economies faced were regarded by
some as a crisis of capitalism. What was not anticipated at the time was
that financial markets would be hailed as the way out of the crisis. Finance
turned into a growth hormone that would restore and sustain economic
expansion.
 The deregulation and transformation of finance was both a response to,
and a cause of, huge social and economic changes which began in the
1970s. Globalization increased competition, particularly in manufacturing,
and in Western countries many communities built on manufacturing –
from toys to steel – saw those jobs head east to Asia. The rust belts of the
American Midwest, northern England and regions of Continental Europe
such as Wallonia in Belgium suffered wrenching social dislocation.
Energy prices soared, driving up inflation and further increasing pressure
on household budgets. The resulting slower economic growth held down
wage rises in richer countries, and hence also the taxes raised by
governments. Inequalities of income and wealth widened as profits’ share
of national income relative to wages grew, in turn partly reflecting the
weakening of workers’ bargaining power, for example by restricting the
rights of trade unions and diluting labour laws.
The competing financial centres of London and New York worked out
that they could attract more business by lightening their regulatory touch,
with lower costs of compliance. In the US there was perceived to be a
shortage of credit for small businesses and home buyers. In fact the real
issue was the price of credit, which economists tended to blame on a
combination of regulation forcing costs up and banks’ monopoly power
pushing charges up; the response was to allow more competition between
lenders. From the 1960s, Federal banking regulators, interpreting Glass–
Steagall with increasing generosity, allowed financial institutions to
undertake a growing range of activities. Household borrowing began to
climb steeply. Under the Heath government in 1971, the UK adopted a
temporary policy known as ‘Competition and Credit Control’, whereby
quantitative ceilings on bank lending were lifted and reserve ratios for
commercial banks were reduced.16 In 1978 minimum commissions were
abolished on the New York Stock Exchange, clearing the way for
competition and higher trading volumes. A year later, the Thatcher
government in the UK abolished exchange controls.
Then, in 1986, Big Bang financial reforms in the City of London did
away with fixed commissions for buying and selling shares on the London
Stock Exchange, allowed foreigners to own a majority stake in UK
stockbrokers, and introduced dual capacity which allowed market makers
to be brokers and vice versa. Most of London’s stockbroking and market-
making firms were absorbed by much bigger foreign and domestic banks.
In the late 1990s, supercharged by the IT revolution, the volume of
securities trading rocketed. Commercial banks could now use their huge
balance sheets, based on customers’ deposits, to speculate. Their
investment banking arms, along with independent investment banks such
as Goldman Sachs, developed financial instruments of increasingly mind-
blowing complexity.

THE LORDS OF (MONEY) CREATION

Large financial firms were, however, careful to secure a lightening of

regulation, rather than the complete deregulation advocated by free-
marketeers such as the Nobel Prize-winning economist Friedrich Hayek.
Their reasoning was as follows. To maintain their high profits, the big
commercial and investment banks still needed regulators who would keep
potential competitors out of the market. Existing big players are therefore
helped if banking licences are restricted. Ironically, the disastrous big bank
behaviour that triggered the 2008 crash forced regulators (especially in
Europe) into further lengthening and complicating an already arduous
process for obtaining a new licence, frustrating their plans to unleash a
hungry horde of ‘challenger banks’. In issuing licences sparingly,
governments and central banks were quietly admitting something they
were still reluctant to announce publicly: the extraordinary power of
private-sector bank lending to affect the pace of money creation, and
therefore economic growth.
That banks create money is still a highly contested notion. It was
politically unmentionable in 1980s America and Europe, where economic
policy was predicated on a ‘monetarism’ in which governments precisely
controlled the supply of money, whose growth determined inflation. Banks
traditionally presented themselves purely as financial intermediaries,
usefully channelling household depositors’ savings into business
borrowers’ investment. Mainstream economists accepted this
characterization, and its implication that banks play a vital economic role
in ‘mobilizing’ savings. Banks are not only empowered to create money as
well as channel it from one part of the economy to another; they also do
remarkably little to turn households’ savings into business investment. In
fact, in the US case, when the flow of funds is analysed in detail,
households ‘invest’ their savings entirely in the consumption of durable
goods while large businesses finance their investment through their own
retained profits.17
They also had to overlook the fact that money appears from nowhere
when firms or households invest more than their savings, and borrow the
difference. When a bank makes you a loan, say for a mortgage, it does not
hand over cash. It credits your account with the amount of the mortgage.
Instantly, money is created. But at the same time the bank has also created
a liability on itself (the new deposits in your account), and banks must
ensure they have sufficient reserves or cash (both forms of central bank
money) to meet requests by you for payments to other banks or cash
withdrawals. They must also hold capital in reserve in case loans are not
repaid, in order to prevent insolvency. Both of these create constraints on
bank lending and mean that banks generally refrain from lending to people
and firms that do not fulfil certain criteria such as creditworthiness or
expected profitability. Money creation also occurs when you pay for
dinner with a credit or debit card. As a matter of fact, only about 3 per cent
of the money in the UK economy is cash (or what is sometimes called fiat
money, i.e. any legal tender backed by government). Banks create all the
rest. It wasn’t until after the 2008 crisis that the Bank of England admitted
that ‘loans create deposits’, and not vice versa.18
So licensing and regulation gave smaller banks a significant cost
disadvantage compared to big ones, which can spread the bureaucratic
costs (and risks) more widely and raise funds more cheaply. This made it
harder for new competitors to enter the market. For existing players, there
was a lot of monopoly rent to extract, and they could easily co-ordinate
between them to avoid excessive competition without needing formal
(illegal) cartel arrangements, while customers trusted them – rarely
questioning their practices or financial health – precisely because
regulators were watching over them. For example, it took an investigation
by the UK’s Competition Commission in 2000 to establish that the
country’s Big Four banks had been operating a complex monopoly on
services for small businesses, using their 90 per cent market share to
extract £2 billion in annual profit and push their average return on equity
up to 36 per cent, by mutually agreeing not to compete.19 If banks’
gambles ever endangered their solvency, the government would have to
rescue them with public money. This implicit guarantee of a public bailout
lowered the biggest players’ cost of raising capital, which further
cemented their market power.

FINANCE AND THE ‘REAL’ ECONOMY

For centuries, income earned by charging interest had been viewed as a

subtraction from productive enterprise rather than a symbol of it. This was
both a moral and an economic judgement. As we have seen, the Roman
Church banned the charging of interest for most of the Middle Ages, while
Enlightenment philosophers such as John Locke, writing in 1692, saw
bankers merely as middlemen, ‘eating’ up a share of the gains of trade
rather than creating any gains themselves.20 Even before the formal study
of economics began in the late eighteenth century, many intellectuals and
writers had concluded that banks did not produce value and often did not
operate in the public interest at all.
For the physiocrats, finance didn’t belong in the agricultural sector and
was therefore seen as unproductive. Adam Smith took a similar view,
though he also rarely mentioned bankers explicitly. According to Smith,
bankers cannot create more than they get; for him, the idea of making
money from money does not work in the aggregate – although it certainly
helps the bankers fill their own pockets.
Karl Marx introduced another idea. He located the financial sector in the
circulation phase of the circuit of capital, where value created in
production is realized through distribution and ultimately used up in
consumption. For Marx, finance is a catalyst, transforming money capital
into production capital (the means of production such as factories,
machinery and living labour – the labour power of workers). Hence any
income is paid out of the value generated by others. Rather than adding to
value, finance simply takes part of the surplus value generated through the
production process – and there is no hard-and-fast rule as to how much it
should take. Taking (not uncommonly) reassurance about capitalism from
its arch-opponent, twentieth-century economists assumed that financial
profits would always be limited by (and total less than) the sum of
productive firms’ profits, and might even move up and down to even out
the flow of profits in the ‘real’ economy.
But this story came under attack after the crisis. Trade in financial
instruments had vastly outgrown trade in real products and was stimulating
the very price fluctuations from which profits are made – by creating
opportunities to buy low and sell high. In fact, systemic fluctuations have
led to a crash historically every fifteen to twenty years.21 Crashes reveal
the investment banks’ ‘risk-taking’ service – which justified their inclusion
in GDP accounting – to be a hollow boast. It is the taxpayer who is called
on to take the real risk, bailing out the banks. But even the most influential
critics of finance in the twentieth century – Keynes and Minsky – did not
succeed in fundamentally challenging the privileged place of financial
institutions in economic policy and in the national accounts. Keynes’s
attention was deflected (and Minsky’s early warnings obscured) by the fact
that financial services’ share of national output was below 4 per cent and
falling from 1933 to 1945, and did not move back above its 1930s level
until the 1970s.
Writing in the 1930s, one of the most influential critics of finance, John
Maynard Keynes, was upfront about what financial speculation entailed. In
his lifetime he observed how financial markets and public attitudes to
financial trading were changing, becoming ends in themselves rather than
facilitators of growth in the real economy. When speculation spread from a
rich leisure class to the wider population, it drove the stock market bubble
that ushered in the Wall Street Crash and 1930s depression; but as public
spending helped to restore people’s jobs and incomes, those with money
again began to gamble it on stocks and shares. Wall Street was, he said,
‘regarded as an institution of which the proper social purpose is to direct
new investment into the most profitable channels in terms of future yield’.
By this yardstick, Keynes commented, Wall Street could not ‘be claimed
as one of the outstanding triumphs of laissez-faire capitalism – which is
not surprising, if I am right in thinking that the best brains of Wall Street
have been in fact directed towards a different object’.22
That ‘different object’, in Keynes’s view, was not a form of production,
but ‘betting’ – and the profits of the bookmaker were ‘a mere transfer’,23 a
transfer which should be limited lest individuals ruin themselves and harm
others in the process. Moreover, Keynes argued, since gambling is luck,
there should be no pretence that financial speculation involved skill. Any
reference to skill – or productiveness on the part of speculators – was a
sign that somebody was trying to trick somebody else. Keynes also
thought that the proceeds from such betting and speculating should go to
the state to remove the incentive – a better word might be temptation – to
reap private gains from it.24 He went on to stress the difference between
this kind of speculation (value extraction) and finance for actual
productive investment (value creation), which he saw as crucial for growth
and which was only possible without the speculative apparatus around it. If
‘the capital development of a country becomes a by-product of the
activities of a casino, the job is likely to be ill-done’.25
The US economist Hyman Minsky, who was much influenced by
Keynes, wrote extensively about the self-destabilizing dynamics of
finance. In his work on financial instability26 he nested Keynes’s critique
within an alternative theory of money. This theory, which began far from
the mainstream but forced its way in when a bubble-bursting ‘Minsky
moment’ broke the long boom in 2008, holds that the quantity of money in
an economy is created by the interplay of economic forces rather than by
an outside agency such as a country’s central bank. Although portrayed as
all-powerful (and so responsible for all financial instability) by Milton
Friedman and the ‘monetarists’ propelled to prominence by 1970s
stagnation, central banks such as the US Federal Reserve can only
indirectly and weakly control the private-sector banks and their money
creation, by setting the base interest rate. Minsky charted the way in which
the banking system would eventually end up moving to ‘speculative
finance’, pursuing returns that depended on the appreciation of asset
values rather than the generation of income from productive activity.
Banks and investment funds may believe they are deriving income from
new production, and their individual ‘risk models’ will show that they will
survive most conceivable financial shocks because of the diversification of
their portfolios. But their incomes are ultimately transfers from other
financial firms, and can suddenly dry up when one firm’s inability to meet
a transfer obligation (defaulting on a loan, or withholding a dividend)
forces others to do so in turn. That is what happened when Lehman
Brothers, the American investment bank, collapsed in 2008, thereby
precipitating the financial crisis.
As long as financial assets can be bought and sold in a reasonable
amount of time without incurring losses, and debt can be rolled over to pay
previous loans, markets are liquid and the economy runs smoothly. But
once investors realize that borrowers are not earning enough to pay interest
and principal (on which the interest is based), creditors stop financing
them and try to sell their assets as soon as possible. Financial bubbles can
be seen as the result of value being extracted; during financial crises value
is actually destroyed. The fallout can be measured not only in output and
job losses but also by the amount of money that governments had to pour
into private banks because they were ‘too big to fail’: the quantitative
easing (QE) schemes that followed the crisis might have been used to help
sustain the economy, but ended up further propping up the banks. The
figures involved were enormous. In the US, the Federal Reserve embarked
on three different QE schemes, totalling $4.2 trillion over the period 2008–
14. In the UK, the Bank of England undertook £375 billion of QE between
2009 and 2012, and in Europe, the ECB committed € 60 billion per month
from January 2015 to March 2017.27

Back in the mid-1980s, to try to prevent the banking system from moving
to speculative finance, Hyman Minsky formulated an economic recipe that
can be summarized as ‘big government, big bank’. In his vision,
government creates jobs by being the ‘employer of last resort’ and
underwrites distressed financial operators’ balance sheets by being the
‘lender of last resort’.28 When the financial sector is so interconnected, it is
very possible for one bank’s failure to become contagious, leading to the
bankruptcy of banks all over the world. In order to avoid this ‘butterfly
effect’, Minsky favoured strong regulation of financial intermediaries. In
this he followed his mentor Keynes, who, as the post-war international
order was being devised at Bretton Woods in 1944, advocated ‘the
restoration of international loans and credit for legitimate purposes’, while
stressing the necessity of ‘controlling short-term speculative movements or
flights of currency whether out of debtor countries or from one creditor
country to another’.29
According to Keynes and Minsky, the possibility of financial crisis was
always present in the way that money circulated – not as a means of
exchange, but as an end in itself (an idea based predominantly on Marx’s
thinking). They believed that government had to intervene to avert or
manage crises. Although controversial in the 1930s (due to its undertones
of ‘socialism’ and central planning) and later (after the revival of free-
market economics, including the idea of unregulated ‘free’ banking), the
idea of intervention in markets was hardly novel or radical. Back in the
eighteenth century, Adam Smith’s belief that a free market was one free
from rent implied government action to eliminate rent. Modern-day free
marketeers, who have gagged Smith while claiming his mantle, would not
agree with him.
Financial regulators have focused on introducing more competition –
through the break-up of large banks and the entry of new ‘challenger
banks’ – as an essential step towards preventing another financial crisis.
But this ‘quantity theory of competition’ – the assumption that the problem
is just size and numbers, and not fundamental behaviour – avoids the
uncomfortable reality that crises develop from the uncoordinated
interaction of numerous players.
There is danger in a complex system with many players. Greater
stability might be achieved when a few large companies serve the real
economy, subject to heavy regulation in order to make sure that they
concentrate on value creation and not value extraction. By contrast,
deregulation designed to reinvigorate a part of the financial sector may
well promote risk-taking behaviour – the opposite of what is intended.
Lord Adair Turner, who took over as Chair of the UK financial regulator
(then called the Financial Services Authority) in 2008, just as the system
was crashing around it, reflected when the dust settled that: ‘financial
services (particularly wholesale trading activities) include a large share of
highly remunerated activities that are purely distributive in their indirect
effects … the ability of national income accounts to distinguish between
activities that are meaningfully value-creative and activities that are
essentially distributive rent extraction is far from perfect’.30
 Neither William J. Baumol (1922–2017), whose descriptions of
‘unproductive entrepreneurship’ could account for much financial activity
but who is now a leading contributor to mainstream portfolio and capital-
market theory, nor Turner, despite his subsequent leading role in the
Institute for New Economic Thinking, discuss finance much in terms of
value theory. Yet their thinking implies that finance should be
fundamentally reformed to create value inside the production boundary,
and that those of its elements outside the boundary should be drastically
reduced, eliminated or competed away. Lord Turner’s more considered
verdict, ten years on from the start of the crisis, was to bemoan the ever
larger amount of debt needed to add an extra dollar to GDP, but then trace
much of this to the bad aggregate effects of essentially good lending,
which ‘private lenders do not and cannot be expected to take into account’.
His prescriptions, requiring more and smarter financial regulation to
monitor and control the system’s aggregate risks, actually imply additional
and permanent effort by public authorities to make the marketplace safe
for private bank (and shadow-bank) profit.
Over the past decades, Keynes’s and Minsky’s insights and warnings
about the potentially destructive nature of an unbridled financial sector
have been totally ignored. Today, the economic mainstream continues to
argue that the bigger (measured by the number of actors) or ‘deeper’
financial markets are, the more likely they are to be efficient, revealing the
‘true’ price and therefore value of an asset in the sense defined by the
Nobel Prize-winning US economist Eugene Fama.31 An ‘efficient’ market
is, in Fama’s definition, one that prices every asset so that no further profit
can be made by buying and reselling it. This way of thinking reconciles the
case for large financial markets with the high incomes paid to employees
in financial services, because incomes supposedly reflect the huge benefits
of financial services to the economy.32
From the perspective of marginal utility, therefore, the expansion of
finance is highly desirable and should increase its value added, and hence
its positive contribution to GDP growth,33 even though it was only a
convenient decision to treat finance as productive in the national accounts
in the first place.34
But it is impossible to understand the rise of finance without analysing
the background dynamics which allowed it to thrive: deregulation and
rising inequality.

FROM CLAIMS ON PROFIT TO CLAIMS ON CLAIMS

Commercial banks seem literally to have been given a licence to print
money, through their ability to create money in the process of lending it,
and to lend it at higher interest rates than they borrow. But such lending
remains a risky source of profit, if those they lend to don’t pay back. And
because they can only lend if a household or business wants to borrow, it’s
a highly cyclical source of profit, rising and falling with the scale of
investment activity. So from the start, commercial bankers have sought to
do more with the money they create – and the additional funds they take in
from depositors – than just lend it to prospective borrowers. They’ve eyed
the lucrative world of financial markets – dealing in shares and bonds, on
behalf of clients and on their own account – as an additional source of
profit. That’s why the Glass–Steagall Act and its counterparts elsewhere,
forcing banks to choose between taking customer deposits or playing the
markets, was so unpopular in banking circles, and why they celebrated its
repeal at the turn of the twenty-first century.
The move into investment banking was made more attractive by other
aspects of financial deregulation. It enabled investment banks to poach
some of the commercial banks’ most profitable clients: large businesses
which could finance investment by issuing bonds rather than taking bank
loans, and high-net-worth individuals seeking private wealth management.
And it opened up a range of new financial markets for investment banks to
gamble on, trading instruments which had long been known about but
which past regulations had effectively banned.
Two classes of financial instrument in particular were made available to
investors by deregulation from the 1970s onwards, and were central to the
subsequent massive growth in financial transactions and profitability.
These were derivatives, contracts on the future delivery of a financial
instrument or commodity which allowed investors to make bets on their
price movement; and securitizations, bundles of income-yielding
instruments that turned these into tradable securities (and enabled their
inclusion in derivative contracts). Commercial banks made a particular
breakthrough in the early 2000s when they began to ‘securitize’ past
lending to finance new lending. Home mortgages were the initial focus,
enabling banks like the UK’s Northern Rock to grow their loans at
unprecedented speed, and win political praise for making these loans
available to households previously dismissed as too poor to borrow. After
the 2008 financial crash – triggered in part by debt securitizations rendered
worthless by default on the underlying mortgages – attention turned to
securitizing other forms of obligation, among them ‘personal contract
plans’ and other car loans, student loans and residential rents.
 Political leaders and financial experts praised financial markets for
helping goods and services markets to work more efficiently and grease
the wheels of capitalism. In his ‘The Great Moderation’ speech in 2004,
Ben Bernanke, who later became the Chairman of the US Federal Reserve,
said: ‘The increased depth and sophistication of financial markets,
deregulation in many industries, the shift away from manufacturing toward
services, and increased openness to trade and international capital flows
are other examples of structural changes that may have increased
macroeconomic flexibility and stability.’35 Spectacular growth in the
volume of derivatives – which can be traded even if the underlying assets
were never delivered or deliverable – was viewed as helping to reduce
systemic risks and ‘get prices right’. The often enormous profits were
dressed up as fulfilling the worthy social objective of spreading and
managing risk so that the previously unbankable and uncreditworthy could
be brought in from the cold and sold products – especially homes – that the
more affluent took for granted.
As we saw in Chapter 3, banks mark up borrowers’ interest rates as an
indication of value added (FISIM): an obvious example of fictitious
financial value. But this is only the tip of the iceberg. Today, leading
investment banks like Goldman Sachs and J. P. Morgan don’t attribute
their employees’ vast salaries to success in ordinary borrowing and
lending. The great bulk of these banks’ profits comes from activities such
as underwriting the initial public offerings (IPOs) of corporate bonds and
shares, financing mergers and acquisitions, writing futures and options
contracts that take over risk from non-financial businesses, and trading in
these and other financial instruments for capital gain.
The subtle yet fundamental change in the way that the banking sector’s
productivity has been redefined over the last two decades or so has
corresponded with its increasing capture of the economy’s surplus. The
massive and disproportionate growth of the financial sector (and with it the
origins of the global financial crisis) can be traced back to the early 2000s,
when banks began increasingly to lend to other financial institutions via
wholesale markets, making loans not matched by deposits. In the UK the
‘customer funding gap’ between loans advanced and deposits from
households (traditionally viewed as the most stable form of bank
financing) widened from zero in 2001 to more than £900 billion ($1,300
billion) in 2008, before the crisis cut it to less than £300 billion in 2011.36
Banks and other lenders found that wholesale funds could be raised much
more cheaply than deposits from retail or business customers, especially
by using their customers’ existing loans, such as mortgages, as security for
more borrowing. These lenders benefited from a seemingly virtuous circle
in which additional lending raised financial asset prices, which
strengthened their balance sheets, giving them the scope to borrow and
lend more within existing minimum capital ratios, the amount of capital
banks had to retain relative to their lending.
As well as lending more to one another and to retail clients, over the
past three decades banks began to target their loans at riskier prospects
offering higher rates of return. This is the part of the story that most people
now understand, having been well covered in the media and popular
culture, in books and films such as Inside Job, Margin Call and The Big
Short. Banks felt they needed to take more risks because, with
governments trying to balance budgets and reduce public borrowing
requirements, the yields on low-risk assets (such as US and European
government debt) had fallen very low. Banks also believed that they had
become much better at handling risk: by configuring the right portfolio,
insuring themselves against it (especially through credit default swaps –
CDSs – that would pay out if a borrower didn’t pay back), or selling it on
to other investors with a greater risk appetite. Investment banks lent to
hedge funds and private equity firms and developed and traded exotic
instruments based on assets like subprime mortgages, because the returns
were higher than lending to industry or government.
When channelling short-term deposits into long-term loans, banks
traditionally took a risk – especially when the loans went to borrowers who
would need a windfall gain (a business that took off, a house price that
rose) to pay back their loans. Ostensibly, that risk disappeared in the 1990s
and early 2000s, when securitization turned a bundle of subprime
mortgages or other loans into a bond with a prime (even triple-A) credit
rating in the shape of a mortgage-backed security (MBS).
Securitization can and does play a valuable role in diversifying risk and
increasing liquidity in the financial system. In 2006 Alan Greenspan, then
Chairman of the US Federal Reserve, and Tim Geithner, the former
President of the Federal Reserve Bank of New York, claimed that
derivatives were a stabilizing factor because they spread the risk among
the financial institutions best equipped to deal with it.37 Greenspan had, a
decade before the crisis struck, vetoed a proposal to regulate over-the-
counter (OTC) derivatives, claiming that on the contrary ‘the fact that
OTC markets function so effectively without the benefits of the
Commodity Exchange Act [CEA] provides a strong argument for
development of a less burdensome regulatory regime for financial
derivatives traded on futures exchanges’. Passed in 1936, the CEA requires
all futures contracts for physical commodities to be traded on an organized
exchange. As was spectacularly shown in 2008, derivatives’ capacity to
transfer and defray risk really exists only at the individual level. At the
aggregate level, the individual risk is merely transferred to other
intermediaries in the form of counter-party risk. Its disappearance from the
balance sheets of the original holders, and the frequent lack of clarity
about who has taken it over, makes the market situation even more
precarious.38
Securitization was also abused, sometimes in ways that bordered on
fraudulence, and that abuse certainly influenced regulators in the years
following the financial crisis. The transformation of relatively low-quality
loans into triple-A-rated securities occurred largely because credit-rating
agencies routinely gave high valuations to securitizations of low-grade
debt, underestimating the likelihood of default, especially on residential
mortgages. To be doubly sure that their high returns were sheltered from a
comparably high risk, banks ‘transferred’ their risk by assigning the
securitized debt to ‘special purpose vehicles’ (SPVs), whose liabilities did
not show up on the banks’ own balance sheets. When lower-income
borrowers began struggling to repay their debts after 2005, the securitized
bonds turned out to be much less safe than their triple-A rating suggested,
and the SPVs bounced back onto the banks’ balance sheets. The golden
combination of high return and low risk turned out to be a statistical
illusion, but one that national accounting had promoted just as
enthusiastically as had banks’ pre-2008 corporate accounts.

A DEBT IN THE FAMILY

Since the 1970s, the growing inequality of wealth and income has
profoundly shaped the way in which finance has developed. The growth of
finance has also fed the growth of inequality, not least by adding to the
influence and lobbying power of financiers who tend to favour reduction
of taxes and social expenditures, and promoting the financial-market
volatility that boosts the fortunes of those who serially buy low and sell
high.
Following deregulation, the enormous increase in finance available to
households was the main reason for the rise in banks’ profits. Commercial
banks profited from direct loans for anything from cars to homes to
holidays, and from credit cards. Investment banks made money by
securitizing commercial-bank ‘products’ and trading the derivatives they
‘manufactured’. Legislators allowed financial intermediaries to regulate
themselves, or imposed only minimal regulation because their operations
were too complex to be understood. Markets (following the marginalists)
were considered to be ‘efficient’ – healthy competition would deter
financial intermediaries from reckless behaviour.
As previously prudent banks bombarded customers with offers of credit
– the age of tempting credit card promotions dropping almost daily
through millions of letter boxes had arrived – household borrowing began
to rise inexorably. Across the financial sector more broadly, the relaxation
of controls on mortgage lending became another source of profit and also
fuelled the increased household borrowing. Whereas in the 1970s
mortgages had been rationed in the UK, by the early 2000s house buyers
could borrow 100 per cent or even more of the value of a property. By
2016, total cumulative household borrowing in the UK had reached £1.5
trillion – about 83 per cent of national output, and equivalent to nearly
£30,000 for each adult in the land – well above average earnings.39
Governments rejoiced when banks offered mortgages to low-paid,
marginally employed home buyers on the assumption that their debt could
be ‘securitized’ and quickly resold to other investors. It seemed less a
reckless gamble and more a social innovation, helping to broaden property
ownership and boosting the ‘property-owning democracy’, while
increasing the flow of income to an already buoyant investor class. Greater
revenue from financial-sector incomes and associated high-end purchases
even pushed the US and UK government budgets into rare surpluses
around the turn of the twenty-first century.40
Loosening the availability of credit to sustain consumption is not in
itself a bad thing. But there are dangers. One is cost. It seemed to make
sense to relax controls on lending when interest rates were low or falling.
It makes less sense if borrowers, lulled into a sense of false security, are
caught out when interest rates rise. Another fundamental danger is the
tendency of the system to overexpand: for credit to become too readily
available, as the Bank for International Settlements has recently
recognized.41 The system is stable when the growth in debt is matched by
the growth in the value of assets whose purchase is financed by that debt.
As soon as people begin to have doubts about the assets’ value, however,
the cracks appear. That is what happened when US property prices
collapsed after the crash of 2008. Home owners may find themselves in
negative equity and even have their property repossessed, although not
before lenders have extracted rent in interest and loan repayments. But
banks can always choose to provide other services than loans. When
uncertainty about the future is high, they can even decide to hoard cash
rather than invest it – often a sound decision, as high interest rates are
associated with a high risk of not obtaining enough for the investment.
The rise in private debt in the US and UK has resulted in household
savings falling as a percentage of disposable income – income minus taxes
– especially in periods of sustained economic growth (during the 1980s,
the late 1990s and the beginning of the 2000s). Simultaneously, household
consumption expenditure has been buoyant. It has outpaced any rise in
disposable income, and its contribution to GDP has grown.42
Income inequality has been on the rise in most advanced economies,
especially in the US and in the UK, over the past four decades. Increasing
inequality in the US has taken three complementary forms.43 First, real
wages have fallen or stagnated for many low- and middle-income
households. For instance, OECD data on the US economy indicate that the
annual real minimum wage (in 2015 US dollars) fell from $19,237 in 1975
to $13,000 in 2005 (in 2016 it was $14,892). Second, in almost every
OECD country wage shares have declined by several percentage points in
favour of rising profit shares, even when real employee compensation has
gone up.44 As Figure 9 below shows, this was the result of average
productivity growth rising faster than average or median real-wage growth
in many countries, especially in the US.
Third, personal distribution of income and wealth has become more and
more unequal. In both the US and the UK, and in many other OECD
countries, those with the highest incomes have enjoyed an increasing share
of total national income ever since the 1970s, as can been seen in Figure
10. Furthermore, income distribution is extremely skewed towards very
high incomes, not just the top 10 per cent and 1 per cent, but especially the
top 0.1 per cent.45 Wealth distribution reveals a similar pattern. A 2017
Oxfam report, An Economy for the 99%, found that in 2016 eight men own
the same wealth as the poorest half of the world’s population. In a report
published a year earlier, An Economy for the 1%, Oxfam calculated that
the club of the wealthiest 1 per cent of individuals globally shrank from
388 members in 2010 to just sixty-two in 2015; in other words, the very
richest were getting even richer relative to others who were also by any
sensible standard very rich. The wealth of the sixty-two very richest
individuals increased by 45 per cent in the five years to 2015, a jump of
more than half a trillion dollars in total. Over the same period, the wealth
of the bottom half fell by just over a trillion dollars – a drop of 38 per
cent.48
 Figure 9. Labour productivity and wages in the US since 1974 (left) and the UK since 1972
(right)46

Figure 10. Income inequality in the US and the UK, 1960–201047

The upshot of growing inequality of income and wealth was that, to

maintain the living standards they had enjoyed from the Second World
War to the 1980s, workers had to shoulder an increasing debt burden from
the 1980s onwards. Looking at the broader economic picture, without
growing household debt, demand might have been weaker and sales by
businesses lower. Finance bridged the gap, in the form of new forms of
credit whose resultant interest flows and charges underpinned the sector’s
expansion.
As a result, private debt, and particularly household debt, increased
substantially as a percentage of disposable income. Figure 11 below shows
that total household debt as a percentage of net disposable income grew by
42 per cent in the US and by 53 per cent in the UK from 1995 to 2005.

Figure 11. Household debt and income in the US and the UK, 1995–200549

In the US, mortgage loans were a principal cause of rising household

indebtedness (Figure 12), partially a reflection of households’ propensity
to extract equity from the rising value of their houses.50
In 2007, the US Congressional Budget Office lent weight to the
argument that the increased value of real estate represented a typical
‘wealth effect’: the assumption that as people’s assets such as their houses
go up in value, they are psychologically more disposed to spend. The rise
in US real-estate prices translated into higher rates of mortgage-equity
withdrawal and ultimately boosted consumer spending.51
The Survey of Consumer Finances produced by the US Federal Reserve
shows that the poorer a family is, the more heavily indebted it is likely to
be. Using data for the 2004 (pre-crisis) period, Figure 13 is based on all
families whose ratio of debt payments relative to their disposable income
is greater than 40 per cent. The families are broken down into groups
according to their income bands (measured as percentiles) and levels of
indebtedness. In the group with the lowest income, the poorest 20 per cent
of the income distribution, 27 per cent of families were ‘heavily indebted’.
Among the richest 10 per cent, it was only 1.8 per cent. This means that
poorer families were much more indebted than richer ones in relative
terms. The stagnation or outright decline in real incomes of the poorest
group forced them to borrow to finance current consumption.

Figure 12. Household debt as a percentage of disposable personal income52

Figure 13. Indebtedness and family income (2004)53

Sustaining economic growth through household borrowing has been

aptly defined as ‘privatized Keynesianism’,54 because ‘instead of
governments taking on debt to stimulate the economy, individuals did
so’.55 But it was an unsustainable solution to the lack of wage-led demand
growth. Aided and abetted by government policy, central banks, instead of
being the lenders of last resort, became the lenders of first resort to the
financial sector, cutting interest rates to avert financial crises. But this
policy drove up the price of assets such as shares and houses and further
encouraged households to borrow. The result was that households were
enrolled in an indirect – if not in fact ‘private’ – management of effective
demand, through highly financialized consumption that left many ever
more impoverished and indebted.

CONCLUSION

By the late twentieth century, finance was perceived as being much more
productive than before. Finance, too, became increasingly valuable to
policymakers, in order to maintain economic growth and manage
inequality of wealth and income. The cost was mounting household debt
and increasing government dependence on tax revenues from the financial
sector.
To ignore the question of value in relation to finance is, then, highly
irresponsible. But in the end, the real challenge is not to label finance as
value-creating or value-extracting, but to fundamentally transform it so
that it is genuinely value-creating. This requires paying attention to
characteristics such as timeframe. Impatient finance – the quest for short-
term returns – can hurt the productive capacity of the economy and its
potential for innovation.
Indeed, the crash of 2008 vindicated the warnings of Keynes, Minsky
and others about the dangers of excessive financialization. Yet while the
crash and the ensuing crisis weakened banks, it still left them in a
dominant position in the economy, sparing the embarrassment of those
who had extolled the value of financial services in the years before they
imploded into bankruptcy and fraud.
In the intervening years, there has, unsurprisingly, been a regulatory
reversal – or at least a partial one. Under political pressure, and
recognizing that they may have gone too far in allowing commercial and
investment banks to share the same roof, regulators in the US and Europe
have since 2008 sought to distance one from the other. Reforms such as
the US Dodd–Frank Act of 2010 attempt to prevent investment banks from
using the deposits of their commercial-bank parents (which are ultimately
backed by government under deposit insurance schemes) to finance their
riskier income-generating activities. New rules have tried, at least partly,
to steer investment banks back to their original function of using borrowed
money raised in wholesale markets to finance risky transactions – which
even mainstream economists sometimes liken to a casino.
Yet today financialization appears to be thriving again despite its
questionable productivity. Financialization remains a powerful force and
its capacity for value extraction is scarcely diminished. Attempts to end
excessively dangerous and socially useless financial processes, or at least
shine a light on them, have merely displaced them into darker corners.
Tighter regulation of the activities that caused the last crash has
encouraged banks to seek ways around the new curbs, while still lobbying
to relax them (except where they conveniently keep out new competitors).
It has led less regulated ‘non-bank financial institutions’ or ‘shadow
banks’ to expand where banks were forced to contract. What we must now
look at is the wider web of different financial intermediaries that have
cropped up, with their desire to make a quick, high return and their effect
on company organization and the evolution of industry.
 5
The Rise of Casino Capitalism

Rather than the financial conservatism that pension funds, mutual funds and insurance
companies were supposed to bring, money manager capitalism has ushered in a new
era of pervasive casino capitalism.
Hyman Minsky, 19921

When we talk about finance, we should bear in mind its many different
forms. While traditional activities like bank lending remain important, they
have been eclipsed by others. One is ‘shadow banking’, a term coined in
2007 to describe diverse financial intermediaries that carry out bank-like
activities but are not regulated as banks.2 These include pawnbrokers,
payday lenders, peer-to-peer lenders, mortgage lenders, investment banks,
mobile payment systems and bond-trading platforms established by tech
firms and money market funds. Between 2004 and 2014, the value of
assets serviced by the ‘informal lending sector’ globally rose from $26
trillion to $80 trillion and may account for as much as a quarter of the
global financial system. Shadow-banking activities – borrowing, lending
and asset-trading by firms that are not banks and escape their more
onerous regulation – all have one thing in common: they funnel finance to
finance, making money from moving existing money around. Another
significant boost to finance has been the rise of the asset management
industry and its different components, from widely marketed retail
investment funds to hedge funds and private equity. While average
incomes have grown, enabling a build-up of savings especially by the
better-off, rising longevity and governments’ reduced appetite for social
insurance and pension provision have put pressure on households around
the world to make their savings work harder. Those who ‘manage’
investments on their behalf can often claim a fee – often a percentage of
the funds under management – whether or not their stock-picks and
strategies have demonstrably added value. Taken together with traditional
banking, and released from the regulations that previously kept financial
firms’ size and risk appetite in check, these forces caused the sector to
grow disproportionately large.
There are two key aspects to the long-term growth of the financial sector
and its effect on the real economy. These two aspects of financialization
are covered in this and the next chapter. I will focus on the UK and the US,
where both forms of financialization have been developing most. The first,
covered in this chapter, is its expansion in absolute terms and as a share of
total economic activity. Today, the sector has sprawled way beyond the
limits of traditional finance, mainly banking, to cover an immense array of
financial instruments and has created a new force in modern capitalism:
asset management. The financial sector now accounts for a significant and
growing share of the economy’s value added and profits. But only 15 per
cent of the funds generated go to businesses in non-financial industries.3
The rest is traded between financial institutions, making money simply
from money changing hands, a phenomenon that has developed hugely,
giving rise to what Hyman Minsky called ‘money manager capitalism’.4
Or, put another way: when finance makes money by serving not the ‘real’
economy, but itself.
The second aspect, covered in the next chapter, is the effect of financial
motives on non-financial sectors, e.g. industries such as energy,
pharmaceuticals and IT. Such financialization can include the provision of
financial instruments for customers – for example, car manufacturers
offering finance to their customers – and, more importantly, the use of
profits to boost share prices rather than reinvest in actual production.
Both these aspects of financialization show how, in the growth of the
financial sector, value creation has been confused with value extraction,
with serious economic and social consequences. Finance has both
benefited from and partly caused widening inequality of income and
wealth, initially in the main ‘Anglo-Saxon’ countries, but spreading since
the 1990s to previously less financialized European and Asian economies.
Rising inequality might be ‘justified’ by economic gains if it promotes
faster growth that raises basic or average incomes, for example by giving
richer entrepreneurs the means and incentive to invest more. But recent
increases in inequality have been associated with slower growth,5 linked to
its social impact as well as the deflationary effect of reducing already-low
incomes. The key issue is: what role does finance, in all its complexity,
play in the economy? Does it justify its size and pervasiveness? Are the
sometimes huge rewards that can be earned from financial activities such
as hedge funds (an investment fund that speculates using borrowed capital
or credit) or private equity proportional to the actual risks taken?

PROMETHEUS (WITH A PILOT’S LICENCE) UNBOUND

Such questions are not new. Back in 1925, Winston Churchill, then
Chancellor of the Exchequer, had begun to get itchy about the way in
which finance was changing. He famously claimed that he would ‘rather
see finance less proud and industry more content’.6 The suspicion
troubling policymakers (and their newly emerging economic advisers) was
that financiers were positioned in relation to industrial producers in the
same way as pre-industrial landowners related to agricultural producers –
extracting a significant share of the revenue, without playing any active
part in the process of production. Investors who passively collected
interest on loans and dividends from shares were ‘rentiers’ in the classic
sense, exploiting their (often inherited) control over large sums of money
to generate unearned income, which – if not used for conspicuous
consumption – added to their wealth, especially in an age of low taxation.
The profits extracted by lenders and stock market investors could not be
used for investment in industrial expansion and modernization. This was a
growing concern, especially in the UK, whose inexorable fall behind the
industrial power of Germany and America (especially in industries that
could convert to military use) had been the subject of increasingly anxious
parliamentary enquiries since the late nineteenth century. The inclination
of British-based banking families and trusts to channel funds abroad in
search of higher returns, while foreign-based investors brought British
assets through its stock market, amplified these concerns as more of the
country’s colonies began to agitate for independence, and the storm clouds
that had heralded the First World War began to gather again. Churchill’s
Chancellorship had also alerted him to rent-seeking behaviour – lobbying
government for rules and entry barriers that would enhance financial
profit, and making loans to investors who expected to repay out of share
price gains – which was soon to rebound internationally in the Wall Street
Crash of 1929.
Yet at the time he wrote, the financial sector in the UK was only 6.4 per
cent of the entire economy.7 Finance trundled along at the same pace in the
first thirty years after the Second World War. Then, after a process of
deregulation begun during the 1970s, and the shifts in the production
boundary reviewed in the previous chapter, it powered ahead of the real
economy – manufacturing and the non-financial services provided by
private-sector companies, voluntary organizations and the state. By
reclassifying them from collectors of rent to creators of financial ‘value
added’, the newly ignited bundle of finance, insurance and real estate
(FIRE) was transformed into a productive sector at which economists of
the eighteenth, nineteenth and even the first half of the twentieth century
would have marvelled.
In the US, from 1960 to 2014, finance’s share of gross value added
more than doubled, from 3.7 to 8.4 per cent; over the same period,
manufacturing’s share of output fell by more than half, from 25 per cent to
12 per cent. The same happened in the UK: manufacturing’s share fell
from over 30 per cent of total value added in 1970 to 10 per cent in 2014,
while that of finance and insurance rose from less than 5 per cent to a peak
of over 9 per cent in 2009, dropping slightly to 8 per cent in 2014.8 So in
the three decades following deregulation, the financial sector
comprehensively outpaced the ‘real’ economy. This can be seen clearly for
the UK in Figure 14.
As regulations started to be lifted in the early 1980s, US private-sector
financial corporations’ profits as a share of total corporate profits – stable
at around 10–15 per cent in the first forty years after the Second World
War – rose to over 20 per cent, peaking at 40 per cent at the beginning of
the twenty-first century (Figure 15).

Figure 14. Gross value added, UK 1945–2013 (1975 = 100)9

 Figure 15. US financial corporate profits as share of domestic total profits10

The proportion of wages that goes to financial-sector workers also

illustrates the sector’s growth. Until 1980, finance’s share of employment
and income was almost identical (the ratio is 1). After that, the ratio
spiked: by 2009 it had almost doubled to 1.7 (Figure 16).11
The financial sector’s profits were fabulous, especially in the UK and
US with their global financial hubs in London and New York City, and
were contributing an increasing share of GDP. It was hardly surprising that
the public went along with ‘financial innovation’. People spent. From
London to Hong Kong the retail and leisure sectors of the world’s financial
centres were doing a roaring trade.
 Figure 16. Finance employee compensation share of national employment share12

From the 1980s onwards the financial sector was on a mission to

convince governments that it was productive. In the minds of
policymakers, finance had become an increasingly productive industry, an
idea they were keen to convey to the public.
Strange as it might seem now, policymakers largely ignored the danger
of financial turmoil. Only a few years after his 2004 Mansion House
speech, in which he paid fulsome tribute to the productivity of the City of
London’s financial and business elite, then Labour Chancellor of the
Exchequer Gordon Brown voiced the hubris which financiers, regulators,
politicians and many economists shared when the economy was still
apparently robust. In his 2007 Budget Statement, months before the first
signs of the coming crash appeared on the horizon, Brown solemnly
declared (not for the first time): ‘We will not return to the old boom and
bust.’
How could Brown – and so many others – have got it so horribly
wrong? The key to this catastrophic misjudgement lies in their losing sight
of one crucial factor: the distinction between ‘price’ and ‘value’, which
over the previous decades had been lost from sight. The marginalist
revolution that had changed the centuries-old theory of value to one of
price had exposed marginalism’s ultimate tautology: finance is valuable
because it is valued, and its extraordinary profits are proof of that value.
So when the global financial crisis arrived in 2007 it blew apart the
ideology that had promoted financialization above all else. Yet the crisis
did not fundamentally change how the sector is valued: two years later the
head of Goldman Sachs could still keep a straight face when arguing that
his bankers were the most productive in the world. And the fact that ex-
Goldman Sachs employees were abundant in both the Obama and Trump
administrations shows the power of the ‘story’ of the value created by
Goldman Sachs across political parties.
In modern capitalism, the financial sector has greatly diversified as well
as grown in overall size. Asset management in particular is a sector which
has risen rapidly and secured influence and prominence; it comprises the
banks which have traditionally been at the centre of the value debate but
also, now, a broad range of actors. Hyman Minsky argued it was reshaping
the economy into what he called ‘money manager capitalism’. But how
much value does it actually create?
During the three decades after the Second World War, Western
economies grew robustly, in the process accumulating massive savings.
These ‘thirty golden years’, better known by their French name of the
trente glorieuses, also saw a huge rise in pension commitments as people
lived longer and were able to save more. The wealth built up in savings
and pensions had to be managed. Investment management developed to
meet the demand and gave an enormous fillip to the size and profits of the
financial sector as a whole. Individual investors, who had made up a
significant part of stock market activity, gave way to massive institutions
run by professional fund managers, many of whom shared the attitudes and
remuneration of the executives running the companies in which the fund
managers invested their clients’ money.
The financial system evolved to meet savers’ needs in an uncertain
future several decades away. Investment had to be long-term, reasonably
liquid and yield an attractive return, particularly to counter inflation’s
inevitable corrosion of savings. Pensions are central to such investments,
especially in the Anglo-Saxon countries, where they make up about half of
wage earners’ retirement funds. Today, it is hard to overstate the
importance of pensions for individual beneficiaries and the economy:
pensions sustain aggregate demand by enabling the elderly to consume
after they retire. But they are also crucial for the whole financial system,
partly by virtue of size – the volume of assets held in pension funds – and,
even more significantly, because the private pensions industry is driven by
profit and returns to shareholders. The number of mutual pension
providers – companies owned by their members – has steadily declined as
they convert to shareholder-owned companies or consolidate in order to
compete with them.
Although the pensions industry existed in the early twentieth century, it
came of age in the post-war years with the rise of the welfare state. In an
era of full employment, often in large enterprises, compulsory pension
schemes to which employers and employees contributed piled up
enormous assets. Voluntary pension savings were common too. Life
insurance has also been an important savings vehicle, but payments into
life insurance policies have not generally been compulsory. In the UK and
the US, governments have long given pension savings significant tax
advantages, partly to encourage private savings and reduce the burden on
state pension provision.
Here, I look at how the investment industry and investment banks,
despite seeming to be highly competitive, often behave more like
monopolies protected from competition. They extract rent for the benefit
of managers and shareholders while the ultimate clients – ordinary
customers and investors in shares, pensions and insurance policies –
frequently pay fees for mediocre returns that do not pass on the benefits of
fund management’s expansion and profitability.

NEW ACTORS IN THE ECONOMY

The post-war accumulation of savings placed asset managers centre-stage.

They were not completely new on the scene. Mutual funds, called unit
trusts in the UK, had existed before the war, and in the UK investment
trusts were a popular form of middle-class saving. But the sheer scale of
the investment required – and the social responsibilities that went with it –
turned asset managers into a new set of actors in the economy. Their job
was not to invest in productive assets like entrepreneurs, but to be the
temporary stewards of savings which they invested in liquid and,
generally, financial assets (as opposed to, say, property). In the US, assets
under management (AUM) grew dramatically from $3.1 billion in 1951 to
some $17 trillion in 2015.13 In the UK, the asset management industry
accounted for £5.7 trillion by the end of 2015, more than three times the
size of GDP in the same year.14
Changes in regulation played an important role in the expansion of asset
management. In the US, pension funds had been obliged to avoid
speculative and risky investment, precisely as a prudent man would have
done. But in the 1970s, the relaxation of the ‘prudent man’ investment rule
allowed pension funds to invest in less conventional ways, such as private
equity (PE) and venture capital (VC), while the Employee Retirement
Security Act of 1974 permitted pension funds and insurance companies to
invest in a greater variety of funds, such as equities, high-yield debt, PE
and VC. Fund managers pushed for this relaxation as a way to make
higher-returning investments, but governments were keen to allow it
because faster-growing private-sector funds would lessen demand for
state-provided pensions. During this time, the rise in the number of very
wealthy people – dubbed high-net-worth individuals (HNWIs) – also
increased demand for professional asset management. An HNWI is now
generally defined as someone with net financial assets (excluding
property) of more than $1 million. Originally a rich-country phenomenon,
it is now global as the ranks of millionaires and billionaires swell in
emerging countries, notably in Asia and Latin America. According to the
consultancy Capgemini, the number of HNWIs rose from 4.5 million in
1997 to 14.5 million in 2014. China now has more billionaires than the
US.15 In 2015 the city with the most HNWIs was London (370,000),
followed by New York (320,000).16
 As fund management expanded, so the proportion of private investors
shrank. Individual ownership of stocks fell in the US from 92 per cent of
the total in 1950 to about 30 per cent today.17 The percentage held by
private investors is even lower elsewhere – 18 per cent in Japan and just 11
per cent in the UK.18 In 1963, UK individual investors owned more than
50 per cent of the stock market; insurance groups, pension groups, unit
trusts and overseas investors together accounted for about 10 per cent.
Since then the trend has reversed: pension funds and, particularly, overseas
investors have rapidly acquired a larger stake in the UK stock market, with
the latter owning more than 50 per cent of quoted UK companies’ shares
in 2014.19 In the US, some 60 per cent of publicly issued shares (equities)
are held in mutual funds. Moreover, the fund management industry is now
quite concentrated, especially in the US, where about twenty-five fund
managers control 60 per cent of all the equities in the hands of investment
institutions.20
In the last two decades the types of fund management have diversified,
most noticeably into hedge funds, private equity and venture capital. The
US has about 5,000 hedge funds, managing total assets of $2 trillion.
Hedge funds have a glamorous image – in London many are clustered in
the exclusive enclave of Mayfair – and some hedge fund managers have
made a great deal of money: in 2016, forty-two were listed among the
world’s billionaires.21 Some are even household names. George Soros shot
into the headlines when on 16 September 1992 he reputedly ‘broke the
Bank of England’, making $1 billion betting against British membership of
the European Exchange Rate Mechanism (ERM), forcing the UK out of
the ERM; the day became known as ‘Black Wednesday’.
Hedge funds, though, are a little tricky to define. One of their chief
characteristics is shorting (betting on the price of investments falling) as
well as going long (betting on the price of investments rising). Ironically,
this was originally intended to take the risk out of their speculative
investments, by enabling them to ‘hedge’ upwards against downward price
movements. In practice, it lets them chase superior returns by placing
expensive one-way bets, often using high borrowing (‘leverage’) to
multiply their gains from tiny differences in price. Compared to other
managed funds, hedge funds also have a high portfolio turnover and invest
in a wide range of assets, from property to commodities. Many
conventional investment funds are much more restricted in how and where
they invest.
Private equity (PE) firms invest in companies, usually to take ownership
and manage them, later – typically after three to seven years – selling them
at a profit. They make their profit, if successful, from the increase in the
equity value of the company after the debt has been paid off. They then
realize the equity value by selling the company (sometimes to another PE
firm) or through an IPO (initial public offering – in other words, a stock
market launch).
These firms are called private equity because the companies they
acquire are not quoted on the stock exchange, and because they themselves
are also privately owned rather than through shares issued in the (public)
stock market. In the US, PE firms control about $3.9 trillion of assets, 5
per cent of the asset management market,22 and own some well-known and
large companies. For example, in the UK the American PE firm Kohlberg
Kravis Roberts (KKR) paid almost $25 billion to acquire a stake in
Alliance Boots, the UK high-street chemist chain. After KKR sold the
final part of its stake in Alliance Boots in 2015 it was reported to have
quadrupled its money.23 Other prominent PE firms include Bain Capital,
BC Partners, Blackstone Capital and Carlyle Group.
Private equity firms claim to make companies more efficient and
profitable, in part because they are the direct owners of these companies.
In theory, separating owners (shareholders) and managers should resolve
the vested interests that the latter have in increasing their own financial
compensation rather than the price of the companies’ stocks. (This is the
main reason why the overriding objective for the contemporary asset
manager is to maximize shareholder value, as measured by the shares’
price.) Critics, however, say that private equity firms have a deleterious
impact on companies: their aim is to cut costs in the short term, for
example by firing workers and reducing investment, in order to make a
quick profit selling the business, at the expense of long-term corporate
health.
The owners of private equity firms are called general partners (GPs).
The funds they use to buy companies come from investors such as pension
funds, foundations, insurance companies and wealthy individuals. Public
and private pension funds contribute about a third of the value of the total
funds PE firms invest. All these types of investors are called limited
partners (LPs). They commit their money for a fixed time, say ten years,
during which time they usually cannot withdraw funds. However, a good
deal of PE firms’ investment funds can be classified as debt, used to buy
the equity stakes in the anticipation of repaying it with gains in equity
value. PE firms are often criticized for placing that debt on the balance
sheets of the companies they buy, while continuing to extract dividends
from the companies rather than service the debt. KKR’s first high-profile
acquisition, the leveraged buyout of cereal and tobacco group RJR
Nabisco in 1988, captured in the book and film Barbarians at the Gate,24
loaded the Shredded Wheat manufacturer with debt from which it never
fully recovered, but launched the PE firm on its continuing global
expansion. PE firms have become particularly adept at borrowing to
acquire a firm and then arranging a ‘special dividend’, often for a similar
sum, which ensures a rapid profit from the deal even if the borrowings,
transferred to the acquired firm, depress its resale price or even doom its
existence. The PE firm TA Associates demonstrated how far this technique
could be stretched when in 2014 it secured a $1.77 billion ‘syndication
loan’ (a type made possible by banks immediately securitizing and
reselling them) against drug-testing firm Millennium Laboratories – and
immediately arranged a $1.29 billion special dividend. The transaction
conformed to all rules imposed after 2008 to prevent ‘asset-stripping’ by
private acquirers. When Millennium declared bankruptcy the following
year, a court indemnified TA and other shareholders (the firm’s former
managers) against any effort by creditors to claw back the dividend, even
after it was revealed that the owners and their loan arrangers had not
informed them that its biggest client, the US government, had successfully
sued it for $256 million over fraudulent tests.25

HOW FINANCE EXTRACTS VALUE

How does finance extract value? There are broadly three related answers:
by inserting a wedge, in the form of transaction costs, between providers
and receivers of finance; through monopoly power, especially in the case
of banks; and with high charges relative to risks run, notably in fund
management.
In certain areas of the economy, such transaction costs are regarded as
reducing efficiency and destroying value, not creating it. Governments are
accused of inefficiency whenever they impose an income tax – which puts
a wedge between what people receive for work and the value they place on
leisure – or when they try to finance social security through a payroll tax,
which disconnects wage costs from total labour costs. When they secure a
pay rise for their members, trade unions are accused of increasing workers’
pay while their contribution to production remains the same.
As far as banks are concerned, their efficiency as useful intermediaries
between borrowers and lenders might reasonably be judged by their ability
to narrow the ‘wedge’, or cost gap, between the two. Maximum efficiency,
friction-free capitalism, would in theory be reached when the interest
differential disappears. Yet the ‘indirect’ measure of financial
intermediation services adopted by national accounts (FISIM, explained in
Chapter 4) assumes that a rise in added value will be reflected in a wider
wedge (or, if the wedge narrows, by increased fees and charges through
which intermediaries can obtain payment directly). The point, of course, is
not to eliminate interest but – if interest is the price of financial
intermediation – to make sure that it reflects increased efficiencies in the
system, driven by appropriate investments in technological change, as
some fintech (financial technology) developments have done.
Banks stand in sharp contrast to supermarkets. As we have seen, the cost
of financial services probably rose in the twentieth century, despite the
dramatic growth of the financial industry, suggesting that financial
consumers did not benefit from economies of scale in the same way as
they did with supermarkets, epitomized by Walmart in the US and Tesco
in the UK. A large part of the explanation for the difference is the
monopolistic – or more strictly, oligopolistic – nature of banking.
In 2010, five big US banks controlled over 96 per cent of the derivative
contracts in place.26 In the UK, ten financial institutions accounted for 85
per cent of over-the-counter derivatives turnover in 2016, and 77 per cent
of foreign exchange turnover.27 Only the biggest banks can take the risk of
large-scale writing and trading in derivatives, since they need a
comfortable cushion of equity between the value of their assets and
liabilities to stay solvent if asset prices fall. Only a few banks worldwide
have grown big enough to sustain the high risks of proprietary trading –
trading on their own account rather than for a client – and to be worthy of
state-supported rescue if the risks prove too great.
As a result, there are few banks with whom governments and large
corporations can place new bond or share issues and expect subsequent
market-making in those securities. The paucity of players, even in large
financial centres such as London and New York, inevitably gives each
bank considerable price-setting power, irrespective of whether or not they
collude among themselves to do so. In retail markets, minimum core
capital requirements for banks (raised after 2008, to 4.5 per cent of risk-
weighted assets in 2013, 5.5 per cent in 2015 and 6 per cent from 2016)28
and the need for prudential regulation limits the number of banking
licences that governments and central banks can issue, and confers
significant market power on the few banks who hold such licences. This
power enabled banks to secure 40 per cent of total US corporate profits in
2002 (up from 13 per cent in 1985). They still enjoyed 23 per cent in 2010
and almost 30 per cent in 2012 – just two years after rebounding after a
brief plunge to 10 per cent in 2008, in a period when corporate profits
were growing much faster than labour income or GDP.29
The high degree of monopoly in wholesale and retail banking is closely
linked to its continuing ability to extract rents from the private and public
sectors, even when these were shrinking in the aftermath of the 2008 crash.
In the UK, since the financial crisis regulators have aimed to promote new
banks and alternative forms of financial intermediation, such as peer-to-
peer lending, in order to spur competition. The handful of new banks
started in the UK since the crisis are somewhat optimistically called
‘challenger banks’ – a challenge that so far has not put much of a dent in
the oligopoly of UK ‘high street’ banks. Nor are alternative forms of
financial intermediation effective substitutes for the dominant banks. Only
licensed banks can create money through loans,30 as distinct from merely
shifting money between savers and borrowers. Once banks’ profitability
has been swelled by the market power that allows them to extract rents
from other sectors, their top employees can in turn exert internal labour-
market power to channel a share of those rents to themselves, helping to
give the financial sector its unique and entrenched bonus culture.
On top of monopoly rent, financial markets give investment banks and
other professional ‘players’ another significant route to high financial
returns, divorced from the high risk that is traditionally understood to
justify those returns. Financial markets instantly adjust the price of
company shares and bonds to the future profits those companies are
expected to make. They can therefore instantly capture (and ‘capitalize’)
the jump in expected future profit when, for example, a new drug wins
approval for hospital use, a social media platform finds a way to monetize
its millions of users, or a mining company learns that its once-exotic metal
is to be used in the next generation of mobile phones. Owning an asset that
suddenly jumps in value has always been a faster way to get rich than
patiently saving and investing out of income;31 and the speed differential
of asset ‘revaluation’ over asset accumulation has been amplified in the
present era of historically low interest rates.
Revaluation gains in the ‘real’ economy are widely hailed as
economically efficient and socially progressive. Entrepreneurs who cash in
on a genuinely useful invention can claim to have reaped just rewards from
genuinely productive risk-taking, especially when they are shown to have
displaced hereditary landowners in the charts of ultra-high net worth. But
when – as is usually the case by the time the revaluation occurs – shares
have passed beyond the original inventors and become owned by private
equity or quoted on financial markets, it is passive rather than active
inventors who capture most of the revaluation gains. Financialization
enables investment bankers and fund managers who picked the right stock
– often by chance – to make profits that would previously have gone to
those who built the right product, by painstaking design. And, having
captured this value, they invariably race to extract it – channelling the gain
into real estate or other financial investments designed to hold their ‘value’
– rather than reinvesting it in more innovative production, which rarely
yields a comparable crock of gold a second time.
The relationship between finance’s share of employment and its share of
income gives an idea of what has happened. Until 1980, finance’s share of
employment and income in the US were almost identical (the ratio is 1).
But, as Figure 17 reveals, by 2015 it had almost doubled to 1.8. This steep
rise in average income per employee – scarcely interrupted by the crash of
2008 – was, according to its supporters, a sign of the financial sector’s
rising productivity and a justification for channelling more resources into
finance. But the productivity gain was, as seen in Chapter 4, highly
dependent on a redefinition that boosts banks’ and other lenders’ ‘value
added’. An alternative explanation for the rising income-to-employment
ratio is that finance was reinforcing its power to extract value, and gain
monopoly rents from other private-sector activities.

Figure 17. Finance employee compensation share of national employment share32

The concentration of banking and financial-market trading among a few

large players, which is at its most extreme in the derivatives markets
(Figure 18) underlines the extent to which financial ‘value added’ may be
traceable to monopoly and oligopoly rents.33 It is in financial regulators’
interest to keep the number of players small, despite the risk of collusive
behaviour: they want to maintain an overview of all market players’
exposure so as to guard against systemic risk, and the decision (after the
2008 crisis) to bring over-the-counter derivatives trades (derivatives that
are not listed on a stock exchange and are often bespoke deals between
professional investors such as banks) onto a more viewable transparent
central platform works in their favour. Indeed, the rigging of a key interest
rate (the London interbank offered rate, Libor, used to set many private-
sector borrowing rates globally) in the aftermath of the crisis may have
occurred with the connivance of some regulators, at least according to
traders who successfully defended themselves against fraud charges.35 The
rigging, and subsequent arguments over who gained and lost from it,
highlight the extent to which banks and other financial market players
today battle over, and perhaps collude in, the distribution of a surplus
created by mainly non-financial businesses.

Figure 18. Concentration of US derivatives contracts ($ billions; fourth quarter, 2010)34

Banks are without doubt instrumental in moving funds from less to

more productive parts of the economy. Instruments such as derivatives,
futures and options can genuinely help to hedge against risks, particularly
for the economy’s producers who are confronting uncertainty over future
prices and exchange rates. Yet it must be said that some bank activities are
clearly not productive, especially when they become too complex or too
large relative to the real economy’s needs. Take the mortgage-backed
security (MBS) market mentioned earlier. In 2009, mortgage-related debt
in the US totalled around $9 trillion, having grown an astonishing 400 per
cent in fifteen years to stand at more than a quarter of all outstanding US
bond market debt. The revenue generated through interest payments on
this debt has been estimated at $20 billion a year between 2001 and 2007.36
After the 2008 financial crisis, this line of business dried up completely.
Around the world, holders of these US MBSs took huge losses, leading to
a cascade of financial crises in other countries as borrowers who held them
as collateral proved unable to repay their debt. Banks had extracted
revenue for ‘managing’ and ‘laying off’ risk – but their own activities had
actually increased risk in the process.
Credit default swaps (CDSs) are another example. Originally an
insurance against a borrower defaulting on their loan, CDSs have largely
become a way to bet on someone else being unable to repay their debts.
CDSs may have their uses for people whose own solvency might depend
on the debtor’s ability to repay. But their speculative use was literally
stripped bare in the case of ‘naked’ CDSs, which played a major role in
promoting sovereign and corporate debt defaults on both sides of the
Atlantic. Naked CDSs are so called when the buyer of a swap has no
vested interest in the credit-taking party being able to repay; in fact, the
buyer, in order to collect his or her winnings, actively wants the debtor to
default. It’s like taking out fire insurance on a neighbour’s house and
hoping it will burn down. Far from seeking to keep the borrower’s (and the
whole system’s) risks down, the swap buyer has every incentive to help
the fire break out.
But even if creditors only ever bought CDSs as an insurance policy,
they are still inherently dangerous because of systemic risk – where default
risk is no longer confined to a few borrowers and spreads to all. At times
of crisis, defaults become highly correlated. One failure to repay triggers
others. Banks or insurers who write CDSs end up underwriting this
systemic risk, as they found to their own – and countless others’ –
enormous cost in 2007–8. By 2010, due to the cost of bailing out banks
and the economic recessions that followed their cessation of business
lending, a number of European countries were experiencing sovereign debt
crises. They were struggling to service their public debts, and in order to
do so severely cut provision of public goods and services. The same banks
that had benefited from the bailout now profited from governments’ plight,
earning some 20 per cent of their entire derivative revenues from such
naked CDSs.
Financial intermediation – the cost of financial services – is a form of
value extraction, the scale of which lies in the relationship between what
finance charges and what risks it actually runs. Charges are called the cost
of financial intermediation. But as we have seen, while finance has grown
and risks have not appreciably changed, the cost of financial
intermediation has barely fallen, apart from some web-based services that
remain peripheral to global financial flows. In other words, the financial
sector has not become more productive. Another way to grasp this simple
fact is to measure the amount of fees charged by institutional investors and
compare them with the performance of the funds they manage. The ratio
between the two can be interpreted as a sort of degree of value extraction:
the higher the fee, the lower is the gain for the investor and the greater the
profit for the manager. So the ways in which manufacturers and non-
financial service firms have used their size to hold down costs and prices
do not seem to apply to finance. An excellent study on this topic
concludes: ‘The finance industry of 1900 was just as able as the finance
industry of 2000 to produce bonds and stocks, and it was certainly doing it
more cheaply.’37
Let’s now take some of the main parts of the fund management
business, a huge financial intermediation machine, and look in more detail
at fees and risks.
Millions of savers invest in funds – usually mutual funds or unit trusts –
either directly themselves or more often indirectly, for example through
pensions. The objective of any fund manager is to produce a rate of return
for the funds he or she oversees. The benchmark for that return will be the
relevant markets in which that fund manager is investing, be it the US
stock market, the European bond market, Australian mining companies
and so on. Managing your fund to outperform the average market return
(or the benchmark) is called ‘active management’, or, more pointedly,
‘picking winners’. Succeeding in doing better than the benchmark is said
to be achieving ‘alpha’ (alpha of 1 per cent means that the return on the
investment over a selected period is 1 per cent better than the market
during that same period). The alternative basic investment management
strategy is called ‘passive’. A passive fund is usually an ‘index’ or
‘tracker’ fund, where the manager simply buys shares in proportion to a
stock market index and tracks that benchmark.
But performance must be balanced with fees. Consider investing long-
term, say over the forty-year working life of a given employee. One of the
leading figures in the US fund management industry is John Bogle. He
founded Vanguard, a very large index investment group (not an active
investor) which charges low fees. Bogle has estimated an all-in cost for
actively managed funds of 2.27 per cent of the funds’ value. The amounts
may not seem excessive. But Bogle never tires of saying to fund investors:
‘Do not allow the tyranny of compounding costs to overwhelm the magic
of compounding returns.’38 In fact, if you assume Bogle’s estimate of fund
management costs and also assume an annual return of 7 per cent, the total
return to a saver over forty years will be 65 per cent higher without the
charges. In hard cash, the difference could mean retiring with $100,000 or
$165,000.39 It’s a good deal for the fund manager; rather less so for the
investor.
 Let’s, however, concede for a moment that there is a role for active
management and the associated fees. Let’s also allow for the increase in
the volume of assets under management and the application of IT to assess
investments, manage them and communicate with clients, which ought to
give fund management benefits of scale and efficiency. What should we
expect the size of those fees to be? In a presentation to the Asset
Management Unit of the Securities and Exchange Commission, the US
regulator, Bogle presented the following statistics:

Figure 19. US mutual fund assets and charges 1951 and 2015

The striking and perhaps surprising conclusion is that over more than
sixty years, expense ratios, even among the same firms, have not gone
down but have gone up – and significantly. Why has this happened?
Fund managers deserve much of the blame. First, fund management’s
strategy of divide and conquer is part of the explanation. In the interest of
diversification and providing investors with plenty of choice in investment
strategies, fund managers have multiplied the number of funds they
manage. They have also handed control of funds to individual portfolio
managers who take a more short-term view of returns than investment
committees of, say, a whole fund management group, which on the whole
takes a broader view. The result has been much more aggressive investing
and a significant increase in asset turnover as managers buy and sell stocks
to try to boost returns. According to Bogle, portfolio turnover rose from 30
per cent in the 1950s and 1960s to 140 per cent in the last decades.40
Another measure of asset management quality is volatility: the degree of
uncertainty or risk about the size of fluctuations in a share’s value. Just as
turnover has risen, so the volatility of funds has increased significantly
from 0.84 to 1.11 over the same period.
 Second, there are transaction costs. Greater turnover – buying and
selling more shares – keeps fees higher than they might have been, adding
to transaction costs without adding to investors’ capital gains given the
zero-sum nature of the market. Crucially for the investor, additional fees
reduce returns by increasing the cost of managing money. While
transaction costs for each trade have fallen over the last thirty years, the
frequency of trading has increased exponentially in recent years. Thus, the
total amount of fees has risen as well. As Bogle notes:
When I entered this business in 1951, right out of college, annual turnover of U.S.
stocks was about 15 per cent. Over the next 15 years, turnover averaged about 35 per
cent. By the late 1990s, it had gradually increased to the 100 per cent range, and hit 150
per cent in 2005. In 2008, stock turnover soared to the remarkable level of 280 per cent,
declining modestly to 250 per cent in 2011. Think for a moment about the numbers that
create these rates. When I came into this field 60 years ago, stock-trading volumes
averaged about 2 million shares per day. In recent years, we have traded about 8.5
billion shares of stock daily – 4,250 times as many. Annualized, the total comes to more
than 2 trillion shares – in dollar terms, I estimate the trading to be worth some $33
trillion. That figure, in turn, is 220 per cent of the $15 trillion market capitalisation of
U.S. stocks.41

Moreover, this massive trading is often between fund managers, which

makes it truly a zero-sum game within the industry. The idea of a financial
transaction tax (related to the Tobin Tax, named after the Nobel Prize-
winning economist James Tobin, an early advocate) is to reduce this
‘churn’ and make investors hold their stocks for longer, by raising the cost
of each sale. It satisfies the conditions for an efficient tax in deterring a
practice which imposes deadweight costs – the main obstacle to its
introduction being that all large exchanges would have to impose it, to stop
trade migrating to those that choose not to.
Hedge funds are in many ways a response to demands from the
increasing number of HNWIs for superior returns on their portfolios. As
more active share traders, hedge fund managers tend to pride themselves
on their ability to pick stocks on the basis of proprietary information. This
information may be obtained legally, for example by detailed research by
an in-house team, although it might also be obtained in some unlawful
way. Superior information should lead to superior returns, but it is also
costly. To the extent that superior returns are obtained, the cost may be
justified. But we should remember that in the end it is a game that balances
winners and losers and has little social value: the gains or above-average
returns that some investors enjoy will be offset by losses or below-average
returns others suffer.
While some hedge funds have certainly been very successful, moreover,
average returns have been less impressive. About 20 per cent of hedge
funds fail each year. Even when returns have been high they often owe as
much to idiosyncratic gambles as to investment genius. A spectacular
example is the American John Paulson, who made $2 billion from betting
in the run-up to the financial crisis that US house prices would crash. Since
then, however, his firm Paulson and Co. has done less well and some
investors have withdrawn their funds.
The middling investment performance of hedge funds stands in sharp
contrast to their glamorous image and – more importantly for investors –
their high fees. For many years typical hedge fund fees have been called ‘2
and 20’ – a 2 per cent fee on the volume of assets managed and a hefty 20
per cent of realized and unrealized profits. Some hedge funds specialize in
high-frequency trading – buying and selling assets very fast and in large
volume, sometimes within fractions of a second, by the use of special
computers – which raises costs for investors. All this adds up to a total
yearly cost of 3 per cent.42
This same ‘2 and 20’ model is also used in venture capital. Like hedge
funds, VC claims special skill in picking profitable opportunities in young
businesses and technologies. In practice, VC usually enters the fray after
others, notably taxpayer-funded basic research, have taken the biggest
risks and the technology is already proven.
Private equity firms provide a case study of how fund managers increase
their likelihood of making a profit. PE firms also charge annual
management fees of the order of 2 per cent. Over the, say, ten-year lifetime
of a fund, this fee represents a commitment of 20 per cent, leaving only 80
per cent which is actually free to earn a return. So limited partners, rather
like investors in mutual funds or hedge funds, start out with an embedded
cost to catch up on – which is hard to do. What’s more, as the New York
Times revealed in 2015, some companies in which PE firms invest end up
paying fees to the PE firms for years after they have been taken public
again.43
In addition to the management fees, PE funds have found many other
ways to get paid in order to avoid relying on their portfolios’ actual
performance. These include paying themselves fees (on top of fees paid to
consultants, investment bankers, lawyers, accountants and the like) for any
transactions undertaken (the acquisition itself, acquisitions of other
companies, the sale of divisions and so on), paying themselves monitoring
fees as part of their role on the boards of these companies, and other
service fees. All in all, this results in a fixed component for them of about
two-thirds of the general partners’ compensation.44
 The final element of the PE firm’s compensation is carried interest – the
investment manager’s share of the profits of an investment above the
amount the manager committed to the partnership. For many years now,
market practice has been that carried interest is 20 per cent of the profits
generated over and above an agreed hurdle rate – i.e. a return on an
investment below which a company will not pursue an investment
opportunity or project. This element of the compensation is specifically
meant to motivate general partners to perform, and PE capital gains are
taxed at a favourable rate. But in practice, fees are so high that carried
interest amounts to only about a third of general partners’ compensation.
PE firms also protect themselves by loading down the companies they
acquire with debt, typically 60–80 per cent of the cost of an acquisition.
Consider this: if an asset worth 100 is bought with 30 put in as equity by
the investment manager and 70 from debt, the investment manager can
make a 100 per cent return if the debt is paid off and the equity value goes
up to 60. And yet PE firms hold on average only 2 per cent of the value of
the funds they manage.
What do PE investors get for their money? When PE firms present their
results to investors, they usually highlight their internal rates of return –
the rate of return on capital invested (technically, the discount rate which
makes the net present value of all cash flows [positive and negative] from
an investment equal to zero). One may well argue that all the charges and
compensation could be justified if they resulted in outsized returns. And in
fact, there are many studies that claim superior returns for PE firms
compared to other investment vehicles. Figure 20, from one highly cited
work, appears to show that in recent years PE has outperformed by 27 per
cent (average and median for the 2000s). But that performance should be
viewed over the ten-year lifetime of a fund, so it actually represents an
outperformance of just 2.4 per cent per year.
To be fair, this is still outperformance in absolute terms. But several
factors effectively negate it. The performance has been achieved through
highly indebted investments that are relatively illiquid (hard to sell). In
fact, limited partners often require extra outperformance to take account of
this additional risk – a premium of the order of 3 per cent – in recognition
that PE’s superior performance is otherwise offset by its increased risk-
taking. Furthermore, the basis for comparison in the table below, the
Standard & Poor’s (S&P) 500 index, is less relevant than an index of
small- and medium-sized companies in the US such as the Russell 2000 or
3000. Relative to these indices, the outperformance is significantly lower,
about 1–1.5 per cent. In short, once the returns reported by private equity
are adjusted for risk and compared to appropriate benchmarks, it becomes
much harder to justify their high charges.

Figure 20. Buyout funds performance vs S&P 50045

The fund management industry naturally argues that the returns it can
make – seeking ‘alpha’ – for clients justify the fees it charges. In an
influential article,46 Joanne Hill, a Goldman Sachs partner, identifies
conditions in which trying to achieve alpha need not be a zero-sum game –
conveniently showing that investment banks’ proprietary trading might
have some social and economic value. But these conditions include an
assumption that the market is divided into traders with short- or long-term
horizons, who are pursuing alpha over different time periods and
measuring it against different benchmarks. Without this artificial
separation, alpha is indeed zero-sum – and turns into a negative-sum game
once active managers deduct the extra fees they must charge for selecting
stocks rather than just buying them in proportion to the relevant index.

CONCLUSION
Asset management has grown into one of modern capitalism’s defining
characteristics. If nothing else, its sheer scale and central importance to the
financial security of many millions of men and women have given
financial management its influence. But at least as significant is that many
of its activities extract value rather than create it. Financial markets merely
distribute income generated by activity elsewhere and do not add to that
income. Chasing alpha – selecting and over- or under-weighting stocks so
as to outperform an index – is essentially a game that will produce as many
losers as winners. This is why actively managed funds frequently fail to
beat the performance of passive funds. Much of fund management is a
massive exercise in rent-seeking of a sort that would have caused raised
eyebrows among the classical economists.
 Reform is not impossible. Financial regulation can be used to reward
long-termism and also help to direct finance towards the real economy, as
opposed to feeding on itself. Indeed, the point of the financial transaction
tax – which has yet to be implemented – is precisely to reward long-term
investments over quick millisecond trades.
Furthermore, the fees being earned by asset managers should reflect real
value creation, not the ‘buy, strip and flip’ strategy common in PE, or the
‘2 and 20’ fee model common to PE, VC and hedge funds. Were the fees
more accurately to reflect risks run (or not run – such as the large
taxpayer-funded investments that often precede the entrance of VCs), the
percentage of realized and unrealized profits retained would be lower than
the customary 20 per cent. It is not that financial actors should not make
money, or that they do not create value; but that the collective effort
involved in the value-creation mechanism should be reflected in a more
equitable share of the rewards. This is tied to Keynes’s notion of
‘socialization of investment’. He argued that the economy could grow and
be better stabilized, and hence guarantee full employment, if the quantity
and quality of public investment was increased. By this he meant that
funding investment in infrastructure and innovation (capital development)
ought to be done by public utilities, public banks or co-operatives which
direct public funds towards medium- and long-term growth rather than
short-term returns.
But rent-seeking is not limited to the financial sector. It has pervaded
non-financial industries as well – through the pressures that financial-
sector profitability, exaggerated by monopoly power and implicit public
guarantees, place on the corporate governance of non-financial firms. If
investors can expect a certain return by putting their money into a fund,
spreading the risks across a wide range of money-making instruments,
they will only sink the same funds into one industrial project if it offers a
much higher return. The return on financial-sector investment sets a
minimum for the return on ‘real’ fixed investment, a floor which rises as
financial operations become more profitable. Non-financial companies that
cannot beat the financial investors’ return are forced to join them, by
‘financializing’ their production and distribution activities.
 6
Financialization of the Real Economy

On the face of it, shareholder value is the dumbest idea in the world.
Jack Welch, former General Electric CEO, 20091

Finance’s extraordinary growth into an economic colossus over the past

thirty years has not been confined to the financial sector; it has also
permeated companies in the broader economy, such as manufacturing and
non-financial services. The financialization of the real economy is in some
respects a more extraordinary phenomenon than the expansion of the
financial sector itself and is a central social, political and economic
development of modern times.
In exploring this phenomenon, I will look chiefly at the US and the UK,
where financialization tends to be most advanced. As we have seen,
businesses such as manufacturing and non-financial services have often
been classed as the ‘productive sector’, unambiguously creating value,
whereas finance is often a cost of doing business, and only contributes to
value creation rather than creating value by itself. More loosely, the
productive sector is often called ‘the real economy’.
It’s a truism to say that the modern corporation is among the most
important forces in the economy. In 2015, the 500 largest public US
companies (those listed on a stock exchange) employed almost 25 million
people worldwide and generated revenues of over $9 trillion. In the same
year, the 500 largest UK companies on the stock market had more than 8
million employees and their total annual turnover was well over £1.5
trillion.2 What’s more, many of the largest companies at the forefront of
innovation in the economy are publicly listed; to these we must add the
many companies that are privately owned but controlled by financially
minded owners such as private equity (PE) or venture capital (VC). The
decisions these corporations take, particularly capital allocation, are
critical to value creation.
This is why it is so important that we understand the huge extent of the
financialization of the productive sector. In the 2000s, for example, the US
arm of Ford made more money by selling loans for cars than by selling the
cars themselves. Ford sped up the car’s transition from physical product to
financial commodity by pioneering the Personal Contract Plan (PCP),
which allowed a ‘buyer’ to pay monthly instalments that only covered the
predicted depreciation, and trade up to a new model after two or three
years rather than paying off the balance. Adopted by most other auto-
makers, and with the additional merit of being bundled into securitizations
and resold on financial markets, PCPs drove car sales to record levels,
alarming only the final regulators, who wondered what would happen if
(as with houses in 2008) cash-strapped contractees walked away from their
vehicles and handed back the keys. Over the same period GE Capital, the
finance arm of the enormous General Electric (GE) group, made around
half of the whole group’s earnings.3 Companies such as Ford and GE
contributed heavily to the sharp rise in the value of financial assets relative
to US GDP in the quarter-century after 1980.
Lending money to customers to buy your cars does not necessarily mean
that you are extracting value to the extent discussed in the previous
chapter. But, as we shall see, financialization more generally can
profoundly affect how companies behave. The strongest evidence of how
financial value can damage real economic value can be found in the
widespread practice of share buy-backs by public companies listed in the
US and UK.

THE BUY-BACK BLOWBACK

Share buy-backs are a way of transferring money from a corporation to its

shareholders. The company buys some of its own shares from existing
shareholders. As a pure matter of finance and economics, these
transactions are just like money paid out as dividends: shareholders
receive, and the company pays out, the same amount. The only difference
is that dividends are paid out evenly to all shareholders, while buy-backs
give cash only to those who want to sell; and, what’s more, buy-backs
avoid any penalty taxes imposed on dividends by governments that want
more profit reinvested.
 A switch from dividends to buy-backs can, however, make a big
difference to executive pay, because (unlike dividends) they reduce the
number of shares. This automatically boosts earnings per share (EPS),
which is one of the key measures of corporate success. Buy-backs
typically increase the pace of EPS growth – a measure which is often used
to determine just how exorbitant the rewards of senior executives will be.
So bosses prefer buy-backs to dividends. Two basically equivalent
measures have been made to diverge, unless accountants adjust the share
count to ensure that identical transactions have the same effect on the
reported results. But bosses are hardly likely to prod them to standardize
their measures of corporate payouts.4
Shareholders also seem impressed by rising EPS, preferring not to
notice that buy-backs remove just as much cash as dividends from the
funds available for investment. They also seem to ignore the fact that
companies are more likely to buy back shares when the price is high than
when the price is low,5 despite the inefficiency of this market timing.
In any case, the numbers are striking. In 2014 the American economist
William Lazonick chronicled the scale of share buy-backs in the top US
companies in recent years.6 Between 2003 and 2012, 449 companies listed
in the S&P 500 index deployed $2.4 trillion in buying back their own
shares, mostly through open-market purchases. That sum constituted 54
per cent of their collective earnings. Add in dividends, which took out a
further 37 per cent, and only 9 per cent of profits were available for capital
investment. Over the same period, the ten biggest re-purchasers in the US
shelled out a staggering $859 billion on share buy-backs, equivalent to 68
per cent of their combined net income. As illustrated in Figure 21 below,
seven of those companies committed more than 100 per cent of their net
income to buy-backs and dividends.
Until recently, few investors seemed to grasp the scale of these
disbursements. While regular dividends are often used by shareholders as a
source of income – which is why shareholders get so upset when they’re
cut – buy-backs, on the other hand, are often considered special payments.
This ignores their status as an active choice not to invest to create long-
term value.
Some investors are finally waking up. In March 2014, Larry Fink, the
CEO of Blackrock, one of the largest institutional investors in the world,
wrote to the CEOs of the S&P 500 companies about excessive profit
distributions. Observing that too many companies ‘have cut capital
expenditure and even increased debt to boost dividends and increase share
buy-backs’, Fink stated that while ‘returning cash to shareholders should
be part of a balanced capital strategy’, such a practice could, ‘when done
for the wrong reasons and at the expense of capital investment …
jeopardize a company’s ability to generate sustainable long-term returns’.7
However, Fink’s message has not been widely echoed by investors. The
ratio of buy-backs and dividends to reported earnings has hardly declined.
Having set a required return on reinvested funds that few managements
feel able to meet, shareholders have grown accustomed to having a steady
stream of funds paid out instead.

Figure 21. Top ten stock repurchasers in the US (2004–2012), ranked by the absolute amount of
share buy-backs8

MAXIMIZING SHAREHOLDER VALUE

Share buy-backs boost executive pay. To defend the idea that incentive
pay realigns executive and shareholder interests, it is often claimed that
share buy-backs maximize shareholder value (MSV) and thus improve the
efficiency of companies.9 Financial techniques, it is argued, are a
legitimate way for managers to improve productivity and therefore benefit
workers and customers as well as shareholders. If a company can earn a
higher return at any given time from putting capital to work financially
rather than directly selling cars or software, it is behaving rationally and in
the best interests of the business. Having a choice between a financial or a
productive use for capital helps to keep the (supposedly) core business of
cars or software on its toes because it has to produce returns which
compete with financial alternatives. By extension, it is argued that making
it easier for customers to obtain credit, especially to buy your own
products, is a service to ordinary people. There is something to this – but
not much. Where did these ideas come from? And do they have validity?
Back in the 1970s, as the economic crisis and stagnation of the decade
impaired the performance and profitability of the corporate sector,
shareholder dissatisfaction made shareholder returns the principal aim of
the corporation. In 1970, Milton Friedman published in the New York
Times Magazine an article which became the founding text of the
shareholder value movement and, in many ways, of corporate management
in general. Titled ‘The Social Responsibility of Business Is to Increase its
Profits’, Friedman’s article advanced the idea that America’s economic
performance was declining because a cardinal principle of mainstream
economics – that firms maximize profits – was being violated. There was
no longer any punishment for managers who failed to profit-maximize.
Shareholders could not inflict such punishment because they were too
dispersed and uncoordinated; and markets could not do so, because listed
companies had monopoly power and would not be assailed by new
competitors if their costs and prices drifted upwards. Some 1960s
economists had viewed ‘managerialism’ as potentially good for society, if
bosses allowed profit to be eroded by paying better wages to employees,
meeting higher environmental or health and safety standards and investing
more in new products. Friedman reset the debate by suggesting that bosses
were more likely to be sacrificing profit to their own expense accounts and
luxury lifestyles; and that even letting costs rise through ‘corporate social
responsibility’ was fundamentally wrong. The piece spawned an academic
literature that would become known as ‘agency theory’.
Friedman’s idea was developed further by the University of Chicago-
trained Michael Jensen, who was steeped in its ‘free market’ ideas. In 1976
Jensen, now a professor at the University of Rochester, wrote a paper with
the Dean of Rochester’s business school, William Meckling (who, like
Jensen, was a student of Friedman at Chicago), on how to implement
Friedman’s idea. It was called ‘Theory of the firm: Managerial behavior,
agency costs, and ownership structure’. The key argument was that
managers (the agents) were not being disciplined by competitive financial
markets or product markets, since they could misallocate resources or run
up unnecessary expenses without incurring losses or endangering their
jobs, and so it was hard for investors (the principals) to keep them
accountable. The only way to do so was through strengthening the
‘market’, which was neutral and objective enough to make sure the
company thrived. The result was a body of theory that argued that the only
way for companies to be well run was if they maximized their ‘shareholder
value’. In this way, investors would indirectly keep company managers
accountable.
In the decades that followed, an entire intellectual apparatus was created
around ‘maximizing shareholder value’, with new developments in law,
economics and business studies. It became the dominant perspective of
leading business schools and economic departments. The overriding goal
of the corporation became that of maximizing shareholder value, as
captured in the corporation’s share price.
However, far from being a lodestar for corporate management,
maximizing shareholder value turned into a catalyst for a set of mutually
reinforcing trends, which played up short-termism while downplaying the
long-term view and a broader interpretation of whom the corporation
should benefit. In the name of MSV, managers sought profits anywhere
they could, directly fuelling globalization and outsourcing production to
locations from China to Mexico. Jobs were lost and communities wrecked.
Meanwhile, the added external pressures on corporate management did
little to enhance its quality. Rather than become properly trained managers
with sectoral expertise, who could make decisions on what to produce and
how to produce it, top graduates in business schools preferred to go to
Wall Street. While in 1965 only 11 per cent of Harvard Business School
MBAs went into the financial sector, by 1985 the figure had reached 41
per cent and has risen since then.
Figure 22 shows how the influence of PE, one of the most aggressive
manifestations of MSV, grew in the US in the first decade and a half of the
twenty-first century. The arguments of Friedman, Jensen and Meckling
suggested that shareholder value was going to waste. So a new type of
investor that could capture this leaking value would be instantly rewarded,
through bigger dividends or share price gains. PE funds and acquisition
vehicles led the pack of new, value-hungry investors that now assailed the
world’s stock markets.
PE is MSV turbo-charged. Many of the companies in which PE firms
invest are not financial ones; often, indeed, they can be found on the
productive side of the production boundary. But whereas traditional
institutional investors were often satisfied to ‘buy and hold’, and to await
share price gains via profit being reinvested rather than paid out, PE seeks
to buy and resell at a higher price within a few years. What this means is
that many firms owned by PE funds are pushed into taking a significantly
shorter-term view than they might have done otherwise – the exact reverse
of ‘patient capital’ and raising productivity to benefit society in the long
run. If the influence of PE on the productive economy seems exaggerated,
consider this: Blackstone, one of the largest PE companies, has a portfolio
of over seventy-seven companies, which together generate over $64 billion
in combined annual revenues and employ more than 514,000 people
globally.11

Figure 22. PE-backed companies as a percentage of all US companies (by enterprise size)10

The recent history of the care home and water industries in the UK
shows how PE can change a business – and not necessarily for the better.
Until the mid-1990s the country’s care homes were owned either by small
family firms or by local authorities.12 Today, for a combination of political
and financial reasons, many local authority homes have closed. A new
breed of financial operator has moved into the market, largely following a
PE model, often ‘selling’ many of its places to local authorities but also
generating private profit. In 2015, the five biggest care home chains
controlled about a fifth of the total number of care home beds in the UK.
These operators were attracted by stable cash flows, part of which came
from local authorities, and opportunities for financial engineering: cheap
debt; property which could be sold and leased back; tax breaks on debt
interest payments and carried interest; and – ultimately – frail and
vulnerable residents whom the state would have to look after if the
business failed. The corporate structures of some care home owners
became exceedingly complex and often hidden in tax havens, while
corporation tax payments were low or nil. Given that local authorities still
funded many care home placements and that the nurses employed in the
homes had been state-trained, opaque corporate structures and minimal tax
payments are hardly the way to provide an essential public service.
Four Seasons Health Care displays many of these characteristics. The
company owns the biggest chain of care homes in the UK, with 23,000
beds in 2015. But it was only a small Scottish chain until its acquisition by
Alchemy Partners, a PE firm, in 1999. Having enlarged the company,
Alchemy sold it in 2004 to Allianz Capital Partners, another private firm,
which two years later sold it to Three Delta, yet another PE firm. By 2008,
during this game of pass the parcel, the company’s external debt had
ballooned to £1.5 billion, carrying an annual interest charge of over £100
million – or an unsustainable £100 per bed per week. In 2012 the company
was bought by Terra Firma – you’ve guessed it, a PE firm – controlled by
Guy Hands, a well-known British financier who had cut his teeth at
Goldman Sachs. Despite a financial restructuring involving losses for
equity holders, bondholders and banks before Terra Firma acquired the
business, by 2014 Four Seasons was losing money, and a pre-tax loss of
£70.1 million in 2015 deepened to £264 million in 2015.13 The cost of
debt-servicing was at least partly to blame. The company blamed local
authorities for freezing the amount they would pay for residents, although
the authorities themselves were suffering severe budget cuts under the
Conservative-led government’s austerity programme. The Care Quality
Commission, the government body which monitors standards in care
homes, was sufficiently concerned about the business health of Four
Seasons that at one point it embargoed twenty-eight of Four Seasons’
homes, meaning that they could not take in new residents.
Similar patterns can be seen in England and Wales’s water industry,
which was privatized in 1989.14 The ten water and sewerage companies
(WSCs) were listed on the London Stock Exchange as part of the then
government’s policy of creating a ‘shareholder democracy’. Today, only
two remain listed. Asian infrastructure conglomerates own three of the
companies; another is a mutual company (Welsh Water, or Dŵr Cymru);
and PE firms own four – Anglian Water, Thames Water (the biggest water
company), Southern Water and Yorkshire Water.
As with care homes, the ratio of debt to equity in the water companies
has increased sharply: a typical feature of companies owned by PE firms,
as we saw in the previous chapter. Between 2003 and 2013 average net
debt rose by 74 per cent while equity fell by 37 per cent in nine of the
companies: Anglian, Thames, Northumbrian, Severn Trent, Southern,
South West, United Utilities, Wessex and Yorkshire. The companies with
the highest net debt – about 80 per cent of capital or more – were all PE-
owned. Net interest payments by the nine English WSCs went up from
£288 million in 1993 to an eye-watering £2 billion in 2012. Interestingly,
the company with the lowest gearing (ratio of debt to equity) and the
highest credit rating was Welsh Water, which is mutually owned. The four
companies with the highest gearing and the lowest credit ratings were all
PE-owned.
Just like some of the care home groups, WSC ownership structures are
often opaque. The combination of shadowy corporate structures and
complex financial engineering may well explain high payouts to water
company owners. Between 2009 and 2013 Anglian, Thames, United
Utilities, Wessex and Yorkshire paid out more in dividends than they made
in after-tax profits. Directors saw their share of the companies’ income rise
from 0.1318 per cent in 1993 to 0.2052 per cent in 2013. Over the same
period the share of the water companies’ income going to salaries and
wages fell from 15.37 per cent to 10.22 per cent: in other words, the
workers’ loss seemed to be diametrically opposed to the owners’ gain. It is
true that the water companies have invested more than £100 billion in the
country’s water and sewerage infrastructure since privatization. But the
financialization of the industry was not anticipated in 1989, and neither
price controls nor limits to returns on capital imposed on the companies by
the Water Services Regulation Authority (Ofwat), the industry’s economic
regulator, appear to have prevented what looks like value extraction.
The cases of care homes and water in Britain are not a blanket argument
against PE or financialization. But they do illustrate how financial
engineering of socially essential services can change the nature of an
industry. It is at the very least debatable whether the opaque ownership
and excessive financialization which characterize these PE-owned
businesses serve their customers more than their owners.

THE RETREAT OF ‘PATIENT’ CAPITAL

Agency theory and MSV, then, are essentially straightforward concepts.

The purpose of the firm is to return as much value to its shareholders – the
equity owners of the company – as possible. In public companies
especially, the shareholder is detached from the running of the business
even though he or she is legally an owner; professional managers run it.
Here is the crux of agency theory: the agents (the managers) are in law
answerable to the principals (the shareholders). But, in relation to
managers, shareholders are disadvantaged: they have less information
about the business; they are numerous where the managers are few; and
they are last in the queue for rewards – after the managers, the workers, the
suppliers, the debt holders and the landlords. They only see a return for
their investment after the other recipients have been paid. The shareholders
are the ‘residual’ claimants, as they are assumed to be the only actors who
do not have a guaranteed return from their contribution to the business.
They are justified in claiming the return the company generates in excess
of the costs associated with other stakeholders in the company.15
For a public company, maximizing shareholder value is effectively the
same as maximizing the value of the equity shareholders’ investment, as
captured in the share price. The same is true, for practical purposes, of
private companies: the owners – whether a family, PE or venture capital –
will value a company by what they can expect to get for selling it or listing
it on a stock exchange. That value will be substantially determined by that
of similar public companies, as revealed by their share price.
MSV’s origins are often traced to the development of the ‘portfolio
theory of the firm’, a popular explanation for the development of the large
industrial conglomerates of the 1950s and 1960s. The portfolio theory of
the firm held that companies – like other investors – could spread their
risks by owning assets in diverse industries. It assumed that corporations
were only a collection of asset-generating cash flows and that professional
managers, who were emerging as the heroes of modern capitalism, were
capable of running any type of industry equally well. Business schools
aimed to train managers with exactly this purpose in mind. Perhaps the
epitome of the conglomerate of the time was the Transamerica
Corporation, which at one stage counted among its sprawling interests the
Bank of America, the United Artists film studio, Transamerica Airlines,
Budget Rent a Car and various insurance operations.
Advocates of MSV argued that conglomerates were ‘destroying’ value,
because managers (however competent and well trained) could not
possibly be experts in getting the best out of such diverse operations.
Diversification was more appropriately left to the shareholders, with the
bosses of each company ‘sticking to the knitting’ and not venturing
beyond their narrow zone of expertise. Conglomerates’ inefficiency could
be practically demonstrated if their constituent parts, broken up and floated
separately, could command a higher total share price than the coagulated
whole. Whether right or wrong, the assumption about managers’
professionalism did not address the problem that they might not always act
in the best interests of shareholders. When the US and other Western
economies slowed down in the 1970s, Friedman and other agency theorists
argued that because principals and agents are motivated by self-interest,
the inevitable conflicts could best be resolved by giving the ultimate
owner, the shareholder, the overriding interest. Conventional wisdom was
turned on its head and conglomerates were broken up, a step also justified
by seeing corporations as nothing more than a collection of cash flows.
The interests of managers and shareholders should, the agency theorists
reasoned, be ‘aligned’: if managers were also paid in the company’s shares
or options on those shares, the argument went, they would be motivated to
maximize the interests of all shareholders.
Another constituency shared the managers’ interest in rent-seeking: the
asset managers, a driving force behind the fashion for breaking up
conglomerates to extract greater shareholder value. Economically and
socially, asset managers were closer to corporate managers than they were
to their real customers, the remote and probably poorly informed members
of pension funds or holders of life insurance policies. MSV offered asset
managers the chance to get rich alongside the managers of the companies
in which they invested their clients’ money. Asset managers became the
major holders of public equities, the ‘residual’ shareholder acting at least
nominally on behalf of others. Their demands on the public corporation
and later – through PE – the private corporation would profoundly affect
the behaviour of the productive economy.
As we saw in the previous chapter, fund managers have played a central
role in the development of contemporary capitalism. In theory, equity
shareholders – largely institutional shareholders – monitor corporate
performance. They act as gatekeepers, resolving the agent– principal
problem generally and in particular monitoring how corporations use and
allocate their capital. Their role should lead to better distribution of
productive resources and make better use of resources already employed:
for example, drawing on agency theory, a positive link has been made
between institutional ownership and innovation.16 But these assessments
often seem to neglect the broader picture. It is no coincidence that the case
for shareholder activism and supervision often accompanies palpable
breakdown of corporate governance: witness the string of corporate
scandals such as Enron and WorldCom in the US, Sports Direct in the UK
and Volkswagen cheating on diesel engine emissions.
Shareholders are not the only gatekeepers. Others include auditors,
rating agencies, government regulators, the media and equity analysts –
specialists who assess companies for investors. The cause of many of the
corporate scandals of recent years, the standard argument goes, is the
failure of these gatekeepers to do their job. Rather than being critical
observers of companies, equity analysts have become their cheerleaders,
and largely failed to see that banks were heading for the rocks.
Independent auditors and rating agencies became business partners of the
companies they oversaw instead of guarding the interests of investors and
the wider community. Governments moved to ‘light-touch’ regulation of
finance, often under pressure from the industry lobby. The media were
slow to spot the scandals and uncover them. Corporate directors – who,
let’s not forget, in the UK have a legal responsibility to act in the best
interests of shareholders – were only a limited counterweight to
managerial over-reach.17 There is no doubt that the incentive to generate
fees – from advising, analysing and auditing companies, for example –
resulted in collusion and conflicts of interest between the gatekeepers and
the public corporations that led to failures of governance.
But the failure of the gatekeepers to fulfil their responsibility also owed
much to the MSV mindset with which they perceived the fundamental role
of the public corporation. And the key actors in the economy whose
interests were most closely aligned with MSV’s objective were the
institutional investors. Principal and agent were meant to eye each other
warily, but instead an unholy alliance developed between them to extract
value from the company. Their relationship worked against other
stakeholders, not least workers, whose pay lagged further and further
behind that of CEOs and senior managers.

SHORT-TERMISM AND UNPRODUCTIVE INVESTMENT

In the Great Depression of the 1930s, long before financialization entered

the modern lexicon, Keynes observed that:
[most] expert professionals, possessing judgment and knowledge beyond that of the
average private investor … are, in fact, largely concerned, not with making superior
long-term forecasts of the probable yield of an investment over its whole life, but with
foreseeing changes in the conventional valuation a short time ahead of the general
public.18

A successful speculator himself, Keynes knew what he was talking about.

He warned that the stock market would become ‘a battle of wits to
anticipate the basis of conventional valuation a few months hence, rather
than the prospective yield of an investment over a long term of years’.19 He
would be proved right. The time within which shareholders seek to make
profit, through a flow of dividends or a share price movement, is
determined by the time for which they hold a particular share. And the
average holding time for equity investment, whether by individuals or
institutions, has relentlessly fallen: from four years in 1945 to eight months
in 2000, two months in 2008 and (with the rise of high-frequency trading)
twenty-two seconds by 2011 in the US.20 Average PE holding times
jumped to almost six years when stock markets froze in the wake of the
2008 global financial crash, but were on a firm downward course again by
2015.21
The ‘short-termism’ which Keynes anticipated is encapsulated in index
fund pioneer John Bogle’s concept that institutional investors rent the
shares of the companies they invest in rather than take ownership for the
long term. Consider the increased turnover of domestic shares: according
to the World Federation of Exchanges, which represents the world’s
publicly regulated stock exchanges, in the US turnover of domestic shares
was around 20 per cent a year in the 1970s, rising steeply to consistently
over 100 per cent a year in the 2000s. Turnover measures how often a
share changes hands and is calculated by dividing the number of shares
traded in a given period by the number of shares outstanding in the same
period. Increasing turnover is a sign that institutional investors’ sights
were trained on the short-term movement of stock prices rather the
intrinsic, long-term value of the corporation. High turnover can be more
profitable for institutional investors than passive, long-term holding of
shares. It should also be said that the short-termist behaviour of
institutional investors reflects mounting pressure over the last four decades
from clients who, expecting quick results and with a dislike of surprises,
quickly withdraw their funds when disappointed. The result has been a
corporate fixation on quarterly performance, which encourages consistent
earnings growth to generate acceptable share price performance.
In 2013 the management consultants McKinsey and Company and the
Canadian Pension Plan Investment Board surveyed 1,000 board members
and senior company executives around the world to assess how they ran
their businesses.22 The majority of respondents said that the pressure to
generate strong short-term results had increased during the past five years
to a point where managers felt obliged to demonstrate strong financial
performance. But while roughly half of the respondents claimed to be
using a time horizon of less than three years in setting strategy, almost all
of them said that taking a longer-term view would improve corporate
performance, strengthen financial returns and increase innovation.23
Another important trend that further demonstrates the scale of MSV’s
impact on corporate behaviour is that of rising hurdle rates. A hurdle rate,
as we saw in the previous chapter, is a return on investment below which a
company will not pursue an investment opportunity or project. It could be
that, over time, there are fewer suitable opportunities available because the
most profitable projects have already been taken up. Excess capacity in
car-manufacturing, for instance, would naturally suggest that building a
new plant would not be logical (though investing in other technologies
very well might be). Fundamental economic forces may also be at work.
Yet what has been happening to the hurdle rate seems to suggest that
something else is also going on.
Hurdle rates are critical to the way in which companies allocate capital,
but they are deeply affected by expectations – or what Keynes called
‘animal spirits’.24 The hurdle rate of a project is usually determined
relative to the cost of capital – basically, interest rates on borrowing and
dividends to shareholders. The project should generate returns, calculated
as an Internal Rate of Return (IRR) or Return on Invested Capital
(ROIC),25 higher than the firm’s cost of capital. But an odd discrepancy
has appeared. On the one hand, the cost of debt-financing has been at
record lows and could reasonably have been expected to encourage that
kind of finance. On the other hand, according to the investment bank J. P.
Morgan,26 the weighted average cost of capital remains quite low at 8.5 per
cent but the median hurdle rate (minimum return on investment needed to
justify a new project) reported by S&P 500 companies is 18 per cent. This
suggests that companies are not pursuing investment opportunities unless
the differential between their expected returns and their cost of capital is
around 10 percentage points. Why would they leave such opportunities on
the table? One explanation, given the exigencies of MSV, is that they have
easier alternatives – such as share repurchases.
MSV, then, sets off a vicious circle. Short-term decisions such as share
buy-backs reduce long-term investment in real capital goods and
innovation such as R&D. In the long run, this will hold back productivity.
With lower productivity, the scope for higher wages will be limited, thus
lowering domestic demand and the propensity to invest in the economy as
a whole. The spread of financialization deep into corporate decision-
making therefore goes well beyond the immediate benefits it brings to
shareholders and managers. As Hyman Minsky observed, there appears to
be an inevitable dynamic of the capitalist system: unless properly regulated
or with the right buffers, it will expand too fast. Steady growth caused by
increased borrowing – which speeds up value extraction – is matched by
the rising value of assets. Everything seems to be fine – until people start
to query the value of assets. Then trouble brews.
 FINANCIALIZATION AND INEQUALITY

One of the key precepts of MSV, as we’ve seen, is that the incentives of
management and shareholders need to be aligned, and that the best way to
do this is to compensate management by awarding them shares. Senior
managers soon embraced MSV when they realized how it could help them
to increase their pay (Figure 23). The original spirit of MSV has been
perverted: the massive share options which have been a major part of
many CEOs’ pay packages do not really align with managers’ and
shareholders’ interests. Managers – depending on the terms on which they
are granted options – enjoy an almost free upside, with no downside. They
are partly insulated against the ups and downs of share prices that are the
lot of long-term investors via anti-takeover devices such as the ‘golden
parachute’, a cash reward if they lose their job, or ‘poison pills’, which
trigger an event such as the sale of a valuable corporate division to reduce
the company’s value when faced with an unwelcome takeover attempt.

Figure 23. Median CEO pay in the US ($m, constant 2011 $)27

Shareholders were not the only stakeholders whose interests were

imperfectly aligned with those of managers. Despite a period of
downsizing (corporate speak for firings), which – especially after the late-
1980s conquest of conglomerates – was meant to strip away surplus
management and raise the productivity of employees who survived the
cull, the ratio of CEO pay to workers’ pay also soared (Figure 24).
 The emphasis on short-term results has also led to another self-fulfilling
outcome: the reduced tenure of management. As seen in Figure 25, the
average tenure of CEOs has over the past few decades dropped from ten
years to six. When one considers that CEO pay is heavily weighted
towards share price performance, the need for companies to perform in the
short term can be viewed not as pressure from an external gatekeeper gone
rogue but as a mutually advantageous set-up that has served the interests of
an elite few at the expense of the many.
The importance of EPS (earnings per share) growth as a measure of
corporate success has become as much a proxy for MSV as the share price.
But EPS has not always enjoyed this totemic status. While Samuel
Palmisano (IBM President from 2000 to 2011, and CEO from 2002 to
2011) argued that IBM’s main aim was to double earnings per share over
the next five years, half a decade earlier in 1968 Tom Watson Jr (IBM
President from 1952 to 1971) argued that IBM’s three core priorities were
(1) respect for individual employees, (2) a commitment to customer
service and (3) achieving excellence. Although they are anecdotal, the two
pronouncements by two different CEOs of IBM at two different times
illustrate how priorities have evolved.

Figure 24. CEO-to-worker compensation ratio in the US28

 Figure 25. CEO tenure in the US29

Palmisano’s statement reflects what most corporate CEOs would parrot

to their investors these days. This measure of a company’s performance
comes down to its two major components: earnings and the number of
shares. The first, earnings, is an output from the profit and loss account of
a company. It is notoriously vulnerable to manipulation. Earnings are
usually calculated according to the Generally Agreed Accounting
Principles (GAAP), the widely accepted framework of standards, rules and
conventions accountants follow in drawing up financial statements. But
within GAAP there is scope to adjust earnings to allow for exceptional
items (which must be reported but can recur for several years), such as
company restructuring charges, and extraordinary items (isolated events
which do not need to be reported), such as hurricane damage. Managers
therefore have some leeway to massage earnings. More than that, earnings
are fundamentally determined by the company’s operating profits, which
in turn are the product of sales growth and earnings margins.
The number of shares outstanding is less vulnerable to accounting
manipulation, but corporate actions can definitely influence it: for example
by granting shares and share options for CEO and management
compensation, and via share buy-backs. A delicate balance must be struck.
Awarding shares to managers as part of their pay reduces EPS growth.
Buying back shares can raise EPS, provided that the cost does not offset
the gains from lowering the number of shares in issue.
Sales growth and improved profit margins, the two components of
earnings growth, are positively influenced by investment, whether in plant
and equipment (capital expenditure) or R&D. Investment is the story
corporate managers like to tell. But there is another, quicker and more
predictable way to improve margins, about which managers are less
forthcoming: cutting costs. It’s a process that companies have embraced –
to the detriment of investment.
Figure 26 shows how business investment in the US is now around its
lowest level for more than sixty years, an amazing and disturbing
phenomenon.
At the same time, as discussed in the previous chapter, the decoupling of
average productivity and earnings means that the share of total value
added going to wage earners has also steadily declined. William Lazonick,
the chronicler of share buy-backs, has characterized these two trends,
when taken together, as a shift from a model of ‘Retain and Invest’ to
‘Downsize and Distribute’. The first strategy – ‘Retain and Invest’ – uses
finance only to set up a company and start production. Once profits are
being made loans are likely to be at least partly repaid because retained
earnings are a cheap way of financing the next production cycle and
investments to expand market share. The second strategy – ‘Downsize and
Distribute’ – is entirely different. It views companies merely as ‘cash
cows’ whose least productive branches have to be sold. The resulting
surplus is then distributed to managers and owners, rather than to others
such as the workers who have also contributed to the business. The result
may hamper the growth of the company and even cut the workforce –
‘Downsize’. If the shareholders are happy, however, the strategy is
justified.

Figure 26. Business investment as percentage of US GDP30

 One way of testing whether ‘Downsize and Distribute’ is a necessary
corporate strategy is to compare public and private companies. Figure 27
shows that on several basic criteria such as size, sales, growth and return
on assets (ROA), private companies seem to invest more than public ones.
It could be said that public companies are less profitable and therefore
have less money to invest. But that doesn’t seem to be true. Figure 28
illustrates that there is little difference between the profit margins of major
US public companies (the S&P’s 500) and those of all US firms derived
from the National Income and Product Account (NIPA) compiled by the
Bureau of Economic Analysis, which is part of the US Department of
Commerce. The graph clearly shows a steady rise in profitability over
forty-five years, culminating in record highs in recent years: truly ‘profits
without prosperity’. In other words, the agent–principal problem does not
have to result in declining investment and short-termism.

Figure 27. Private-sector firm vs public firm investment rates (percentage of total assets)31
 Figure 28. Non-financial sector public company profitability (GMO)32

So, if margins are high but investment is low, what have companies
done with their profits? Following the money leads us directly to
shareholders. As we can see from Figure 29, corporations have largely
returned profits to shareholders in the form of dividends and share buy-
backs. Having averaged 10–20 per cent in the 1970s, the percentage of
cash flow returned to shareholders has remained above 30, and sometimes
substantially more than that for most of the past thirty years, although it
dipped during the tech boom in the early 2000s when companies were
investing.
What emerges from the evidence presented so far is that, just like
finance, the financialization of the productive sector extracts value –
objectively, rent. But not only in the productive sector. In recent years a
wide range of businesses in the UK, from social providers like care homes
to utilities such as water, both of which had previously been regarded as
steady and unexciting investments, have been subject to financial
engineering by new owners, often PE firms. The result is a transformation
of public goods into private goods.
Figure 29. Percentage of cash flows returned to shareholders (US non-financials five-year moving
average)33

Financialization has a long arm. It reaches into society as well as the

economy, and despite claims that its encroachment into the productive
economy is a solution to issues such as average earnings, skills and
inequality, the evidence is not encouraging. As John Bogle has noted: ‘The
highest-earning 0.01 per cent of U.S. families (150,000 in number), for
example, now receives 10 per cent of all of the income earned by the
remaining 150 million families, three times the 3 to 4 per cent share that
prevailed from 1945 to 1980. It is no secret that about 35,000 of those
families have made their fortunes on Wall Street.’34

FROM MAXIMIZING SHAREHOLDER VALUE TO STAKEHOLDER VALUE

Shareholder-value ideology is based on shareholders being the ‘residual
claimants’. They are the lead risk takers, with no guaranteed rate of return.
Friedman summarized the classic view of entrepreneurial firms as
eternally struggling to stay afloat in a turbulent market (while hinting at
the temptation to escape by subverting that market) by defining the
purpose of a business as being to ‘use its resources and engage in activities
designed to increase profits so long as it stays within the rules of the game,
which is to say, engages in open and free competition, without deception
or fraud’.35
A truth more complex than the primacy of the shareholders, however, is
that wealth creation is a collective process. After all, important as
shareholders are, it is hard to imagine a company being successful without
the involvement of many groups, including employees, suppliers,
distributors, the broader community in which the company’s plants and
headquarters are located, and even local and central government.
Moreover, it is wrong to assume that these groups have a guaranteed return
while shareholders are stuck at the back of queue. Indeed, as we shall see
in the next chapter, governments which make risky investments in new
technologies and basic research – both of which are later adopted by
companies reluctant to assume this high level of early risk – have no
guaranteed return at all.
Recognizing the collective nature of value creation takes us from a
shareholder to a stakeholder view. Whereas MSV boils valuation down to
a single measure – the share price – an opposing argument is that
corporations should focus on maximizing stakeholder value: creating as
much value as possible for all stakeholders and seeing any decision as a
balance of interests and trade-offs to achieve that goal – hardly an easy
task, given the complexity of many business decisions. The charge which
proponents of stakeholder value level against MSV is that the ‘pursuit of
gains for shareholders at the expense of other stakeholders [is] a pursuit
which ultimately destroys both shareholder and stakeholder value’.36 Even
Jack Welch, whose twenty years as General Electric CEO were often
hailed as a triumph for the MSV approach, begged to differ when in 2009
he cited customers, employees and products as the key to that success,
denouncing shareholder value as ‘the dumbest idea in the world’.
The stakeholder theory of business is more than a theory of how to run a
company better; it also has far-reaching social and economic implications.
It answers the question, ‘What makes a business successful?’ very
differently to the proponents of MSV. In sharp contrast to Friedman and
Michael Jensen, who advocated strongly that a company succeeds simply
through profit maximization, a stakeholder view emphasizes the social
relationships between management and employees, between the company
and the community, the quality of the products produced, and so on. These
relationships give the company social goals as well as financial ones.
Together they can create more sustainable ‘competitive advantage’. And
because value is created collectively, through investments of resources by
a multitude of actors, it should also be distributed more collectively – not
just to the shareholders.
In contrast to MSV and its goal of short-term profit maximization and
its marginalization of human capital and R&D, stakeholder value sees
people not just as inputs but as essential contributors who need to be
nurtured. Trust – critical for any enterprise – is then built between workers
and managers, in a process that acknowledges the vital role of workers in
value creation. Investing in people is an admission that workers add value.
We have seen how short-termism distorts finance, making it more
speculative. A stakeholder understanding of value denotes a very different
type of finance: one that is more ‘patient’ and supports necessary long-
term investments. In some countries this is achieved through public banks,
such as the Kreditanstalt für Wiederaufbau (KfW) in Germany. KfW was
intimately involved in Germany’s post-war recovery and economic
growth, lending more than €1 trillion since its founding in 1948.37 Most of
the countries that have public banks tend to follow a stakeholder model of
corporate governance, for example by having workers on company boards.
Of course, no form of corporate governance is perfect – as the recent
Volkswagen (VW) ‘dieselgate’ scandal proves. The car maker boasted
several attributes which agency theorists consider helpful for far-sighted
investment and honest practice, widening the shareholder base and
extending its interests beyond short-term profit. German workers, who
would have little to gain from tricking the US government, had a powerful
say in the company’s affairs. A family holding company, a German state
and a Middle Eastern sovereign fund control 90 per cent of the shareholder
votes. All are very long-term investors. The company had a reputation
among customers and industry specialists for engineering excellence. It did
not seem like the sort of company that would get into serious trouble.
But it did. VW wilfully designed a system to reduce emissions during
testing but not during driving, and has paid fines of $20 billion and lost
roughly $100 billion of stock market capitalization as a result. Half a
century earlier, Ford incurred similar financial and reputational damage
when top managers very deliberately calculated that the cost of fixing a
fatal flaw in its Pinto model exceeded the cost of paying compensation for
the customers it killed.38 At VW, a hidden design flaw (potentially just as
injurious to life and health) arose less through cynical calculation at the top
than through pressures placed on subordinates to promote financial
performance. The problem seems to have been a culture of
competitiveness and fear which drove some engineers to take desperate
measures to drive sales and many others to remain quiet about what they
knew was a deception. There was long-term thinking at the top – but only
about increasing market share, not about reputation. The unspoken but
clear message to the employees who could have refused to comply was
that failure to pass emissions tests was unacceptable, so it was preferable
to cheat than admit defeat. In short, the VW scandal tells us that corporate
governance structures and rules are unlikely to work unless corporate
values are aligned with public values (a concept we will visit in Chapter
8).

CONCLUSION

Sky-rocketing rewards for the lucky few have widened social divisions and
increased inequality in much of the Western world, notably in the US, the
home of financialization.
This state of affairs can be – and is – attacked on moral grounds.
Inequality reveals what we think of millions of our fellow humans. The
economic issue with value extraction is not normative, however. As we
have seen, in a capitalist economy some rent is necessary: there is an
unavoidable price tag to maintaining the circulation of capital in the
economic system. But the scale of the financial sector and of
financialization generally has increased value extraction to the point where
two critical questions must be answered: where is value created, extracted
and even destroyed? And how can we steer the economy away from
excessive financialization towards true value creation? Proposals such as
taxing away very high incomes and accumulations of wealth may treat
some of the symptoms of excessive finance. They do not, however, treat
the causes, which lie deep in a system of value extraction which has grown
up over the last forty years or so.
If the objective is long-term growth, the private sector must be rewarded
for making decisions that target the long-term over the short-term. While
some companies might be focusing on boosting their stock prices through
share buy-backs, aimed at increasing stock prices and hence stock options
(through which executives are paid), others may be taking on the difficult
investments to increase the training needed for workers, introduce risky
new technology, and investment in R&D, eventually leading, with luck, to
new technology and more likely leading to nowhere. Companies could be
rewarded for doing more of the latter and less of the former.
Executive pay should be kept in check through an understanding that
there are many other stakeholders who are critical to value creation, from
workers and the state to civil society movements. Reinvestment of profits
back into the real economy – rather than hoarding or engaging in share
buy-backs – should be a condition attached to any type of government
support, whether through subsidies or government grants and loans.
The British-Venezuelan scholar Carlota Perez has argued that the
decoupling of finance from the real economy is not ‘natural’ but an
artefact of deregulation and excess belief in the power of free markets. Her
groundbreaking work has identified a pattern of intense financialization
followed by its reversal in each technological revolution.39 She shows that
the early decades of each of the five revolutions to date (from the steam
engine to the IT revolution) have been times of financial mania and
increasing inequality. But after the financial bubbles collapse, and amid
the ensuing recession and social turmoil, governments have tended to rein
in finance and promote a period that favours the expansion of production,
benefiting society more broadly and making finance serve its real purpose.
But if and when government does not step in and play its part,
financialization can have no end.40
The next chapter turns to the world of innovation, a glamorous arena of
inspired inventors and fearless entrepreneurs where ‘wealth creation’ is not
all it is claimed to be.
 7
Extracting Value through the Innovation Economy

First, only invest in companies that have the potential to return the value of the entire
fund.
Peter Thiel, Zero to One: Notes on Startups, or How to Build the Future (2014)

STORIES ABOUT VALUE CREATION

The epicentre of a still-unfolding technological revolution, Silicon Valley
is the most dynamic industrial district in the world for high-tech start-ups.
Since the 1980s it has made millionaires of many thousands of founders,
early-stage employees, executives and venture capitalists – and billionaires
of a significant number too. The ingenuity of these people has undoubtedly
been instrumental in changing how we communicate, transact business and
live our lives. Their products and services epitomize our contemporary
idea of progress.
Silicon Valley’s entrepreneurs are often viewed as heroic do-gooders.
Indeed, Google’s stated mission is Do No Evil. In April 2016 a front cover
of the Economist showed the Facebook founder Mark Zuckerberg dressed
like a Roman emperor under the headline ‘Imperial Ambition’.
Meanwhile, innovation is seen as the new force in modern capitalism, not
just in Silicon Valley but globally. Phrases like the ‘new economy’, ‘the
innovation economy’, ‘the information society’ or ‘smart growth’
encapsulate the idea that it is entrepreneurs, garage tinkerers and their
patents that unleash the ‘creative destruction’ from which the jobs of the
future come. We are told to welcome the likes of Uber and Airbnb because
they are the forces of renewal that sweep away the old incumbents,
whether black cabs in London or ‘dinosaur’ hotel chains like Hilton.
 The success of some of the companies has been extraordinary. Google’s
share of the global desktop search engine market is more than 80 per cent,1
while just five US companies (Google, Microsoft, Amazon, Facebook and
IBM) own most of the world’s data, with China’s Baidu being the only
foreign company coming close. This market share also results in immense
wealth: Apple’s cash pile was over $250 billion in 2017.
These companies’ huge profits, and their domination of their respective
markets, are claimed to be justified in terms of the value they create: such
profits and such domination are simply a reflection of their enormous
wealth-creating power. Similarly, big pharmaceutical companies have
justified the enormous increase in drug prices – where cures for diseases
like hepatitis C can cost up to a million dollars –through stories about their
extraordinary innovation capability and associated costs, or – when those
costs are revealed to be much lower and/or actually picked up by the
taxpayer – through the notion of ‘value’-based pricing.
This chapter takes a critical look at the innovation economy and the
stories around it. It explores how the dominant narratives about innovators
and the reasons for their success fundamentally ignore the deeply
collective and cumulative process behind innovation. This failure to
recognize these processes has in turn led to a problematic distribution of
the rewards for innovation, and to policies which, in the name of
innovation, have enabled a few companies to extract value from the
economy.
Value extraction in the innovation economy occurs in various ways.
First, in the way that the financial sector – in particular venture capital and
the stock market – has interacted with the process of technology creation.
Second, in the way that the system of intellectual property rights (IPR) has
evolved: a system that now allows not just the products of research but
also the tools for research to be patented and their use ring-fenced, thereby
creating what the economist William J. Baumol termed ‘unproductive
entrepreneurship’. Third, in the way that prices of innovative products do
not reflect the collective contribution to the products concerned, in fields
as diverse as health, energy or broadband. And fourth, through the network
dynamics characteristic of modern technologies, where first-mover
advantages in a network allow large economies to reap monopolistic
advantages through economies of scale and the fact that customers using
the network get locked in (finding it too cumbersome or disadvantageous
to switch service). The chapter will argue that the most modern form of
rent-seeking in the twenty-first-century knowledge economy is through the
way in which risks in the innovation economy are socialized, while the
rewards are privatized.

WHERE DOES INNOVATION COME FROM?

Before looking at these four areas of value extraction, I want to consider

three key characteristics of innovation processes. Innovation rarely occurs
in isolation. Rather it is by nature deeply cumulative: innovation today is
often the result of pre-existing investment. Innovation is, moreover,
collective, with long lead-times: what might appear as a radical discovery
today is actually the fruit of decades of hard work by different researchers.
It is also profoundly uncertain, in that most attempts at innovation fail and
many results are unexpected. (Viagra, for instance, was initially developed
for heart problems.)

(i) Cumulative Innovation

If there is one thing that economists agree on (and there are not many), it is
that technological and organizational changes are the principal source of
long-term economic growth and wealth creation. Investments in science,
technology, skills and new organizational forms of production (such as
Adam Smith’s emphasis on the division of labour) drive productivity and
long-term increases in GDP. Building on the work of Marx, who
highlighted the role of technological change in capitalism, Joseph
Schumpeter (1883–1950) is probably the economist who has most
emphasized the importance of innovation in capitalism. He coined the term
‘creative destruction’ to describe the way that product innovations (new
products replacing old) and process innovations (new ways to organize
production and distribution of goods and services) caused a dynamic
process of renewal but also a process of destruction, with old ways falling
aside and in the process causing many companies to go bankrupt.
Schumpeter was particularly fascinated by ‘waves’ of innovations, which
he believed occurred every thirty or so years. While Marx’s interest in
technological change led him to look at the crises that capitalism would
experience due to the effect of innovation on capital’s ability to create
surplus value (or, to put it another way, if machines replace labour, how
will the exploitation of labour – the source of profits – occur?), later
economists focused mainly on the positive side of innovation that
Schumpeter had underscored: its role in increasing the productive capacity
of national economies.
 In 1987 Robert Solow, a professor at the Massachusetts Institute of
Technology, won the Nobel Prize in Economics for showing that
improvements in the use of technology explained over 80 per cent of
economic growth. Following many before him who were readers of
Schumpeter, Solow argued that economic theory had to better understand
how to describe technological change.2 Practising what they preached, they
explored what forces drive technological change. But where does
innovation come from? Is it lone entrepreneurs working in their garages,
genius scientists having a eureka moment in the laboratory, heroic small
businesses and venture capitalists struggling against the commercial odds?
No, they concluded that inventions are overwhelmingly the fruits of long-
term investments that build on each other over years.
To take one obvious example: innovation in personal computers, which
replaced clunky mainframes, came after decades of innovation in
semiconductors, in memory capacity and in the box itself (reducing the
size of mainframes to much smaller units). Individual companies such as
IBM were key to the introduction of personal computers in the late 1970s
and 1980s. But there would have been little innovation without the
contribution to that lengthy process of other actors, such as the US
government’s investment in semiconductor research and its procurement
power in the 1950s and 1960s. Or, later, the investments made by the US
government in the Internet, or that made by companies like Xerox Parc –
itself a beneficiary of large amounts of public co-funding – in the
development of the graphical user interface, which Steve Jobs later made
use of in Apple’s first Macintosh, Lisa.

(ii) Uncertain Innovation

Innovation is uncertain, in the sense that most attempts to innovate fail. It
also can take a very long time: decades can pass from the conception of an
idea to its realization and commercialization. The types, sources and
magnitude of risks vary across technologies, sectors and innovations.
Technological risks, for instance, can increase with the complexity of the
target (e.g. going to the moon, solving climate change) or the paucity of
knowledge within the organizations involved.3 The longer the time
required to devise certain solutions, the greater the chance of a competitor
reaching the market first, establishing what are known as first-mover
advantages. Additional risks that militate against recouping the initial
investment or the viability of the business include spillover effects (an
event brought on by an apparently unrelated event elsewhere); the lack of
demand for goods even if they make it to the market; investors’ exposure
to labour or tax problems; and changing economic conditions. These are
all reasons why an appetite for risk – in both the public and private sectors
involved in innovation – is essential.
Yet contrary to the prevailing image of fearless, risk-taking
entrepreneurs, business often does not want to take on such risk. This is
especially the case in areas where a lot of capital is needed and the
technological and market risks are high – pharmaceuticals, for instance,
and the very early stages of sectors, from the Internet to biotech and
nanotech. At this point the public sector can, and does, step in where
private finance fears to tread, to provide vital long-term finance.

(iii) Collective Innovation

Understanding both the role of the public sector in providing strategic
finance, and the contribution of employees inside companies, means
understanding that innovation is collective: the interactions between
different people in different roles and sectors (private, public, third sectors)
are a critical part of the process. Those who might otherwise be seen as
lone entrepreneurs in fact benefit from such collectivity; moreover, they
stand on the shoulders of both previous entrepreneurs and taxpayers who,
as we will see, often contribute to the underlying infrastructure and
technologies on which innovation builds.
Such processes are evident in the technologies underpinning some of
today’s most ubiquitous products: the iPhone, for instance, depends on
publicly funded smartphone technology, while both the Internet and SIRI
were funded by the Defense Advanced Research Projects Agency
(DARPA) in the US Department of Defense; GPS by the US Navy; and
touchscreen display by the CIA. In the pharmaceutical sector, research has
shown that two-thirds of the most innovative drugs (new molecular entities
with priority rating) trace their research back to funding by the US
National Institutes of Health. Meanwhile, some of the greatest advances in
energy – from nuclear to solar to fracking – have been funded by the US
Department of Energy, including recent battery storage innovations by
ARPA-E, DARPA’s sister organization. Both Bill Gates, CEO of
Microsoft,4 and Eric Schmidt, Executive Chairman of Alphabet (the parent
company of Google),5 have recently written about the immense benefits
their companies gained from public investments: as well as the Internet
and the html code behind the worldwide web written in CERN, a public
lab in Europe, Google’s very algorithm was funded by a National Science
Foundation grant.
The collective role of innovation can be seen not only in the cooperation
between public and private but also in the role that workers play. Countries
that have a more ‘stakeholder’ approach to corporate governance, many of
which are to be found in Northern Europe, tend to involve workers more
directly in the innovation process and to train them through well-
developed vocational programmes: worker skills are most heavily invested
in; they contribute more, and thereby are more able to share in the rewards
that their work generates. When trade union representatives sit on the
boards of companies, they are more likely to demand that any sacrifices in
wages are compensated by higher investments in areas that eventually
create more and better jobs. And countries with a more stakeholder-driven
economy are more likely to embrace the kinds of public and private
collaborations that are required for value creation: the strength of German
manufacturing, for instance, is closely related to the strong links between
science and industry fostered by public-private organizations like the
German Fraunhofer Institutes.6
An understanding of the uncertain, collective and cumulative
characteristics of innovation is helpful to understand both value creation,
as indicated above, but also value extraction. There are four key ways in
which value extraction occurs in the innovation economy. The first is to be
found in the economy’s interaction with the financial markets.

FINANCING INNOVATION

Given the lengthy and cumulative process of innovation, understanding

which actors enter the innovation process, how they do it and at what point
is key. In Figure 30 we can see how financial returns to innovation evolve
through the innovation process. In the early days returns are low due to the
very high risks; then, if the innovation proves successful, returns increase,
often exponentially, before flattening out. This cumulative process is
shown through a cumulative distribution curve. But it’s also true that who
is doing what changes over that time period. In the very early days it is
often public R&D agencies or universities that fund the science base, and
only when innovation is close to having a commercial application do
private actors enter. Public R&D agencies include organizations like
DARPA and ARPA-E and even public sources of early seed money for
innovative firms often tend to precede private venture capital. These
include public venture capital funds (like Yozma in the Israeli
government); the funding of small enterprises linked to public
procurement programmes (such as the Small Business Innovation
Research Programme in the USA); or through innovation funds inside
public banks like the European Investment Bank, the KfW in Germany or
the Chinese Development Bank. Evidence shows that it is only after these
high-risk patient funds have been invested that the more risk-averse private
financial funds enter, for example private VC.7

Figure 30. Cumulative returns for innovation

In the case of venture capitalists, their real genius appears to lie in their
timing: their ability to enter a sector late, after the highest development
risks had already been taken, but at an optimum moment to make a killing.
While many such investments fail, the few that succeed can make the
investment fund in question a fortune, as exemplified by the success of the
VC company Kleiner Perkins. In 1976, Kleiner Perkins invested $100,000
in the biotechnology company Genentech, which four years later, during
its initial public offering on the stock market, was valued at $300 million.
In 2009, Genentech was acquired by a Swiss-based healthcare company,
Roche, for $47 billion, making a fortune for the investors. Similarly, Peter
Theil’s $500,000 investment in Facebook back in 2004, which bought him
a 10.2 per cent stake in the company, made him £1 billion when he sold
the majority of his shares in 2012. These early investors are doubtless
crucial to the innovation process. The critical question here is: are their
rewards proportionate to the risks they take?
You might imagine, in the instances where public funds have made the
initial risky investments – the private VC only entering at the point where
investment looks more of a sure bet – that these funds would receive
appropriate remuneration for their boldness. But in fact, the opposite is
true. In these cases, the private VC industry’s share of the rewards tends to
be about 20 per cent, excluding other fees and charges; by contrast, the
public sector’s direct share is close to nil. The public sector is generally
deemed to reap its rewards in other, more indirect ways: through taxation
or from the benefits of products with high quality and low cost. Not only is
this a way of thinking that all but ignores the crucial and risky early
investments made by public funds in innovation; it disproportionally
privileges the later, private investors in terms of rewards.
Let’s look at this a bit more closely.

VC – Timing is All
The VC industry began in the USA in 1946 when the American Research
and Development Corporation (ARD) was set up to raise funds from
wealthy people and college endowments to invest in entrepreneurial start-
ups in technology-based manufacturing. It was soon making eye-catching
investments. In 1957, ARD invested a total of $70,000 in DEC, a computer
company; nine years later, this same investment was already valued at $37
million. Nevertheless, the VC industry’s growth was sedate until the
1980s, when it boomed, the role of pension funds upboosting its capital.
From the start of the VC industry, entrepreneurs and venture capitalists
had often surfed on a wave created by decades of government investment.
Starting after the Second World War, government investment in high-tech
ventures grew significantly in the 1950s as part of the military-industrial
complex, largely due to the Cold War.8 Before becoming famous around
the world as ‘Silicon Valley’, a name coined in 1971, the San Francisco
Bay area was producing technology for military use or, from the 1960s,
spin-offs of military technology for commercial purposes.9 The first formal
VC firm in Silicon Valley – Draper, Gaither and Anderson – was headed
by two former US Army generals and the author of a secret report to
President Eisenhower on how the US should respond to the USSR’s
launching of Sputnik.10
 Much of the work to commercialize military technology was done in the
research labs of established ICT companies like General Electric, Texas
Instruments, AT&T, Xerox and IBM. Employees of these companies left
to found their own start-ups. The Small Business Investment Company, set
up in 1958 by the government’s Small Business Administration, itself
founded in 1953, helped many of the start-ups to raise capital.
The establishment in 1971 of NASDAQ – a new stock market that did
not have the stringent listing requirements of the New York Stock
Exchange – complemented the government’s programmes. The creation of
a highly liquid national market for more speculative corporate securities
was important for attracting venture capitalists to invest in the IT industry,
secure in the knowledge that there was now a feasible exit route from their
investments.11 Venture capitalists typically look to exit from investments
within three to five years, impatient to make a buck in one enterprise and
start again elsewhere.
In 1972, the Silicon Valley VC industry began to coalesce at 3000 Sand
Hill Road in Palo Alto; a year later the National Venture Capital
Association (NVCA) was formed. The NVCA quickly became an
influential lobby. By the early 1980s it persuaded Congress to halve capital
gains tax rates, arguing that it would be an incentive to greater VC
investment. Warren Buffett became a lead critic of this policy, admitting
that he and most investors don’t look at tax, they look at opportunities.12
Indeed, the VC industry, from when it began, followed the opportunities
created by direct ‘mission-oriented’ government investments in areas like
the Internet, biotech, nanotech and cleantech.
As we saw in Chapter 5, another crucial success for the NVCA came
when it persuaded the US government to relax the interpretation of the
‘prudent man’ investment rule (keeping pensions funds out of high-risk
investments) to allow pension fund managers to invest up to 5 per cent of
pension funds in riskier investments like VC ones. It meant that, from
1979 onwards, large sums of workers’ pensions savings flowed into VC
funds – funds on which venture capitalists typically received a
management fee of 2 per cent of total volume, as well as 20 per cent
‘carried interest’ of profits (i.e. the share of the profits that go to those
managing the funds), like private equity.13
In 1984, during a tour of Silicon Valley by the then French President,
François Mitterrand, the discrepancy between the venture capitalists’
newfound bullishness and their actual achievements was picked up in an
exchange between Paul Berg, one of the winners of the Nobel Prize in
Chemistry that year, and Tom Perkins (the co-founder of Kleiner-Perkins)
boasting about his sector’s role in biotech. Berg said: ‘Where were you
guys in the ’50s and ’60s when all the funding had to be done in the basic
science? Most of the discoveries that have fuelled [the industry] were
created back then.’14 For the venture capitalists, however, the prospect of
astonishing profits now lay before them. Nothing summed up this new
spirit of enterprise better than the upstart company that went public the
same year: Apple.15

Heads I Win, Tails You Lose

Apple Computer Company had been founded in a Californian garage in
1976. When it went public in 1980 it was the largest IPO (initial public
offering) since the venerable fifty-three-year-old Ford Motor Company’s
back in 1956.16 Apple turned into a legend overnight. It also blazed a trail:
the IPO has since become the rite of passage for hundreds of hopeful high-
tech start-ups, synonymous in the public mind with the success of Silicon
Valley – and for very good reasons.
An IPO is the point at which expectation and potential come face to face
with the realities of the marketplace. IPOs capture in one moment value
generated over a long period, capitalizing the future profit potential of a
business into a market price. For VC, in other words, timing is all.
By orchestrating this moment of alchemy – when the long and winding,
always uncertain, usually collaborative, journey of innovation is
crystallized into hard cash – venture capitalists, other investors, founders
and early-stage employees have been able to reap extraordinary rewards.
In that one moment, the ‘trapped equity’ – the sum of all the ingenuity,
effort, risk-taking, collaboration and persistence that went into developing
the new idea – is released and paid out to the flotation’s controllers, who
may not have been the original innovators or risk takers.
IPOs are, first, a way for early investors to get their money out. The
very possibility of an IPO encourages investment – although it has to be
said that investors with one eye on the exit door and the other on the clock
might not be ideal for nurturing a company to its potential. Second, IPOs
can raise new capital for business expansion, which can be valuable in
some sectors but less significant in others (like software), where the most
important capital is human. Third, founders can realize the value of their
ingenuity and sweat equity that has remained latent in the company.
Fourth, employees, who may have been induced to leave secure jobs by
the promise of equity in a risky venture, can realize the value of that equity
– or at least see the possibility of doing so now that there is some liquidity
in the company’s stock. This, indeed, was the primary motivation for
Microsoft’s IPO in 1986, having awarded stock options to its employees
since 1982.17
To restate: investments in early-stage businesses are risky and most will
fail. The volatility of returns to VC across the business cycle reveals the
perils.18 Nonetheless, many venture capitalists have found themselves
among the super-rich as a result of the success of high-tech firms in
Silicon Valley. How has this happened? They have taken risks, of course –
although mostly with other people’s money – which deserve to be
rewarded. Yet the returns have come from investing in companies whose
value was often created by decades of prior government investment. When
the investment bets have paid off in a successful IPO or sale, the venture
capitalists have benefited disproportionately from their favourable position
as insiders. Then they have gained again from the increasingly favourable
tax treatment of their capital gains within a tax system their industry has
worked hard to shape.
The allocation of shares during an IPO favours insiders, including
investment banks that underwrite the deal. The insiders have incentives to
encourage hype about the IPO, setting the price low and limiting the
stock’s availability to encourage the price to spike. As outsiders clamour to
get their hands on the latest hot tech stock, insiders can sell at a large
profit.19 It is as close to a ‘heads I win, tails you lose’ bet as it is possible to
make.
All of which was writ large in the developing microelectronics industry
of the 1980s, a fertile test bed for the evolution of the American VC
industry. Previous post-war decades of US government investment meant
that new companies in the sector could produce marketable products
within the time horizons that VC investors demanded. Gradually the VC
model migrated to other emerging sectors. The biopharmaceuticals
industry, again, was built on massive US government investment, this time
through the life sciences knowledge base, the National Institutes of Health
(NIH), since 1938. Between 2009 and 2016, the NIH have been spending
an average of $31.5 billion a year (in constant 2009 dollars), twice the
level of the 1990s, and three times the level of the 1980s. In 2016 the
amount totalled $32.3 billion. But in the biopharmaceutical sector the
product cycles are much longer and more speculative than in
microelectronics: less obviously a good fit with the VC financing model of
exiting within five years.20 Along with firms like Amgen, Genzyme and
Biogen, Genentech (now part of Roche) is one of only a small number of
biopharmaceutical companies to keep their promise of producing a
blockbuster drug (sales over $1 billion), of which the sector has generated
only thirty in total.21
Despite this patchy record, hundreds of biopharmaceutical startups have
been able to raise finance through IPOs and continue in business for many
years, often without the encumbrance of an actual product. These product-
less IPOs (or PLIPOs) survive through R&D contracts with big
pharmaceutical companies and through the speculative trading of their
shares on NASDAQ, fermented by news about the success or failure of the
latest clinical trial. Yet, if it has proved hard to make reliable money from
the development of actual new blockbuster drugs, it seems that there have
been plenty of ways to derive income by speculating about the possibilities
of doing so. Nor has this unremarkable history of turning taxpayer-funded
investments in life sciences into successful products prevented top
executives in those companies being well rewarded in salaries and stock.
The classical economists would have had little time for the way in
which the VC industry has extracted value by shifting money around
rather than creating value: for them the point was to nurture the production
of value rather than its simple circulation.
Yet the examples of the fortunes made in the 1990s and early 2000s by
founders, venture capitalists, early-stage employees and senior executives
from the Silicon Valley tech boom rippled out, resetting the norms and
expectations for what leaders in more established sectors ought to be paid.
Similarly, inflated expectations have also been built into the patent system,
and more pervasively in innovative industries like ICT, biotech and
pharmaceuticals. Patents, indeed, have become synonymous with value
extraction.

PATENTED VALUE EXTRACTION

The second key way in which value has been extracted from the
innovation economy is by the appropriation of returns through the patent
system (IPR). In the last century patents, and associated tools like
copyrights and trademarks, have gone from being devices to stimulate
innovation to means of blocking it.
Patents are protections granted to inventions that are novel, inventive
(non-obvious) and suitable for industrial application. In theory they protect
the innovator from having his or her idea copied. In practice, however,
most innovations are not patented, which in itself shows that patents are
not really necessary, as there are other ways to protect innovations,
including lead-times and trade secrecy. One study found that between
1977 and 2004, only 10 per cent of ‘important’ innovations were
patented.22 Patents tend to be granted for two reasons, which must be held
in constant tension for the system to function effectively. The first is to
reward and incentivize inventors for developing new ideas by granting
them a time-limited monopoly entitlement over their inventions,23 or what
is known as the appropriability function of patents. In exchange for this
monopoly entitlement, the inventor must reveal detailed information about
his or her invention. Which brings us to the second reason: once the patent
has expired, the invention can diffuse rapidly through the economy in a
process known as the disclosure function of patents. If the system works
well, the appropriability function is properly balanced against the
disclosure function and the public gains from the rapid diffusion of this
new knowledge through the economy.24
Looked at in this light, patents are best understood not as intellectual
property ‘rights’ in the sense of something that is universal or immutable,
but as a contract or deal based on a set of policy choices. Something is
given up (information about the invention) in exchange for something
gained (the ability to exploit the invention exclusively for a limited
period). In balancing the private benefits with the broader public good,
policymakers must make trade-offs. Granting patents can help increase the
incentives for inventors, which in the long run can result in higher rates of
technical progress. But such grants also increase the market power of
patent holders, resulting in less ‘economic efficiency’ during the time
patents are enforceable, and slower knowledge diffusion.
The original purpose of patents is value creation. Patenting your
brilliantly cheap and effective innovation is meant to ensure that the hard
work you put into the invention is protected for a period during which it
earns profits until others are allowed to copy it. That period is currently
twenty years. Not all industries make equal use of patents; they tend to be
less important for areas like software25 and more so for science-based
industries like pharmaceuticals. Indeed, there are also other ways to
maintain market dominance, for example through first-mover advantages
and secrecy.
To understand how patents relate to the dynamics of value extraction,
we must look both at what exactly is being patented and at the structure of
the patents themselves. The current dominance of the narrative of
entrepreneurs as wealth creators has, I would contend, shifted the balance
of the patent system away from an emphasis on the diffusion of knowledge
towards private reward.26

Patents Can Inhibit Innovation

Today, the patent ‘deal’ has become unbalanced, to the extent that the
patent system no longer aids the innovation economy but inhibits it.
Changes in four major areas are responsible for this unbalancing: what is
being patented; the length of patent protection; the ease with which patents
can be obtained; and the reasons for seeking patent protection.
First, since the 1980s the patentability domain has been expanding in the
US. The domain has moved ‘upstream’: that is, patents are no longer
restricted to actual ‘inventions’ (products), but now include ‘discoveries’
(the knowledge behind products). This means that patents are no longer
confined to inventions with ‘practical or commercial utility’. Now, they
may also apply to discoveries that help in the exploration of future
innovative possibilities, such as diagnostic procedures, databases, analytic
methods, or scientific principles with some potential practical application.
Patents, in other words, are now gatekeepers to the knowledge base.
Instrumental in this shift was the US Bayh–Dole Act of 1980, which
made it possible for universities and government research laboratories to
hold patents on the results of publicly funded research.
The aim of the Bayh–Dole Act was to strengthen university–industry
interactions and incentivize commercialization. Yet granting an exclusive
licence on a university-owned patent deters follow-on innovations. Firms
must now negotiate – and pay for – a licence before entering a market to
access proprietary information that would previously have been available
in publications.27 Instead of encouraging better technology transfer – for
example, of human stem cell patents held by the University of Wisconsin –
the system has delayed technology diffusion.28
Where the US led, the rest of the world has followed. Such university
licensing challenges the traditional ‘open science model’, where basic
research outcomes were – as they should be – freely and equally available
to everyone. Today, a more proprietary and exclusionary model has taken
over, as the university-licensed patents on online search engines such as
Google and Netscape illustrate.
Second, legal changes have extended the protection patents offer: now,
patents can be renewed. These changes came on the back of persistent
lobbying, for instance by pharmaceutical companies, whose pressure
resulted in the US Hatch–Waxman Act of 1984, which besides getting the
generics industry off the ground (by being able to circumvent some FDA
regulations), also resulted in the extension of the patent life for brand-
name drugs. And since then the Act has been manipulated by industry
lawyers to get patents extended even more.29 There is a parallel here with
copyright laws: over the last century the entertainment industry has
increased copyright protection from fourteen years to ninety-five.30
Third, patents are now much easier to obtain. The squeeze on budgets
for courts and the FDA, which licenses medical drugs, has cut the number
of staff checking patents, leaving them often more likely to grant a patent
than not.
And fourth, large companies have increasingly used ‘strategic’ patenting
to patent around areas with a view to blocking competitors. This goes
against the second role of patents, which is to allow the diffusion of
resources. Such strategic patenting can be especially effective when a
patent is obtained at an early stage of the development of a technology,
before the technical standard is properly determined, or in fast-paced and
patent-intensive fields such as ICT or biotech, where innovations are
highly interdependent or complementary.31 An early patent gives its owner
the chance of setting the dominant standard and blocking improvements
others might make. The risk of infringing the patent can also prevent other
firms from marketing their products or services.
Another related and growing practice is ‘patent-trolling’: the strategic
holding of patents, not to develop or commercialize the underlying idea
but deliberately to collect royalties through patent enforcement. A market
for patents has emerged in which the value of the patent is divorced – or
effectively monetized – from the value of the production of goods or
services the patent makes possible. It has been argued that strategic
patenting can aid innovation by providing small firms with liquidity as
they seek to bear the costs of development and commercialization32 – but
the evidence suggests that this practice is also causing harm. James Bessen
and Michael J. Meurer, authors of The Patent Litigation Explosion,
estimate that ‘patent trolls cost defendant firms $29 billion per year in
direct out-of-pocket costs’.33 Another study finds that in aggregate, ‘patent
litigation destroys over $60 billion in firm wealth each year’,34 with the
costs falling more heavily on smaller firms.35

UNPRODUCTIVE ENTREPRENEURSHIP

It might be said that these changes have, collectively, caused patents to

result not in productive but in unproductive entrepreneurship. We cannot
assume that entrepreneurship will always be ‘productive’, in the sense of
leading to the discovery of new products, services or processes that
increase society’s wealth. In many circumstances, entrepreneurship can be
unproductive: where it involves innovations in rent-seeking, for instance,
or discovering unused but effective legal gambits to deploy against
competitors. Today, the patent system offers many opportunities for these
kinds of ‘unproductive entrepreneurship’; patents can reinforce
monopolies and intensify abuse of market power, block the diffusion of
knowledge and follow-on innovations, and make it easier to privatize
research that is publicly funded and collectively created. Indeed, in the
words of economist William J. Baumol, ‘at times the entrepreneur may
even lead a parasitical existence that is actually damaging to the
economy’.36
A common assumption is that rents are simply the result of
imperfections in the competitive process that otherwise would lead to
beneficial results for all. An alternative view, following Marx, is that rents
(including those generated from patents) arise from value creation itself –
i.e. not from cheating or breaking the rules of the system, but from the
rules of the system itself. The way the modern-day patenting system is
structured (e.g. allowing upstream patenting, and strategic patenting), I
would contend, is analogous to what Marx called ‘unproductive labour’,
because it extracts rather than creates value. The patent holder derives
rents from enforceable property rights over productive resources simply by
excluding others from access to those resources. Holders of patents can
appropriate surplus value generated by labour and not paid out in wages.
In the modern economy there are few limits to the accumulation of such
IPR, and therefore few constraints on the scale of value appropriation.
Duncan Foley, a heterodox economist in New York studying the
relationship between modern value extraction practices and the classical
approach to rent, claims: ‘Any individual creator [of strategically located
intellectual property] can expand her or his income effectively without
limit, but this does nothing to expand social value production or surplus
value appropriation.’37
Today’s narrative, which plays up the role of the private sector in
innovation and plays down that of the state, has created space for broader
and stronger patents to proliferate. Such patents are justified as rewarding
the efforts of entrepreneurs, who can then continue to shoulder the risks of
innovation. But neither the risks of innovation nor support for future
innovation – both undeniably important – are enough to justify tipping the
balance so far in the direction of this prevailing story. Instead of the
creation of value, the expansion of patents has fuelled rent-seeking, value
extraction, value destruction, strategic gaming and the privatizing of the
results of publicly funded scientific research. As The Economist has
observed: ‘Patents are supposed to spread knowledge, by obliging holders
to lay out their innovation for all to see … Instead, the system has created
a parasitic ecology of trolls and defensive patent-holders, who aim to block
innovation, or at least to stand in its way unless they can grab a share of
the spoils.’38
All of which has major implications for global development.
Industrialization in today’s advanced economies like the US, Britain and
Germany actually took place under much narrower and more flexible IPR
rules than those we have today. And while later industrializing countries
such as Japan and South Korea benefited from a ‘friendly’ or ‘loose’
international IPR environment, developing economies now encounter a
more closed and privatized knowledge creation system, supported by
international trade agreements.39

PRICING PHARMACEUTICALS

Perhaps nowhere is the modern patent system more pernicious than in

pharmaceutical pricing. It is a vivid lesson in how the concept of value is
abused. In patent-intensive sectors like pharmaceuticals, greater patent
protection has not led to increases in innovation. In fact, the opposite has
happened. We have more drugs with little or no therapeutic value.40 At the
same time, there have been numerous lawsuits attempting to extend patent
validity on existing drugs by reshuffling old combinations of compounds.
These suits lend weight to the claim that the patent legal system has
become the main source of value extraction, rather than providing
incentives for value creation through pharmaceutical innovations. Worse,
because public institutions funded most of the key scientific discoveries
behind health innovations,41 taxpayers are now paying twice: first for the
research and second for the premium that pharmaceutical companies
charge for their drugs. Furthermore, increasing returns from patents
reinforce the position of incumbents and lock out competitors.
A recent case illustrates how patents lead to monopoly pricing. In early
2014, the pharmaceutical giant Gilead brought a new treatment for the
hepatitis C virus to the market. The drug is called Sovaldi. It is a
remarkable advance over existing therapies against this life-threatening
disease, which affects around 3 million people in the US and 15 million in
Europe.42 Later that year, Gilead released an improved version of Sovaldi
called Harvoni. The launch of these two new drugs had wide media
coverage. The reason, however, was not their therapeutic power. It was
their price. A three-month treatment costs $84,000 (exactly $1,000 a pill)
for Sovaldi and $94,500 for Harvoni.43
Sovaldi and Harvoni are not isolated cases. The price of ‘specialty’
drugs – which treat complex chronic conditions such as cancer, HIV or
inflammatory disease – has skyrocketed in recent years, fuelling a heated
debate about why prices are so high and whether they are justified. Anti-
cancer drugs that only add a few months to patients’ life expectancy cost
hundreds of dollars a day. The case of Sovaldi drew the attention of the US
Congress: two members of the Senate Finance Committee, including the
then Chairman Ron Wyden, sent a letter to Gilead expressing concern and
demanding a detailed account of how the price of Sovaldi had been
determined.44 It was a good question to ask. Prices of specialty drugs are
completely unrelated to manufacturing costs. For example, researchers
have put the manufacturing cost of a twelve-week course of Sovaldi at
between $68 and $136.45 So how does the pharmaceutical industry justify
charging prices that are hundreds of times higher than production costs?

Patient Health and Impatient Profits

The standard defence by pharmaceutical companies used to be that these
high prices are necessary to cover the R&D costs of developing new drugs
and of compensating for the risks associated with both the research and the
clinical trials. But public opinion is increasingly sceptical about this
argument, and for good reason: research has disproved it.46
First, basic research expenditure by pharmaceutical companies is very
small compared to the profits they make.47 It is also much less than what
they spend on marketing,48 and often less than what they spend on share
buy-backs aimed at boosting short-term stock prices, stock options and
executive pay.49
Second, the research leading to real pharmaceutical innovation,50
broadly defined as new molecular entities, has come mostly from publicly
funded laboratories.51 The pharmaceutical industry has increasingly
concentrated its R&D spending on the much less risky development phase
and on ‘me too drugs’ – slight variations on existing products.
For example, NIH and the US Veterans Administration funded the
research leading to the main compound in both Sovaldi and Harvoni –
from early-stage science even into later-stage clinical trials. Private
investors spent no more (and perhaps much less) than $300 million in
R&D outlays for Sovaldi and Harvoni over the course of a decade.52 If we
consider that in the first six months of 2015 the two drugs combined
produced around $9.4 billion in sales (and $45 billion in the first three
years since launch from 2014 to 2016) it is clear that their price bears no
relation to R&D costs.53
 So, unsurprisingly, pharmaceutical companies are turning to a different
line of defence. They argue that these prices are proportionate to the
intrinsic ‘value’ of the drugs. ‘Price is the wrong discussion,’ declared
Gilead’s Executive Vice-President Gregg Alton, responding to criticism
over the price of Sovaldi: ‘value should be the subject.’54 John LaMattina,
former Vice-President of Pfizer and a leading figure in the pharmaceutical
industry, was even more explicit. In a 2014 piece published in Forbes
under the title ‘Politicians shouldn’t question drug costs but rather their
value’, he argued that:
in the mind of patients, physicians, and payers, the pricing of drugs should have little to
do with the expense of biomedical R&D, nor should it be associated with recouping
R&D investment. Pricing should be based on only one thing – the value that the drug
brings to healthcare in terms of:
1) saving lives;
2) mitigating pain/suffering and improving the quality of life of patients;
3) reducing overall healthcare costs.

Interestingly, LaMattina was also explicit that value-based pricing is meant

to justify charging prices that are completely out of line with production
costs and R&D expenses. Commenting on the world’s most expensive
drug, Alexion’s Soliris, which is used to treat a rare form of anemia and
also a rare kidney disorder, Mattina noted that the price (Alexion charges
$440,000/year per patient) ‘is really not related to the R&D costs needed
to bring this drug to the market’. Yet, he continued:
private insurers and national health agencies in Europe willingly pay for this drug.
Why? Because the costs of caring for patients with these conditions can run into
millions each year. Soliris, even at this high price, actually saves the healthcare system
money because using it results in dramatic decreases in other healthcare system
expenses generated by these patients.55

The high price of specialty drugs – the argument goes – is justified by how
beneficial they are for patients and for society in general. In practice, this
means relating the price of a drug to the costs that the disease would cause
to society if not treated, or if treated with the second-best therapy. So we
read, in a ‘fact sheet’ prepared by the US industry trade body PhRMA to
justify high prices, that ‘every additional dollar spent on medicines or
adherent patients with congestive heart failure, high blood pressure,
diabetes and high cholesterol generated $3 to $10 in savings on emergency
room visits and in patient hospitalizations’, that ‘a 10 per cent decrease in
the cancer death rate is worth roughly $4.4 trillion in economic value to
current and future generations’ and that ‘research and medicines from the
biopharmaceutical sector are the only chance for survival for patients and
their families’.56 While these claims may be true, it is striking that they are
used as an explanation (or justification) for high drug prices.
Critics have replied that there is in fact no discernible link between
specialty drug prices and the medical benefits they provide. They have
some evidence on their side. Case studies have shown no correlation
between the price of cancer drugs and their benefits.57 One 2015 study,
based on a sample of fifty-eight anti-cancer drugs approved in the US
between 1995 and 2013, illustrates that their survival benefits for patients
do not explain their mounting cost. Dr Peter Bach, a renowned oncologist,
put online an interactive calculator with which you can establish the
‘correct’ price of a cancer drug on the basis of its valuable characteristics –
increase in life expectancy, side effects and so on. The calculator shows
that the value-based price of most drugs is lower than their market price.58
Unfortunately, however, most of the pharmaceutical industry’s critics
fight its arguments on the field big pharma has chosen. In other words,
they implicitly accept the idea that prices should be linked to some
intrinsic value of a drug, measured by the monetary value of the benefits –
or avoided costs – to patients and society. This is not as odd as it might
sound.
The idea of value-based pricing was initially developed by scholars and
policymakers to counteract rising drug prices and to allocate public
healthcare budgets more rationally. In the UK, for example, the National
Institute for Health and Care Excellence (NICE) calculates the value of
drugs in terms of the number of quality-adjusted life years (QALY) that
each class of patients receives. One QALY is a year of perfect health; if
health is less than perfect, QALYs accrue at less than one a year. Cost-
effectiveness is assessed by calculating how much per QALY a drug or
treatment costs. Generally, NICE considers a pharmaceutical product cost-
effective if it costs less than £20,000–£30,000 per QALY provided. A
price-based assessment of this sort is powerful: NICE advises the UK
National Health Service (NHS) on its choice of drugs.
A cost-effectiveness analysis like the one NICE conducts makes sense
for allocating a national healthcare system’s finite budget. In the US,
where there is no cost-effectiveness analysis and the national insurance
system is forbidden by law from bargaining with drug companies, drug
prices are much higher than in the UK and are increasing more rapidly.
The outcome is that, measured by a yardstick such as QALY, specialty
drug prices in the US are not related to the medical benefits they provide.
Basic mainstream analysis of elasticity of demand (that is, how sensitive
consumers are to changes in prices, depending on the characteristics of
goods) is sufficient to explain the very high prices of specialty drugs,
which makes pharma’s vague and rhetorical arguments about value all the
more unconvincing. Specialty drugs like Sovaldi and Harvoni are covered
by patents, so their producers are monopolists and competition does not
constrain the prices they set. Normally, however, you would expect the
elasticity of demand to be a constraint: the higher the price, the lower the
demand for the monopolist’s product. But the elasticity of demand for
specialty drugs is of course very low: peoples’ lives are at stake. They
need these drugs to have some chance of surviving, and medical insurers,
whether public or private, are under an obligation to pay for them.
The logical outcome of a combination of monopoly and rigid demand is
sky-high prices, and this is precisely what is happening with specialty
drugs. It explains why pharmaceutical companies enjoy absurdly high
profit margins: in addition to the normal profit rate, they earn huge
monopoly rents.59 A value-based assessment of the kind NICE carries out
can be helpful because it reduces demand for the monopolists’ drugs and
prevents them from charging whatever price they choose. The downside,
however, is that increased elasticity of demand for drugs comes at the cost
of leaving some patients without the medicines they need, because
pharmaceutical companies may not cut their prices enough to treat
everyone who needs the drug if doing so would reduce profit margins by
more than the companies want. This is already happening in the UK,
where NICE has rejected some cancer drugs for use in the NHS because of
their price. It is also happening in the US, where some private and public
insurers refused to provide Harvoni to insured patients until they reached a
very advanced stage of the disease.
What is not being pointed out, however, is that the principle that a
specialty drug’s price should equal the costs it saves society is
fundamentally flawed. If we took such a principle seriously, basic
therapies or vaccines should cost a fortune. For that matter, how high
should the price of water be, given its indispensable value to society?
The con around drug pricing has created a constant battle between
government-funded healthcare systems (where they exist), private and
public insurance programmes, and the big pharmaceutical firms. Only by
debunking the ideas about value underpinning these drugs can a long-
lasting solution be found which results in access to genuinely affordable
drugs.

NETWORK EFFECTS AND FIRST-MOVER ADVANTAGES

I have looked at how innovation, something inherently uncertain and
cumulative, is financed, and at the dynamics of that finance. We have also
explored how the risks and rewards of innovation have been shared
problematically, with medical drugs being the most severe case in point.
Now, I want to look at another aspect of innovation: the effect of modern
digital networks on the ability of a few firms to achieve monopolies in
their markets.
In just a few years, firms such as Google, Facebook, Twitter, Amazon
and eBay have come from nowhere to being almost indispensable in the
lives of billions of people around the world. These companies increasingly
dominate how we find information, connect and communicate, maintain
our friendships, document our lives, shop and share our thoughts with
anyone who cares to listen. The new technologies behind these companies
have revealed – or created – in us new wants and needs. Any number of
firms, each with broadly similar technologies, might have met these needs.
Many have tried. But what is interesting is how quickly and how
comprehensively such a small number of firms have come to dominate.
And with this dominance comes the ability to extract value on a massive
scale.
How has this happened? The answer lies in the characteristics of
innovation, where small differences of timing, foresight or chance can
have consequences out of all proportion to the initial disparity. Anyone
who gains an initial advantage – in setting a standard or capturing part of a
‘sticky’ market – can be very hard to displace. And as their dominance
becomes entrenched, they are able to capture a disproportionate share of
the value in the market.
The history of many innovations demonstrates these dynamics very
well. The internal combustion engine has retained its dominance for over a
hundred years, not because it is the best possible engine, but because
through historical accident it gained an initial advantage. Subsequent
innovations did not seek to supplant it, but clustered around improvements
to it, so that it became post factum the best engine.60 The same goes for the
QWERTY keyboard layout, named for the first six letters on the top from
left to right. In the days of mechanical typewriters, the very inefficiency of
this keyboard layout gave it an advantage over alternatives such as the
faster DVORAK layout because the mechanical keys would jam less
frequently. The mechanical necessity for the QWERTY layout has long
passed in these days of electronic keyboards, but its advantage has
remained. Once people learned how to type using the QWERTY layout
they resisted change. This social inertia meant its arbitrary initial
advantage got locked in.
Such examples show the potential for dynamic increasing returns to
scale (the more subscribers the better), from innovation due to path
dependency (continuing to use a practice or product because of past
preference for it) or social inertia, even when the initial advantage may be
slight or arbitrary. Another example of the phenomenon are so-called
‘network externalities’. Just as the value of a telephone increases as the
number of people its owner can connect to rises, so a social network
becomes more valuable to its owner if more people join. Facebook or
Twitter do all they can to increase the number of subscribers: the bigger
the network, the stronger the company’s position.

Networking Profits
All this sounds fine until you ask yourself what it might mean for the size
of companies. A strong source of increasing returns to scale necessarily
expands companies. Google’s size is a direct result of the network effects
typical of Internet-based services. Google is not just a search engine. It is
also an email address (Gmail), a conference call maker (Google Hangout),
a document creator and editor – all designed to maximize the advantages
of sticking to Google: you cannot use Google Hangout without a Gmail
address.
What’s the problem? Giant online firms like Facebook, Amazon and
Google are often portrayed by their managers and by their apologists as
‘forces for good’ and for the progress of society rather than as profit-
oriented businesses.61 Excited advocates have talked of a rising and
revolutionary ‘sharing economy’, or even of ‘digital socialism’,62
advancing a rosy view according to which digital platforms ‘empower’
people, giving us free access to a wide range of services, from social
networking to GPS positioning and health-monitoring. Silicon Valley is
starkly and favourably contrasted with Wall Street. The Valley bridges the
consumption gap by providing services that everyone can access, almost
independently of their income; the Street intensifies the concentration of
power and wealth in the hands of the 1 per cent.63
Of course the Internet giants are valuable to their users, sometimes
greatly so. They can add to people’s well-being and in some cases increase
their productivity, for instance by making it easier and faster to find some
web content, route, person or book. But the view that these services are
offered to everyone for free out of Silicon Valley’s goodwill, with the aim
of ‘empowering’ people and creating a more open world, is exceedingly
naïve. A more realistic analysis should start from a grasp of how these
firms work and where their profits come from, with an eye to assessing
their overall social impact in terms of value creation and value extraction.
Firms like Google, Facebook and Amazon – and new ‘sharing-
economy’ firms like Airbnb and Uber – like to define themselves as
‘platforms’. They don’t face a traditional market, in which the firm
produces a good or service and sells it to a population of potential
consumers. They operate, instead, in what economists call two-sided
markets, developing the supply and demand sides of the market as the
lynchpin, connector or gatekeeper between them. On the one side, there is
a service offering to users. On the other side, there is a market offering to
other firms – from sales to advertising space to information on users’
behaviour. Firms have long operated in more than one market. The
peculiarity of two-sided markets, however, lies in how the two sides are
connected. As the number of users on one side of the market (using a
search engine or joining a social network) rises, clicks on ads and
information on consumers’ behaviour also increases, boosting profitability
in the other side of the market. It suits Google and Facebook to charge
their users nothing: they need as many people as possible to join to make
the product they sell to firms on the other side of the market more
attractive. ‘Socialism’, digital or otherwise, doesn’t come into it.
We should not see Google, for example, as providing services for free to
its users. Rather, it is users who provide Google with necessary inputs for
its production process: their looks on ads and, most importantly, their
personal data. In return, they obtain online searches and other services.
The bulk of Google’s profits come from selling advertising space and
users’ data to firms. If something is free online, you are not the customer,
you are the product.64 Facebook’s and Google’s business models are built
on the commodification of personal data, transforming through the
alchemy of a two-sided market our friendships, interests, beliefs and
preferences into sellable propositions. The so-called ‘sharing economy’ is
based on the same idea. For all the hype about ‘sharing’, it is less about
altruism and more about allowing market exchange to reach into areas of
our lives – our homes, our vehicles, even our private relationships – that
were previously beyond its scope and to commodify them.65 As Evgeny
Morozov has warned, it risks turning us all into ‘perpetual hustlers’,66 with
all of our lives up for sale, while at the same time undermining the basis
for stable employment and a good standard of living.
 Standing on Platform Capitalism
‘Platform capitalism’ is often referred to as the new way in which goods
and services are produced, shared and delivered – more horizontally, with
consumers interacting with each other, and less intermediation by old
institutions (e.g. travel agents). The so-called sharing economy, based on
this framework, works by reducing the frictions between the two sides of
the market: connecting buyers to sellers, potential customers to advertisers,
in more efficient ways. It is presented as a radical transformation in the
way that goods and services are produced, shared and delivered. It adds
value by taking what was previously peripheral to the service – in Uber’s
case, ordering, selecting, tracking and paying for a cab – into its core. But
when disabled users have complained to Uber about their drivers refusing
to put wheelchairs in the boot of the car, Uber has sought to evade
responsibility on the basis that it is not a taxi company, merely a
platform.67 Likewise, there is increasing evidence that Airbnb is similarly
reluctant to take responsibility for such matters as the safety of premises
offered on its site or racial discrimination against renters by property
owners.
Furthermore, Uber’s pursuit of economies of scale (based on the size of
the network) and economies of scope (based on the breadth of different
services, including UberEats) has led to higher profits on the backs of the
key contributors to value creation for the company: the drivers. Indeed,
while costs have been falling for the consumer, they have been rising for
the drivers: in 2012 Uber Black (one of the company’s car services) cost
riders in San Francisco $4.90 per mile or $1.25 per minute. When, in 2016,
charges fell to $3.75 per mile or $0.65 per minute, consumers gained. But
the result of this sharing economy is that Uber Black drivers are paid less,
‘standards’ rise (with pressure for drivers to offer ‘pool’ services to
customers) and competition from Uber’s other services intensifies.68 While
drivers are increasingly complaining, Uber’s market reach is higher than
ever and growing every day: as of October 2016 it had 40 million monthly
riders worldwide.69 In 2016 it had 160,000 drivers in the US, with millions
more spread across 500 cities globally – all working as ‘independent
contractors’, so that Uber does not have to provide them with the kind of
healthcare and other benefits which they would receive as full-time
employees.
Uber, like Google, Facebook and Amazon, seems to have no limit to its
size. The network effects that pervade online markets add an important
peculiarity: once a firm establishes leadership in a market its dominance
increases and becomes self-perpetuating almost automatically. If everyone
is on Facebook, no one wants to join a different social network. As most
people search on Google, the gap between Google and its competitors
grows wider because it can elaborate on more data. And as its market share
rises, so does its capacity to attract users, which in turn increases its
market dominance.70
Contrary to the pious pronouncements of Internet pioneers, network
effects are increasingly centralizing the Internet, thereby placing an
enormous concentration of market power in the hands of a few firms.
Google alone accounts for 70 per cent of online searches in the US, and 90
per cent in Europe. Facebook has more than 1.5 billion users, a quarter of
the planet’s population and streets ahead of its competitors. Amazon now
accounts for around half of the US books market, not to mention e-books.
Six firms (Facebook, Google, Yahoo, AOL, Twitter and Amazon) account
for around 53 per cent of the digital advertising market (with just Google
and Facebook making up 39 per cent).71 Such dominance implies that
online giants can impose their conditions on users and customer firms.
Many book publishers, for example, are unhappy with the conditions
Amazon insists upon and are asking for better ones. But they have no
leverage at all, because – as Evgeny Morozov puts it – ‘there is no second
Amazon they can turn to’.72 The powerful network effects in the two-sided
market have entrenched these companies’ position. Companies like
Google are de facto monopolies.73 But they are not recognized as such and
have not attracted the kind of anti-trust legislation that large companies in
more traditional industries – tobacco, autos, food – have done.
The dominant position of a platform provider in core markets can then
be used to favour their products and services in satellite markets, further
extending the company’s reach. The European Commission is
investigating Google precisely because it is alleged systematically to tilt its
search results in favour of its own products. By the same token, many
users are not happy about Facebook appropriating, storing, analysing and
selling to third parties so much of their personal data. But as long as all
their friends are on Facebook, there is no equivalent competitor they can
turn to. The standard defence of companies such as Facebook that
‘competition is just one click away’ is simply false in markets where
network effects are so important.
A recent study by researchers at the University of Pennsylvania
surveyed 1,500 American Internet users to understand why they agree to
give up some privacy in return for access to Internet services and
applications. The standard explanation is that consumers compare the cost
of losing some privacy with the benefit of accessing these services for free,
and accept the deal when benefits exceed costs. A competing explanation
is that many users are simply unaware of the extent to which online
companies invade their privacy. But, interestingly, the results of the
Pennsylvania survey are inconsistent with both explanations. Instead, they
suggest that consumers accept being tracked and surrendering their
personal data, even if ideally they would prefer not to, not because they
have happily embraced this quid pro quo, but out of resignation and
frustration.
It is understandable that people feel they have no choice. In today’s
society, it is hard to live and work without using a well-functioning search
engine, a crowded social network and a well-supplied online shopping
platform. But the price of accessing these services is to accept the
conditions the dominant provider imposes on a ‘take it or leave it’ basis,
given that there are no comparable alternatives.

CREATING AND EXTRACTING DIGITAL VALUE

The digital giants’ enormous market power raises critical issues about
privacy protection, social control and political power. But what concerns
us here is the impact of this market power on the relationship between
value creation and value extraction.
The particular dynamics of innovation – the power of early adoption of
standards and associated network effects tending towards market
dominance – have profound consequences for how the value created is
shared and measured.
The first major consequence is monopoly. Historically, industries
naturally prone to being monopolies, for example railways and water, have
been either taken into public ownership (e.g. in Europe) or heavily
regulated (e.g. in the US) to protect the public against abuses of corporate
power. But monopolistic online platforms remain privately owned and
largely unregulated despite all the issues they raise: privacy, control of
information and their sheer commercial power in the market, to name a
few. In the absence of strong, transnational, countervailing regulatory
forces, firms that first establish market control can reap extraordinary
rewards. The low rates of tax that technology companies are typically
paying on these rewards are also paradoxical, given that their success was
built on technologies funded and developed by high-risk public
investments.74 If anything, companies owing their fortunes to taxpayer
investment should be repaying the taxpayer, not seeking tax breaks.
Moreover, the rise of the ‘sharing economy’ is likely to extend market
exchange into new areas, where the dynamics of market dominance look
set to repeat themselves.
The second major consequence of the dynamics of innovation is about
how value is created, how this is measured, and how and by whom this
value is extracted. If we go by national accounts, the contribution of
Internet platforms to national income (as measured for example by GDP)
is represented by the advertisement-related services they sell to firms. It is
not very clear why advertisements should contribute to the real national
product, let alone social well-being, which should be the aim of economic
activity. But national accounts, in this respect, are consistent with standard
neoclassical economics, which tends to interpret any voluntary market-
based transaction as signalling the production of some kind of output –
whether financial services or advertising, as long as a price is received, it
must be valuable.75 That is misleading: if online giants contribute to social
well-being, they do it through the services they provide to users, not
through the accompanying advertisements.
The classical economists’ approach appears much more fruitful for
analysing these new digital markets. As discussed in Chapter 1, they
distinguished between ‘productive’ labour, which contributes to an
increase in the value of what is produced, and ‘unproductive’ labour,
which does not. The activities which make profits for online platforms –
advertising and analyses of users’ private information and behaviour – do
not increase the value of what is produced, which is services to users such
as posting a message on Facebook or making a search on Google. Rather,
these activities help firms competing against one another to appropriate,
individually, a larger share of the value produced.76 The confused and
misleading approach to the concept of value that is currently dominating
economics is generating a truly paradoxical result: unproductive
advertising activities are counted as a net contribution of online giants to
national income, while the more valuable services that they provide to
users are not.
The rise of big data is often talked about as a win-win opportunity for
both producers and consumers. But this depends on who owns the data and
how it is ‘governed’. The fact that IPR has become wider and stronger, and
more upstream, is due to the way it is governed – or not. Markets of any
type must be actively shaped in order for knowledge to be governed in
ways that produce the market outcomes that we as a society want. Indeed,
regulation is not about interference, as is commonly perceived, but about
managing a process that produces the results that are best for society as a
whole. In the case of big data, the ‘big five’ – Facebook, Google, Amazon,
IBM and Microsoft – virtually monopolize it. But the problem is not just a
question of competition – the size and number of firms in the sector. It
could be argued that a few large companies can achieve the economies of
scale required to drive down costs and make data cheaper – not a bad thing
given falling real incomes.
The key issue is the relationship between the Internet monopolies and
these falling incomes. The privatization of data to serve corporate profits
rather than the common good produces a new form of inequality – the
skewed access to the profits generated from big data. Merely lowering the
price monopolists charge for access to data is not the solution. The
infrastructure that companies like Amazon rely on is not only publicly
financed (as discussed, the Internet was paid for by tax dollars), but it
feeds off network effects which are collectively produced. While it is of
course OK for companies to create services around new forms of data, the
critical issue is how to ensure that the ownership and management of the
data remains as collective as its source: the public. As Morozov argues,
‘Instead of us paying Amazon a fee to use its AI capabilities – built with
our data – Amazon should be required to pay that fee to us.’77

SHARING RISKS AND REWARDS

Acknowledging the collective nature of innovation should result in more

sharing of the rewards that accrue from the process of innovation. And yet
ignoring the collective story, and only giving credit to a narrow group of
individuals, has affected thinking about who should own IPR, how high a
medicine’s price can acceptably be, who should or should not retain equity
in a new firm or a new technological advance, and the fair share of tax
contributions. It is this gap between the collective distribution of risk-
taking in innovation and the more individualized, privatized way in which
the returns are distributed that is the most modern form of rent.
Current stories about value, wealth creation and risk-taking that
privilege the contribution of individual inventors and capitalists lead to
ways of thinking whereby it is acceptable to divide up the fruits of
innovation between them – the concept of ‘just deserts’. The term comes
from the English philosopher John Locke (1632–1704). His concept of
individual entitlement – ‘just deserts’ – to the product of work was based
on a production system where individual labour was more important, and
was easier to identify, than it is today when collective contributions have
been central to technology-driven growth. This point was made by Herbert
Simon (1916–2001), who made his name in the study of organizational
decision-making, and who won the Nobel Prize in Economics in 1978. ‘If
we are generous with ourselves,’ Simon considered, ‘I suppose that we
might claim that we “earned” as much as one-fifth of our income. The rest
of the patrimony [is] associated with being a member of an enormously
productive social system, which has accumulated a vast store of physical
capital, and an even larger store of intellectual capital – including
knowledge, skills, and organizational know-how held by all of us.’78
Ignoring this collectively produced social system, certain individuals feel
justified in earning a much higher proportion of a nation’s income than
their own contribution warrants. But, more specifically, it has affected
policies on taxes, patents and prices, thus fuelling the dynamics of
inequality.
The question is: what can we do about it?
Policymaking should start from understanding that innovation is a
collective process. Given the immense risks the taxpayer takes when the
government invests in visionary new areas like the Internet, couldn’t we
construct ways for rewards from innovation to be just as social as the risks
taken? These ways might include: capping prices of publicly developed
medicines; attaching conditions to public support, such as the requirement
that profits be reinvested back into production rather than spent on
speculative share buy-backs; allowing public agencies to retain equity or
royalties in technologies for which they provided downstream funding; or
by making income-contingent loans to businesses as we do for students.
As is the nature of early-stage investment in technologies with uncertain
prospects, some investments are winners, but many are losers. For every
Internet (a success story of US government financing), there are many
Concordes (a white elephant funded by the British and French
governments). Consider the twin tales of Solyndra and Tesla Motors. In
2009, Solyndra, a solar-power-panel start-up, received a $535 million
guaranteed loan from the US Department of Energy; that same year, Tesla,
the electric-car manufacturer, got approval for a similar loan, of $465
million. In the years afterwards, Tesla was wildly successful, and the firm
repaid its loan in 2013. Solyndra, by contrast, filed for bankruptcy in 2011,
and among fiscal conservatives became a byword for the government’s
sorry track record when it comes to picking winners. Of course, if the
government is to act like a venture capitalist, it will necessarily encounter
many failures. The problem, however, is that governments, unlike venture
capital firms, are often saddled with the costs of the failures while earning
next to nothing from the successes. Taxpayers footed the bill for
Solyndra’s losses – yet got hardly any of Tesla’s profits. Strangely, the US
government had put in a claim for 3 million shares into Tesla only if it did
not pay back the loan – almost as if the US government has an interest in
owning a part of failed companies! Tesla did pay back the loan in 2013,
and so had the US government taken a stake in Tesla as a success rather
than as a failure, it would have been able to more than cover its losses
from Solyndra. The year Tesla received its government loan, the company
went public at an opening price of $17 a share; that figure had risen to $93
by the time the loan was repaid. Today shares in Tesla trade above $200.
In the case of prices of drugs, instead of focusing on the debatable and
arbitrary quantification of ‘what it would cost society not to treat’, we
should try to understand the production side of the pharmaceutical industry
and its interdependencies with related industries such as the biochemical
industry and the medical devices industry. We could engineer prices to
ensure continuous production of drugs that are actually needed (reducing
the amount of ‘me too’ drugs which have little extra benefit); supply the
drugs to whomever needs them; and maintain a steady and well-targeted
flow of R&D to develop new drugs. A system of this kind does not
necessarily need drug prices to be above manufacturing costs. We could,
for example, abolish patents on pharmaceutical products and at the same
time establish a competitive prize system to reward and incentivize public
and private entities to come up with well-targeted pharmaceutical
innovation. If we make more use of generic drugs – drugs which are the
same medically as branded ones – we can make then widely available and
push pharmaceutical companies to concentrate on breakthrough
innovations rather than on producing ‘me too’ drugs or running share
repurchasing programmes to boost their stock prices.
Policymakers should have a clear understanding of who the different
actors in the process are in order to prevent free-riding on publicly funded
innovation and a ‘winner-takes-all’ outcome. Rather than creating myths
about actors in the innovation economy such as venture capitalists, it is
important to recognize the stages at which each of these actors is
important. Tax policy could be changed to encourage truly dynamic links
between the different participants in innovation, for example by bringing
the rewards and tax breaks that venture capitalists enjoy more into line
with the risks they actually take compared with other stakeholders.
Understanding that the state’s role is to do what the business sector is not
willing to do – engage in high-risk early-stage development and
fundamental research – also means that particular policies such as R&D
tax credits must be devised so that the subsidy encourages investment in
needed innovations over and above random potentially profitable ones.
 Treatment of employees is also very important here. When, typically in
the name of maximizing shareholder value, a successful company fires
experienced employees, it is quite probable that the unlucky victims
committed their time to the enterprise in the expectation of sharing in the
returns if and when it succeeded. They are now cut off from the rewards
that they deserve, while others such as venture capitalists who came in at a
later stage receive a disproportionately large share of the rewards.
Employees’ contribution to the enterprise deserves to be better protected.
Deals are being developed in European capitals, such as Berlin and
Paris, to place limits or conditions on the operations of companies like
Airbnb, Uber and Netflix.79 Patent pools can be set up that guarantee the
use of patents for common goals. Government can earn equity stakes or
royalties when investing in high-risk areas, whether in products or
technologies. Prices of products that have received public support can be
negotiated to reflect the public contribution. Big data can be governed so
that it reflects the public data and publicly funded infrastructure upon
which it rests. This means that we must not hype up technological
advances, but recognize the collective contribution that created them, and
govern them so that they produce a public good.

CONCLUSION

Economic growth without innovation is hard to imagine. But innovation

must be properly governed to make sure that what is produced and how it
is produced leads to value creation and not gimmicks for value
appropriation. This means paying attention both to the rate and direction of
innovation (what is produced), and to the deals that are struck between the
different creators of that new value.
First, it is crucial to understand that innovation is not a neutral concept.
It can be used for different purposes – in the same way a hammer can be
used to build a house or as a weapon. The big data revolution itself can go
either way. It can become a way for public data (on health, on energy use,
on shopping preferences) to serve private profits, or it can be used to
improve the services that consumers and citizens receive. Citizenship
should in the process not be confused with being a client. As citizens, we
have rights to enjoy the opportunities that innovation presents us with, to
make use of public space, to be able to contest authority, and to share
experiences and tastes without our stories and preferences ending up on a
website or a database. In this sense movements for ‘inclusive’ innovation
are important in how they focus on who is involved in envisioning change
and benefiting from it.
 Second, innovation has both a rate and a direction. A democratic debate
about the direction is just as important as those that occur about the rate of
growth – and key to understanding the multiple pathways that innovation
may take, and how policy affects this. The assumption is that policy should
be about ‘levelling the playing field’. But achieving innovation-led growth
and innovation of a particular type (e.g. green innovation) will require not
levelling but tilting the playing field. And furthermore, this requires not
only a different policy mindset but also a different organizational structure:
the ability to explore, experiment and strategically deliberate inside the
public sector. It was this capacity that was central to the organizations that
fostered some of the most radical innovations of our age, from the Internet
to GPS to fracking. More discussion is needed on how to use mission-
oriented innovation to battle societal and technological grand challenges –
like climate change or social care.80 Just as the IT revolution was chosen
and directed, we can choose and direct green and care as the new paths for
innovation. This does not mean top-down dictation of what should be
produced, and which actors are ‘productive’ and how each must behave.
Rather, it requires new types of contracts between public and private actors
(as well as the third sector and civil society) in order to foster symbiotic
relationships, sharing the kinds of investments that will be needed to
redirect economies away from high material content and energy based on
fossil fuels. There are lessons from ‘mission-oriented’ investments such as
going to the moon. Making sure our earth remains habitable demands the
same ambition, organization, planning, bottom-up experimentation, public-
private risk-sharing and sense of purpose and urgency as the Apollo
project.81 But it is also true that because these investments are
transformational, more debate should also be had on why it is that some
technologies are pursued, and what is done with them. It is curious, for
example, that there was so little debate about fracking – which was
government-financed – until after its arrival.
Third, as argued in the previous section, innovation is produced
collectively, and hence the benefits should be shared collectively. The
deeply flawed reasoning behind pharma prices, patents and the dynamics
of big data is a good example of how a confused and misleading approach
to the concept of value can be costly, allowing large monopolies to get
away with huge rents at the expense of society. But it need not be this way
if we think radically.
Patents themselves should not be seen as ‘rights’ (IPR), but rather as a
tool with which to incentivize innovation in the sectors where they are
relevant – but in such a way that the public sector also gets its return; drug
prices could become ‘fairer’, reflecting the collective contribution of
different actors and making a healthcare system sustainable. The sharing
economy would not be based on the ability of a few companies to use
public infrastructure for free and the dynamics of network economies to
monopolize a market. A true sharing economy must by definition respect
the hard-won gains of all workers, irrespective of race, gender or ability.
The eight-hour day, the weekend and holiday and sick pay fought for by
workers’ movements and trade unions were no less important economic
innovations than antibiotics, the microchip and the Internet.
In an era in which profits are being hoarded at record levels, it’s
important to understand what led to the agreements whereby business
reinvested profits instead of hoarding them. And the answer is confident
and capable government, which has built up its own capacity to invest in
technological opportunities and, just as important, to negotiate the
landscape that they create. Monopolies like patents are contracts which
must be negotiated. One party (business) receives protection of its profits,
the other party (government) receives benefits for the public, whether
through lower costs and prices (by economies of scale), diffusion of
innovation (by the way patents disclose information), or through
reinvestment of the profits in specific areas considered beneficial for
growth – in this case, innovation.
Developing countries are used to such deals over foreign investment:
you come and make use of our resources as long as you reinvest profits
locally to benefit us. But negotiation of this sort is largely absent from
modern Western capitalism. Just as governments have allowed companies
to use patents for unproductive rather than productive entrepreneurship,
they have also allowed companies to stop reinvesting profits. That would
be fine (perhaps) if those profits were generated from their own activity,
independent of public funds. But, as I have argued throughout this chapter,
the technology and the underlying networks have been produced
collectively. They should therefore be negotiated collectively.
A key issue behind all these considerations is government’s contribution
to economic growth – public value. Why, historically, have no economists
referred to it? And, more importantly, why have governments now lost
their confidence in fighting for public value, while previously they limited
the scope of patents or put pressure on monopolies to reinvest profits? We
will turn to these matters in the next chapter.
 8
Undervaluing the Public Sector

The important thing for Government is not to do things which individuals are doing
already, and to do them a little better or a little worse; but to do those things which at
present are not done at all.
John M. Keynes, The End of Laissez-Faire, 19261

The January 2010 edition of The Economist was devoted to the dangers of
big government. A large picture of a monster adorned the magazine’s
cover. The editorial opined: ‘The rich world has a clear choice: learn from
the mistakes of the past, or else watch Leviathan grow into a true monster.’
In a more recent issue, dedicated to future technological revolutions, the
magazine was explicit that government should stick to setting the rules of
the game: invest in basic goods like education and infrastructure, but then
get out of the way so that revolutionary businesses can do their thing.2
This, of course, is hardly a novel view. Throughout the history of
economic thought, government has long been seen as necessary but
unproductive, a spender and regulator, rather than a value creator.
Previous chapters revealed how actors in both the financial sector and
Silicon Valley have been particularly vociferous in their self-aggrandized
claims about wealth creation, using these claims to lobby for favourable
treatment that has in turn enabled them to reap rewards disproportionate to
the value they actually created. By the same token, others have widely but
mistakenly been regarded as ‘unproductive’.
As we have seen, finance has, ultimately, been less productive than it
claims to be. In this chapter I want to look at government, an actor that has
done more than it has been given credit for, and whose ability to produce
value has been seriously underestimated – and this has in effect enabled
others to have a stronger claim on their wealth creation role. But it is hard
to make the pitch for government when the term ‘public value’ doesn’t
even currently exist in economics. It is assumed that value is created in the
private sector; at best, the public sector ‘enables’ value.

The concept of ‘public value’ has existed for millennia, debated in

philosophy and society at least from the time of Aristotle’s Nicomachean
Ethics. It is, however, a Cinderella subject as far as the study of economics
is concerned. There is of course the important concept of ‘public goods’ in
economics – goods whose production benefits everyone, and which hence
require public provision since they are under-produced by the private
sector – but, as we shall see, the concept has also been used to hinder
government activity (restricting specific areas in which it is OK for the
public sector to tread) rather than help government think creatively about
how it produces value in the economy.
The narrative that government is inefficient and its optimum role should
be ‘limited’ to avoid disrupting the market is extremely powerful. At best,
the story goes, government should simply focus on creating the conditions
that allow businesses to invest and on maintaining the fundamentals for a
prosperous economy: the protection of private property, investment in
infrastructure, the rule of law, an efficient patenting system. After that, it
must get out of the way. Know its place. Not interfere too much. Not
regulate too much. Importantly, we are told, government does not ‘create
value’; it simply ‘facilitates’ its creation and – if allowed – redistributes
value through taxation. Such ideas are carefully crafted, eloquently
expressed and persuasive. They have resulted in the view that pervades
society today: government is a drain on the energy of the market, an ever-
present threat to the dynamism of the private sector.
But there is one area of mainstream economic theory which recognizes
– indeed, emphasizes – where governments can play a positive role: fixing
‘market failures’. As discussed, market failures arise when the private
sector does not invest enough in an area considered good for the public
benefit (e.g. basic research, as it’s so hard to make profits from this output)
or invests too much in areas considered bad for public benefit (e.g.
polluting industries, creating a negative externality not embodied in
company costs). A government subsidy may be placed on the good and a
tax on the bad. But the current message to government is: intervene only if
there is a problem, otherwise sit back, focus on getting the ‘conditions’
right for business and let the business sector do its thing, which is to create
value.
But while this is the accepted view of government’s role, a brief glance
at the history of capitalism reveals some other powerful, if less simplistic,
stories about government’s place in the economy. In the middle of the
Second World War Karl Polanyi, a radical Austro-Hungarian thinker who
combined the reasoning of political economy with a deep understanding of
anthropology, history and philosophy, wrote a very important book: The
Great Transformation. In it, he argued that markets were far from ‘natural’
or inevitable – rather, they resulted from purposeful policymaking: ‘The
road to the free market was opened and kept open by an enormous increase
in continuous, centrally organized and controlled interventionism …
Administrators had to be constantly on the watch to ensure the free
working of the system.’3
Polanyi traced the long history of local and international markets. In the
process, he showed that the national capitalist market – the one studied in
economics classes with supply and demand curves – was actually forced
into existence by the state. Government, Polanyi asserted, does not
‘distort’ the market. Rather, it creates the market. Put bluntly: no state, no
market. This is not a normative point – the government can of course
invest in areas that are considered problematic, from wartime technologies
to fracking technology, which some have argued strongly against. And it is
precisely this potentially powerful role that should alert us all to better
understand what taxpayers’ money (or printed money) is being invested in.
As discussed in the previous chapter, government policy has been
crucial to envisioning and funding key technologies such as the Internet,
critical to Silicon Valley’s success. In the process, government has given
life to new markets that have sprung from these technologies (the dot.com
economy).
This historical and institutional view of markets’ relationship with
government contrasts sharply with the current prevailing orthodoxy and is
not to be found in mainstream economics. Here – to get technical for a
moment – you only find government as a player in the macroeconomic
models that look at the effect of regulation or the effect of a stimulus
programme on GDP (through the multiplier which we discuss later in the
chapter). But government is totally missing from what in microeconomics
is known as the ‘production function’: the relationship between the
quantity of outputs of a good and the quantity of inputs needed to make it,
or, to put it simply, the analysis of how firms behave. And thus it is
assumed that it is only in firms that value is created. Government is left
outside the production boundary.
Some theories go further. Government, they argue, is innately corrupt
and liable to ‘capture’ by vested interests. Because government is
inherently unproductive, if we can restrict what it does we can reduce
unproductive activities, thereby improving conditions for productive ones,
steering economies towards growth. The logical conclusion is that
government should be curbed, stripped back: perhaps by budget cuts,
privatization of public assets, or outsourcing. In contemporary parlance,
‘austerity’.
This chapter will argue that the prevailing view of government is wrong,
that it is more the product of ideological bias than anything else. The
stories told about government have undermined its confidence, limited the
part it can play in shaping the economy, undervalued its contribution to
national output, wrongly led to excessive privatization and outsourcing,
ignored the case for the taxpayer sharing in the rewards of a collective –
public – process of value creation, and enabled more value extraction. Yet
these stories have become accepted as ‘common sense’ – always a term to
be treated circumspectly. We have become accustomed to much talk about
the pros and cons of austerity. The debate about government, though,
should not be about its size or its budget. The real question is what value
government creates – because to ask about the role of government in the
economy is inevitably to question its intrinsic value. Is it productive or
unproductive? How do we measure the value of government activities?

THE MYTHS OF AUSTERITY

After the 2008 financial crash – a crisis chiefly brought about by private,
not public, debt – governments saved the capitalist system from
breakdown. Not only did they pump money into the financial system: they
took over private assets. A few months after Lehman Brothers collapsed,
the US government was in charge of General Motors and Chrysler, the
British government was running high street banks and, across the OECD,
governments had committed the equivalent of 2.5 per cent of GDP to
rescuing the system.
And yet, even though the crisis was caused by a combination of high
private debt and reckless financial-sector behaviour, the extraordinary
policy conclusion was that governments were to blame – despite the fact
that, through bailouts and counter-cyclical stimulus, they had saved the
financial system from crumbling. Instead of being seen as the heroes that
stepped in to fix the mess created by private finance, they became the
villains. Of course there had been failings on all sides – abnormal interest
rates had contributed to the rise in debt – but the narrative became twisted
out of all recognition. This distortion was enabled by a view held since the
1970s that somehow the public sector is less able to engineer growth than
the private sector. What followed was a drive towards austerity across
Europe. And tragically, instead of being allowed to invest their way back
to pre-recessionary levels of output and employment, weaker European
countries were repeatedly told by the ‘troika’ (the IMF, European Central
Bank and European Commission) to cut public spending to the bone. Any
country whose budget deficits rose beyond the level stipulated in the
Maastricht Treaty were penalized severely, with conditions placed on
bailouts that even the pro-austerity IMF later admitted were self-defeating.
In a nutshell, austerity assumes that public debt is bad for growth, and
that the only way to reduce it is to cut government spending and debt by
running a budget surplus, irrespective of the possible social cost. With debt
down to an unspecified level and government finances ‘sound’, the private
sector will be freed to reignite prosperity.
The politics of ‘austerity’ has framed the policies of successive UK
Chancellors of the Exchequer and European finance ministers for almost a
decade. In the US, from Newt Gingrich in the 1990s to the legally
mandated spending cuts – sequestration – after the last financial crisis,
Congress has threatened periodically to shut down the Federal government
unless lower budget targets are met.
But this fixation on austerity to reduce debt misses a basic point: what
matters is long-run growth, its source (what is being invested in), and its
distribution (who reaps the rewards). If, through austerity, cuts are made to
essential areas that create the capacity for future growth (education,
infrastructure, care for a healthy population), then GDP (however ill
defined) will not grow. Moreover, the irony is that just cutting the deficit
may have little effect on the debt/GDP if the denominator of the ratio is
being badly affected. And if the cuts cause more inequality – as the
Institute for Fiscal Studies has shown was the case with the UK austerity
measures of the last years – consumption can only grow through debt (e.g.
credit cards), which maintains purchasing power. Instead, if public
investment is made in areas like infrastructure, innovation, education and
health, giving rise to healthy societies and creating opportunities for all,
tax revenues will most likely rise and debt fall relative to GDP.
It is crucial to understand that economic policy is not scientifically
ordained. You can impose austerity and hope the economy grows, even
though such a policy deprives it of demand; or you can focus on investing
in areas like health, training, education, research and infrastructure with
the belief that these areas are critical for long-run growth in GDP. In the
end, the choice of policy depends heavily on one’s perspective on the role
of government in the economy – is it key to creating value, or at best a
cheerleader on the sidelines?

Magic Numbers
The current debate about austerity has avoided any mention of public
value. Neither budget doves nor budget hawks have seriously questioned
the theory of value that underpins much ‘common-sense’ understanding of
market processes. A major reason for this lack of curiosity is that both
camps seem to have been in thrall to the so-called ‘magic’ numbers which
have framed the debate.
When, in 1992, European integration came into being through the
Maastricht Treaty, there were various obligations that the signatory
countries signed up to, one of which was to keep spending in check. Total
public debt was to be limited to 60 per cent of GDP, with annual deficits
(debt is the accumulation of deficits) not larger than 3 per cent of GDP.
These numbers purport to set objective limits to government indebtedness.
But where do they come from? You might imagine they are arrived at
through some kind of scientific process – but if so, you’d be wrong. These
numbers are taken out of thin air, supported by neither theory nor practice.
Let’s start with debt. In 2010 the American Economic Review published
an article by two top economists, professors at Harvard University:
Carmen Reinhart, ranked the following year by the Bloomberg Markets
magazine among the ‘Most Influential 50 in Finance’; and Kenneth
Rogoff, a former chief economist of the IMF.4 In this piece the pair
claimed that when the size of government debt (as a proportion of GDP) is
over 90 per cent (much higher than the 60 per cent of the Maastricht
Treaty, but still lower than that of many countries), economic growth falls.
The results showed that rich countries whose public debt exceeded that
percentage experienced a sharp drop in growth rate for the period 1946–
2009. This was a very important finding, as so many countries’ public debt
levels are close to or exceed this percentage. According to IMF data the
US debt/GDP ratio stood at 64 per cent in 2007, and 105 per cent in 2014.
For the UK the equivalent numbers were 44 per cent and 81 per cent; for
the European Union 58 per cent and 88 per cent, and for the Eurozone 65
per cent and 94 per cent.
Aware that the argument clearly gave ammunition to advocates of the
smaller state, the authors hastened to reassure their readers that they had
no skin in the game: that their argument had no ideological foundation, but
was based purely on empirical data. They even went so far as to stress that
their research had no underlying theory of government: ‘our approach
here’, they emphasized, ‘is decidedly empirical’.5
Predictably enough, politicians and technocrats eager to ‘balance’ public
spending seized on Reinhart and Rogoff’s research, which proved highly
influential in the post-2008 crisis debate about austerity measures. In his
Federal Budget Plan for 2013, passed by the US House of Representatives,
the Republican Congressman Paul Ryan cited the study as evidence for the
negative impact of high government debt on economic growth. It also
informed austerity policies proposed by then UK Chancellor George
Osborne and the EU Economy Commissioner, Olli Rehn.
Also in 2013, as part of his PhD studies, Thomas Herndon, a twenty-
eight-year-old student at the University of Massachusetts Amherst, tested
Reinhart and Rogoff’s data.6 He couldn’t replicate their results: his
calculations showed no steep drop in growth rates when debt was high.
Examining the professors’ data sheet, Herndon found a simple spreadsheet
error. He also discovered inconsistencies in the countries and data cited.7
In two articles in the New York Times,8 the professors defended their
general results, but accepted the spreadsheet error. Magic numbers were
not so magic after all.
Now on to the other magic number held so dear by EU economists: the
number 3. The ‘periphery’ countries of the Eurozone have been urged to
restore their competitiveness by downsizing the state. In line with the
Maastricht criteria, bailouts for countries like Cyprus, Greece, Ireland and
Portugal have been conditional on their cutting spending. If that spending
goes above 3 per cent of GDP then bailouts are jeopardized. Between 2010
and 2017, Greece received €260 billion in bailout aid, in exchange for
cutting state expenditure. However, since its problems were too structural
to be solved by a simple ‘austerity’ measure, the cuts pitched it into a deep
recession, turning into full-blown depression. And, rather than decreasing
Greece’s debt, the lack of growth has caused the debt/GDP ratio to rise to
179 per cent. The cure is killing the patient.
This obsessive focus on countries’ deficits ignores a stark reality. Some
of the weakest Eurozone countries have had lower deficits than the
stronger countries – Germany, for instance. What matters is not the deficit
but what government is doing with its funds. As long as these funds are
invested productively in sectors like healthcare, education, research and
others that increase productivity, then the debt/GDP denominator will rise,
keeping the ratio in check.
Italy is another glaring example of how magic numbers don’t work. For
the last two decades Italy’s budget deficit has been lower than Germany’s,
rarely exceeding the 3 per cent limit specified for euro membership.
Indeed, Italy has been running a primary budget surplus since 1991, the
only exception being 2009. And yet Italy has a high and rising debt/GDP
ratio: 133 per cent in 2015,9 way above the 60 per cent ceiling. The ratio is
less affected by the numerator (the budget deficit) than by the lack of
public and private investment determining the denominator (growth of
GDP). After three successive years of austerity, GDP grew by just 1 per
cent in 2015 (0.1 per cent in 2014, 0.9 per cent in 2016). (In fact, the
austerity years were responsible for an outstanding fall in real GDP: −2.8
per cent in 2012, −1.7 per cent in 2013.) So why has the economy
stagnated? The answer is complicated, but in part it is the result of
inadequate investment in areas that raise GDP, such as vocational training,
new technology and R&D. To make matters worse, a prolonged squeeze
on government spending has weakened demand in the Italian economy and
lowered the incentive to invest.
Yet Eurozone policy blindly persists in the conventional view that
austerity is the solution, and that inadequate growth indicates insufficient
austerity. Back in 2014, in a stinging attack on Eurozone political
economy,10 Joseph Stiglitz wrote: ‘Austerity has failed. But its defenders
are willing to claim victory on the basis of the weakest possible evidence:
the economy is no longer collapsing, so austerity must be working! But if
that is the benchmark, we could say that jumping off a cliff is the best way
to get down from a mountain; after all, the descent has been stopped.’ The
austerity policy of cutting taxes and government spending does not revive
investment and economic growth, when the real problem is weak demand.
And in countries like Greece and Spain, where 50 per cent of young people
cannot find work, pursuing policies that don’t actually affect investment –
and hence jobs – means that an entire generation can lose its right to a
prosperous future.
Questions of government debt and budget deficits are often also
confused with ones about the size of government, usually measured as the
ratio of government spending to the size of the economy. And yet there are
no magic numbers for what is too big or too small. France, frequently
touted as an example of ‘big government’, has a government
expenditure/GDP ratio of 58 per cent. The UK government’s spending is
also often regarded as quite big, but at about 40 per cent its ratio is not
much different to that of the US at 36 per cent – although the US is often
cited as an example of ‘small government’. Surprisingly, China, often
perceived as a state-run economy, has a ratio of only 30 per cent.
However, recent research into the impact of government size on
economic growth has found almost unanimously that small government is
‘bad’ if, for example, it cannot even maintain basic infrastructure, rule of
law (e.g. funding of police) and the educational needs of the population.
Conversely, the same research concludes that bigger government might be
‘bad’ if it is a result of activity that ‘crowds out’ (reduces) the private
sector11 or unduly restricts private-sector activity and interferes too much
in people’s lives.12 But within these rather obvious limits, the ideal size of
government is hard to quantify – not least because it depends heavily on
what you want government to do and how you value government activity.
And here we have a problem: there has been a dearth of thinking by
economists – both historically and in recent decades – about the value
created by government.

GOVERNMENT VALUE IN THE HISTORY OF ECONOMIC THOUGHT

Economics emerged as a discipline in large part to assert the productive

primacy of the private sector.
 Starting with the French physiocrats, economists found that government
was required for the orderly functioning of society and thus for setting
conditions for the production of value. But in itself, government was not
inherently productive; rather, it was a stabilizing background force. The
physiocrats pleaded with King Louis XV to laissez-faire – not to micro-
manage the economy by siphoning off as much gold as possible, and
thereby upset the intricate mechanism by which value was really created13
– through productivity of the land, not by accumulating precious metal.
We saw in Chapter 1 how, according to Quesnay’s Tableau Économique,
value produced in agriculture flowed through the economy. But
government was absent, ‘unproductive’. As part of the ruling class,
members of the government got a share of the value apportioned simply
because they were in power.14
Nevertheless, Quesnay knew, the Tableau did not work by itself. There
was something to be ‘governed’. Quesnay argued that the wealth of the
nation could only be upheld through ‘proper management by the general
administration’ – what we would call government regulation.15 He thought
that free competition would best benefit the economy – but to achieve this,
far from excluding government, he favoured an activist state that would
break monopolies and establish the institutional conditions necessary for
competition and free trade to flourish and value creation to thrive.16
Adam Smith, meanwhile, devoted the fifth book of his The Wealth of
Nations to the role of government in the economy. His aim was not only to
explain the prosperity of the nation, but also ‘to supply the state or
commonwealth with a revenue sufficient for the public services’.17 Like
Quesnay, Smith believed the state was necessary. Indeed, he was
convinced that national wealth could only be increased through division of
labour in ‘a well-governed society’,18 in which he singled out three crucial
functions of government: the military, the judiciary and other public
services such as provision of infrastructure.19 These are public goods –
producers cannot exclude anyone from consuming them. For Smith, such
public goods had to be paid for by the state;20 some sort of taxation was
therefore necessary.
David Ricardo was perhaps the most anti-government of the classical
economists. Although the title of his The Principles of Political Economy
and Taxation contains a key activity of government (taxation), he never
considered how taxation could allow government spending to encourage
production and hence value creation. For Ricardo, taxes are the ‘portion of
the produce of land and labour, placed at the disposal of government’ to
spend on areas such as education.21 If these expenditures are too high, he
writes, the capital of the country is diminished, and ‘distress and ruin will
follow’.22 Ricardo never asks, as Smith did, whether some taxes are
necessary to help capitalists carry out production. He assumes
infrastructure – the judiciary and so on – as a given. In effect, Ricardo
narrows the production of economic value strictly to the private sphere.
Admiring Ricardo’s rigorous analytical arguments, in comparison with
Smith’s more fluid and interdisciplinary philosophical and political
approach, economists followed him and excluded government from the
productive sector.
Marx’s view of government, meanwhile, derived from his materialist
view of history, whereby the organization of society (including
government structures) reflects the economic system (which he called the
mode of production) and the underlying social relations: the interaction
between classes. So, in his view, under the capitalist ‘mode of production’
– based on surplus value generated from exploitation of labour –
government and law reflected the needs of capitalists. Marx ridiculed some
followers of Smith and Ricardo for haranguing state officials as ‘parasites
on the actual producers’, then realizing that they were after all necessary to
support the capitalist system. Nevertheless Marx, like Smith before him,
while stressing the necessity of some functions of the state, placed state
officials in the category of unproductive labourers outside the production
boundary. The capitalist class had an interest in maintaining the state in a
position strong enough to guarantee the rule of law and advance their class
interests – but nothing more than that: ‘The executive of the modern state
is nothing but a committee for managing the common affairs of the whole
bourgeoisie.’23 The question concerning Marx was what constituted the
‘right’ size of government to provide the necessary services without taking
away any additional profits.
While the neoclassical economists broke with the labour theory of
value, they did not depart from their predecessors’ view that government
was necessary but unproductive. Marginal utility, as we have seen, locates
value in the price of any transaction that takes place freely in the market.
According to this perspective, government produces nothing: it cannot
create value. And government’s main source of income is taxes, which are
a transfer of existing value created in the private sector.
The immensely influential Alfred Marshall was quite nuanced in his
discussion of economic life in his Principles, but still recommended that
economics should avoid ‘as far as possible’ the discussion of matters
associated with government.24 He believed that government interference
in, or regulation of, the market would often happen in response to attempts
by vested interests to rig the market in their favour (i.e. government would
be ‘captured’ by such interests) – thus only hurting a particular competitor
rather than benefiting society as a whole.25

KEYNES AND COUNTER-CYCLICAL GOVERNMENT

To the humble citizen, however, it might not be so obvious that

government does not create value. We have already seen three ways in
which it does so: bailing out the banks; investing in infrastructure,
education and basic science; and funding radical, innovative technologies
which are transforming our lives.
The crucial point is that many of these activities involve taking risks and
investing – exactly what austerity doesn’t do – and in so doing they create
value. But that value is not easily visible, for the simple reason that much
of it goes into the pockets of the private sector. One man at least partly
understood this problem: John Maynard Keynes.
When in 1929 the global economic crisis struck, recovery seemed
elusive. The Great Depression shattered the idea of unbounded economic
progress because, contrary to the prevailing theoretical consensus, the
economy did not recover by itself. Keynes’s explanation for this was a
radical departure from the conventional wisdom of the time.26 Markets, he
claimed, are inherently unstable and, in a recession, may remain ‘in a
chronic condition of sub-normal activity for a considerable period without
any marked tendency, either towards recovery or towards complete
collapse’.27 In these circumstances, he stressed, the role of government is
crucial: it is the ‘spender of last resort’.
Let’s remind ourselves that Keynes was concerned in his General
Theory to explain how an economy might find itself in a state of
‘involuntary unemployment’ due to insufficient demand – that is, workers
who wanted work would not be able to find it. This, he argued, would
produce a low level of GDP, compared to a situation in which the
economy would be running at full capacity (and full employment).
Neoclassical economic theory is ill suited to explain this situation because
it assumes that people choose what they prefer, including how much
labour they ‘supply’ to the market at a given price (the wage), and that the
market makes sure to sort things out so that everyone gets the maximum
utility out of it. In such a view, unemployment becomes voluntary.
Keynes disposed of the assumption that supply creates its own demand.
He argued instead that producers’ expectations of demand and
consumption determine their investment, and consequently the
employment and production that follow from it;28 therefore, low
expectations could lead to underemployment. This he called the ‘principle
of effective demand’: investment can fall as a result of expectations or bets
on the future – and we know, not least from the 2008 financial crisis, that
such bets can go horribly wrong.
On the back of this theory, Keynes proposed a new role for government.
When the private sector cuts production in times of downbeat expectations
about demand, he argued, government could intervene positively,
increasing demand through additional spending, which in turn would lead
to more positive expectations of future consumption and induce the private
sector to invest, with higher GDP as a result.
In Keynes’s macroeconomics, therefore, government creates value in
that it allows the economy to produce more goods and services than it
would without government involvement. This was a pivotal shift in the
way we regard government’s role in the economy. For Keynes,
government was in fact essential because it could create value by reviving
demand – precisely when demand might be low, as in recessions, or when
business confidence is low.
Of course, government would have to borrow to finance this spending,
which means bigger government debt in a recessionary economy. But
higher debt is a result of a crisis, not its cause. Keynes argued that this
increased debt should not overly worry the government. Once the recovery
was under way, the need for big deficits would pass and the debt could be
paid off.
Keynes’s concept of a deficit-led recovery quickly won over
governments. It was applied most intensively at the end of the 1930s to
stimulate post-depression growth, and at the beginning of the 1940s as
wartime spending. Spreading rapidly after the Second World War,
Keynes’s ideas were widely credited with generating the unprecedented
prosperity of the three post-war decades – the trente glorieuses. Towards
the end of the twentieth century, Keynes’s ideas earned him a place in
Time magazine’s list of the 100 most important people of the century: ‘His
radical idea that governments should spend money they don’t have may
have saved capitalism.’29 As it turned out, these words were prophetic.
Some eighty years after the publication of the General Theory, in the wake
of the financial crisis governments around the world introduced stimulus
packages: a move that owed much to Keynes.
In the end, however, Keynes only went part of the way. He changed our
thinking about how government can create value in the bad times, through
counter-cyclical policies; but he, and his followers, had much less to say
about how it can do so in good times as well. Even as Keynesianism and
the post-war boom were at their height, dissenting voices could be heard.
With great ingenuity, the American Paul Samuelson (1915–2009) – one of
the most influential economists of the second half of the twentieth century,
a professor at the Massachusetts Institute of Technology and the first
American to win the Nobel Prize in Economics – attempted to prove that
neoclassical theory could explain how the economy behaved in normal
times, except when recessionary periods made monetary policy have little
effect: i.e. when increasing the money supply does not lower interest rates
and only adds to idle balances rather than spurring growth (what is known
as the ‘liquidity trap’). In essence, Samuelson argued that in normal
economic times there was little need for governments to try to manage the
economy along Keynesian lines and that government intervention (e.g.
aimed at increasing employment) in these cases would only lead to higher
inflation.
In the 1970s, inflation began to increase, opening the way for the
monetarists, led by Milton Friedman. A libertarian, Friedman rejected the
idea that government spending is beneficial, arguing that it most likely
leads to inflation, ignoring that this assumes that the economy is already
operating at full capacity so that any extra demand (stimulated by
government) would result in higher prices. But Keynes’s whole point was
that the economy would often be working at under-utilized capacity. For
Friedman, what mattered was controlling the quantity of money in the
economy. The new classicals also challenged Keynes by arguing that
government spending was useless and only crowded out private
investment. According to them, an increase in the public deficit raises the
rate of interest (due to the effect of issuing bonds on interest rates) which,
in turn, decreases the amount of private investment. For these reasons,
government’s role should be restricted to incentivizing individual
producers and workers to supply more output and labour – for example by
cutting taxes.
The new classicals, however, misunderstood how interest rates affect
investment. First, interest rates are not a market phenomenon determined
by supply and demand. Rather, they are set and controlled by the central
bank through monetary policy,30 and an increase in government
expenditure financed by the deficit does not raise the interest rate. Second,
lower interest rates do not necessarily lead to more investment, since firms
tend to be less sensitive to interest rates and more sensitive to expectations
of where future growth opportunities lie. And it is precisely these
opportunities that are shaped by active government investment, as we saw
in Chapter 7.
 GOVERNMENT IN THE NATIONAL ACCOUNTS

As we saw in Chapter 3, national accounts were highly influenced by

Keynes’s thinking. GDP can be calculated in three ways: production,
income and expenditure. Despite its size and importance in the economy,
however, the word ‘government’ rarely appears in discussions of
production and income. Instead, it is usually examined simply in terms of
expenditure – how the value produced and earned is spent.
For Keynes, additional public spending was needed to make sure
economies were not constantly prone to recessions and depressions; by
purchasing goods, government added to GDP on the expenditure side to
make up for what was often too low business investment. The accounting
method adopted was simply to add up the costs of government production,
subtract intermediate material inputs and equate the difference – basically,
government employees’ salaries – with the output of government.
Although government played an active part in national accounting, its
image was still as a big spender rather than a producer.
This is all extremely important. The accounts seem to say that
government is just spending what it taxes away from value-adding
companies. But can that be true?
The national accounts fail to capture the full amount of this government
value added and have several major flawed assumptions. First of all,
national accounts regard most of government value added only as costs,
mainly pay to government employees; government activity lacks an
operating surplus, which would increase its value added. Let’s compare it
with the private sector. The share of pay in private-sector value added is
rarely above 70 per cent. On that basis, you could say that government
value added is on average only 70 per cent of what it should be.
Second, the return on investment by government is assumed to be zero;
by this logic it does not earn a surplus. If it were more than zero it would
show up as operating surplus. The US did not officially separate public
current expenditures (e.g. costs to run the everyday business of
government, such as civil servants’ salaries) and capital expenditure (e.g.
to fund new infrastructure) until the 1990s, which strengthened
accountants’ impression that the government only spent money. But of
course vital government investments abound: obvious examples include
infrastructure projects like the Federal interstate highway system in the US
or motorways in the UK. It makes no sense simply to assume that the
return on enormous government investments is zero, when similar
investments by the private sector do produce a return. Moreover, it is
perfectly possible to estimate a return. One way of doing this is to assume
a market rate of return such as the yield on municipal bonds – the overall
return on bonds issued by cities.31 The crucial point here is that zero
government return on investment is a political choice, not a scientific
inevitability.
Third, to assume that the value of government output equals the value of
input means that government activities cannot increase the economy’s
productivity in any meaningful way: an increase in productivity, after all,
is obtained by growth of output outpacing the growth of inputs. But if the
output of government is defined simply as what it costs to do something,
then an increase in output will always require the same increase in inputs.
In 1998, the UK’s Office for National Statistics began to measure public-
sector output by deploying different physical indicators, for example the
number of people benefiting from public services (in areas such as health,
education and social security) for every pound spent. In 2005 the British
economist Sir Anthony Atkinson (1944–2017) improved on this by
introducing important changes to the quantity measures of each public
service, along with elaborating some quality measures for health and
education.32 Intriguingly, when these changes were applied, it was found
that productivity fell on average by 0.3 per cent per year between 1998 and
2008.33 Productivity increased significantly only after the financial crisis.
But the increase was the result of fewer inputs, not improved outputs.
Austerity aimed to cut back the inputs (government spending) while
producing the ‘same’ outputs.34 It is hardly surprising that this kind of
productivity ‘improvement’ does not result in better services – we only
have to look at the long NHS waiting times to see this.
Fourth, governments often own productive businesses such as railways,
postal services or energy providers. But, by accounting convention, state-
owned enterprises that sell products at market prices are counted as private
enterprises in the value added of the relevant sector: public railways are
part of the transport sector, not the government sector. Even though state-
owned corporations earn profits (and in the stats, higher profits means
higher value added), their profits are accounted for in the industrial sector
they work for, not the ‘government’ sector. So if the state-owned railway
makes huge sales and profits (high value added), it boosts the transport
sector value added, even if that sector is perhaps only successful because
of state ownership. Only government-owned entities that don’t sell at
market prices are by definition included in the government sector. In short,
from the perspective of national accounting, you don’t count as
government if you are doing market production. So, in the case of free
public education, while increasing the number of teachers might add to
GDP (because they are paid), the value they actually produce does not
increase GDP. All of which means that government can only increase its
value added with non-market production, thereby obscuring the true
importance of government in the economy: value that government
businesses do add is not shown in official statistics, nor is the value that
education or health generate.
These rules have been made in order to find a straightforward way to
account for economic activity. Yet, when you consider the combined
weaknesses of accounting conventions – government is lumped with
households as a ‘final’ consumer; government cannot make a surplus, earn
returns, increase its productivity or raise value added through market
production – you can’t help but notice that, while every effort has been
made to depict finance as productive, the opposite seems to be true for
government. Simply because of the way that productivity is defined, the
fact that government expenditure is higher than value added reinforces the
widely held idea that ‘unproductive’ government has to take before it can
spend. This thinking by definition restricts how much government can
influence the course of the economy. It underpins the theory of austerity.
And it is a consequence of fables about government told over several
centuries.

Multiplying Value
National accounts do not consider the interaction between public
expenditure and other components of output, consumption, investment and
net exports.
In order to understand this interconnection, economists estimate the
value of what is called the ‘multiplier’. The multiplier was an important
reason for Keynes’s positive view of government. Developed by Keynes’s
Cambridge student and colleague Richard Kahn (1905–1989) and used by
Keynes himself, it formalized the idea that government spending would
stimulate the economy. Quite literally: every pound that the government
spent would be multiplied, because the demand it created would lead to
several rounds of additional spending. Importantly, the Keynesian
approach also quantified the size of the multiplier, so policymakers – who
quickly took up the idea – could support their arguments for stimulus
spending with hard numbers.35
More precisely, the multiplier refers to the effect that an increase in
expenditure (demand) has on total production. Its significance lies in the
fact that, in the view of Keynes and Kahn, government spending benefits
the economy way beyond the amount of demand that spending generates.
The company from whom the government purchases its additional goods –
let’s say concrete for motorways – pays incomes to its workers, who go
out and spend those extra incomes on new goods – let’s say wide-screen
TVs – which another company produces, and that company’s employees
have more to spend – let’s say on holidays in Cornwall – and so it goes on
multiplying through the economy. Additional government demand creates
several subsequent rounds of spending, multiplying the original amount
spent. Government spending in recession was seen as especially powerful
in getting the economy back on track, since its effect on overall output was
much greater than the actual amount invested.
This powerful and important idea has inevitably attracted controversy,
particularly over the size of the multiplier – that is, how much £1 of
government spending generates in the economy. The sizeable literature on
the subject can be divided into two schools of thought: the ‘new classical’
and the Keynesian.
According to the ‘new classicals’, the proponents of fiscal austerity
measures, the multiplier’s value is less than one, or even negative.36 On
this basis they can argue that public expenditure has a non-Keynesian
effect on output. In other words, an increase of £1 of public expenditure is
supposed to generate less than £1 or even have a negative effect on total
GDP because it crowds out private investment. In the case of a negative
multiplier they assume that public expenditure destroys value, since the
increase of £1 in public expenditure is more than offset by a decrease in
the other components of GDP: consumption, investment and net exports.
However, the Keynesian view has been revived recently, since it has
been shown that austerity measures implemented in, for example, southern
European countries have led to a fall in total output and consequently a
rise in unemployment, rather than GDP growth and increased employment.
The poor economic performance of these countries calls into question the
austerity prescription of the ‘new classical’ authors. Recent IMF studies
have also suggested that government spending has a positive effect on
output37 and that the value of the multiplier is greater than one – to be
precise, 1.5.38 An increase of £1 of public expenditure leads to an increase
in total output of £1.50. In short, more credence is being given to the view
that government expenditure does not destroy private value but can create
value added by stimulating private investment and consumption.

PUBLIC CHOICE THEORY: RATIONALIZING PRIVATIZATION AND OUTSOURCING

The 1980s backlash against government was in part driven by the notion
that economies should worry more about ‘government failure’ than
‘market failure’. Government failure emerged as a concept from Public
Choice theory, a set of ideas closely associated with economists like the
American James Buchanan and the University of Chicago, where
Buchanan studied. In 1986 he was awarded the Nobel Prize in Economics.
Public Choice theory argues that government failure is caused by private
interests ‘capturing’ policymakers through nepotism, cronyism, corruption
or rent-seeking,39 misallocation of resources such as investing public
money in unsuccessful new technologies (picking losers),40 or undue
competition with private initiatives (‘crowding out’ what might otherwise
be successful private investment).41
Public Choice theory stresses that policy must be vigilant to make sure
that the gains from government intervention in the economy outweigh the
costs of government failures.42 The idea is that there is a trade-off between
two inefficient outcomes: one generated by free markets (market failure)
and the other by governmental intervention (government failure). The
solution advocated by a group of economists called the neo-Keynesians
(people who built on Keynes’s ideas) is to focus on correcting only some
failures, such as those that arise from positive or negative externalities.
The former might include ‘public goods’ like basic research, which the
government needs to fund when the private sector doesn’t (because it’s
hard to make profits), while the latter could involve the costs of pollution
which companies do not include in their regular cost-accounting, so
government might have to add that cost through a carbon tax.43 So while
Public Choice theorists worry more about government failures and neo-
Keynesians more about market failures, in the end their debates about
policy intervention have not seriously challenged the primacy of marginal
utility theory.
Taken to its extreme, Public Choice theory, which derives from
marginalism, calls for government to intervene as little as possible in the
economy in order to minimize the risk of government failure. The public
sector should be insulated from the private sector, for example to avoid
agency capture – when a regulatory body grows too close to the industry it
is meant to regulate.
Fear of government failure has convinced many governments that they
should emulate the private sector as far as they can. The premise here is
that government is inevitably prone to corruption and laziness because
agent and principal are too close to each other. It is essential, therefore, to
make public services more ‘efficient’. From the 1980s onwards, private-
sector measurements of efficiency were applied to the public sector and in
the process ‘marketized’ government. Even the very language changed:
hospital patients, social-service beneficiaries and even students all became
‘clients’ or ‘customers’.
The logic of Public Choice theory resulted inexorably in government
shedding responsibilities, reducing its investment in its own capacity-
building, and eventually to privatization. Privatization can occur through
the actual sale of a unit, as has happened with public banks. Or it may be
indirect privatization through ‘outsourcing’, whereby a private contractor
is paid by government to provide a service – such as publicly funded
education, housing, health, transport and even prisons, road traffic
management and benefits assessment.
The 1980s, when Public Choice began heavily to influence public
policy, saw a wave of privatizations and outsourcing, first in the UK and
the US, and then slowly spreading across much of Europe. It was also the
decade when, as we have seen, financialization started to take hold. The
idea (or ideology) that government control of productive enterprises was
inefficient and wasteful became accepted wisdom. In the UK it chimed
with the Thatcherite ideological purpose of creating a nation of asset
owners, whether of shares or privatized council houses. These were the
years of ‘If you see Sid, tell him’, the famous advertising campaign to
persuade British citizens to buy shares in British Gas, which was
privatized in 1986, and the privatizations of British Telecom and British
Airways, the electricity and water industries and a host of smaller
government-owned enterprises. The following decade saw the
privatization of the railways.
Many other countries did not always embrace privatization with the
same enthusiasm as the UK – the French electricity industry, for example,
remains basically state-controlled – but it quickly became a worldwide
trend. The IMF and World Bank often deployed their considerable weight
to persuade developing countries to sell state-owned enterprises. Even in
countries where the privatization wave has weakened – if only because
most suitable assets have been sold – the idea that the state should not own
but only fund (if that) is firmly lodged in the public mind. Today, few
governments or politicians argue for wholesale nationalization and
government ownership.
But Public Choice theory always ran the risk of throwing out the baby
with the bath water. By insisting that government could not create value –
indeed, was likely to destroy value – it shouted down the subtler but no
less substantive debate about what value government did produce. There
may be a strong case for retaining a significant public share in industries
that have a natural tendency towards monopoly – essential utilities such as
water, gas and electricity – in order to benefit from economies of scale in
provision, and also to avoid speculative rent-seeking on basic goods
needed. In more consumer-oriented industries, especially ones in which
technology is transforming the market (mobile phones, for example), the
case for a strong public presence may be less strong – though history
shows that often a hybrid public-private form might prove the most
interesting, as with French Telecom (which later became Orange).
The solution to the problem of natural monopolies was regulation. In the
UK a series of regulatory agencies sprang up, each intended to stand
between the public and industry. Regulatory capitalism replaced state
capitalism. It was not what pure Public Choice theorists intended; indeed,
regulatory capitalism resulted in exactly the kind of government cronyism
and corruption that they had warned about.
Another consequence of Public Choice theory has been the rise of
intermediary mechanisms to fund public activity. This has mainly taken
two forms. One is private finance initiatives (PFIs), for example to build
hospitals. The other, mentioned earlier, is outsourcing to private providers
to run a wide range of services. In both cases, public activity is financed
privately. Turning to PFIs in this way has been called ‘pseudo-
privatization’, because the private firms receive their income not from
clients in the ‘market’ but from government through a guaranteed profit
margin. An outsourcing contract is in effect a type of monopoly which
locks the government in as the sole customer. In the UK, moreover, the
degree of competition between providers of outsourcing services is
questionable: only a handful, dominated by Capita, G4S and Serco,
account for most the contracts.44
The aim of PFI financing is to share costs and remove from the
government’s balance sheet the debt associated with large projects such as
hospitals; however, it can be costly for the public sector because projects
are financed with private debt and equity, which is significantly more
expensive than public borrowing. Governments also pay private
contractors an annual charge, running for decades and usually indexed to
inflation, to cover the capital repayment plus interest and maintenance
costs. So exclusive PFI contracts in effect create monopoly licences. The
end result can be one where the costs to government are often more than if
it had provided the service/s itself. We look at two examples below,
healthcare and infrastructure.
 Privatizing and Outsourcing Healthcare
In 1948, when the UK was still undergoing a long and difficult post-war
reconstruction (public debt was well above 200 per cent over GDP in that
year), British citizens received a leaflet on which was stated: ‘Your new
National Health Service begins on 5th July. What is it? How do you get it?
It will provide you with all medical, dental, and nursing care. Everyone –
rich or poor, man, woman or child – can use it or any part of it.’ The
National Health Service (NHS) was created that year, following the
initiative of the Minister of Health, Aneurin Bevan. The following three
core principles were behind its establishment:45

that it meets the needs of everyone

that it be free at the point of delivery
that it be based on clinical need, not ability to pay

Over its almost seventy years of existence, the NHS has become one of the
most efficient and equitable healthcare systems in the world, as recognized
by the World Health Organization46 and also more recently by the
Commonwealth Foundation.47 In the UK it is considered a national
treasure, sharing its place in the pantheon with the Queen and the BBC.
The NHS is also among the cheapest healthcare systems in advanced
economies: according to OECD figures from 2015,48 health expenditure
relative to GDP in the UK was only 9.9 per cent, almost half of what the
US has spent (16.9 per cent) on its far less efficient semi-private system.
The NHS owes much of its past successes to its public mission and to its
universality principle, translated into an efficient central provision of
healthcare services aimed at reducing transaction costs. UK citizens have
repeatedly recognized the importance of its public nature: currently, 84 per
cent of them think that it should be run in the public sector.49 Even Prime
Minister Thatcher stated: ‘The National Health Service is safe with us’
during the 1982 Conservative Party conferences, temporarily discarding
plans for outright privatization set out by the Central Policy Review Staff
within the Cabinet Office.
Nevertheless, such positive rhetoric on the merits of the NHS soon
became the cover for a long series of reforms that have progressively
introduced elements of private provision in the British healthcare system.
With the National Health Service and Community Care Act of 1990,
management and patient care were forced to behave as part of an ‘internal
market’, with health authorities and general practitioners becoming
autonomous purchasers of services under a limited budget. Hospitals were
transformed into self-governing NHS trusts and their resources became
dependent on contracts stipulated with purchasers. Contracting out to the
lowest bidder was also introduced as a first element of outsourcing, with
the NHS progressively moving away from its role of provider towards
becoming a mere customer. Since 1992, the outsourcing process created by
the Private Financing Initiative (PFI) has involved also the building of
NHS hospitals. Through PFI, private companies were allowed to build
hospitals which were then rented back to the NHS for a substantially high
price. PFI was widely used throughout the ‘New Labour’ governments to
save on infrastructure investment, with the renting price of hospitals
subsequently burdening the NHS budget. Finally, the 2012 Health and
Social Care Act de facto abolished the second principle of the original
NHS, by introducing user charges and an insurance-based system that
resembles the US healthcare model, passing costs and risks to patients,
now customers in a market for healthcare provision. This final reform has
also further increased the scope for outsourcing in many different areas,
such as cleaning, facilities management, GP ‘out of hours’ services,
clinical services, IT and so on.50
Those reforms were aimed at producing a more efficient and cost-
effective NHS, through the introduction of market elements in the
provision of healthcare. In reality the efficiency has hardly improved,
while ever-scarcer resources are largely misallocated. This is what Colin
Crouch has called ‘the paradox of public service outsourcing’.51 Market-
oriented reforms of healthcare fail to appreciate the evidence that there is
no such thing as a competitive market for those services: contracts run for
several years and they are granted to a small number of firms which come
to dominate the outsourcing market. Those firms become effectively
specialized in winning contracts from the public sector across different
fields in which they do not have a corresponding expertise. As a result, the
market is highly concentrated and the diversity of tasks makes it difficult
to obtain a quality-efficient outcome in all the services provided.
A study by Graham Kirkwood and Allyson Pollock shows that increased
private-sector provision is associated with a significant decrease in direct
NHS provision, a reduction in quality, and costs being propped up by the
public sector.52 There are many examples of inefficient outcomes created
by the outsourcing process, for example Coperform with the NHS’s South
East Coast ambulance service and Serco with out-of-hours GPs contracts
in Cornwall;53 in some cases the public had to cover losses when private
contractors withdrew from their obligations. Moreover, the whole system
of contracting out has a distortive effect on the activities of NHS
personnel. As noted by Pollock, ‘clinicians, nurses, managers and armies
of consultants and lawyers spend their days preparing multiple bids,
tenders and awarding contracts, instead of providing patient care’.54
Finally, outsourcing appears to be immensely cost-inefficient.
Contracting activities create a ‘new market bureaucracy’ that has to deal
with the cumbersome process. These administrative burdens are
effectively transaction costs that in the US represent around 30 per cent of
total healthcare expenditure, while in the UK the actual figure is not
known, although it was in the order of 6 per cent in the pre-marketization
NHS.55 Yet, perhaps the elephant in the room will be the huge burden for
the public that the PFIs will have created by the time their contracts expire.
Especially in the case of NHS hospitals, that cost is estimated to be several
times higher than the actual worth of the underlying assets.56
Although reaching a more efficient provision of healthcare services for a
lower cost has always been the stated purpose of outsourcing in the NHS,
recent evidence seems to suggest that this might just be the second phase
of what Noam Chomsky has called the ‘standard technique of
privatization: ‘defund, make sure things don’t work, people get angry, you
hand it over to private capital’.57

Outsourcing Scotland’s Infrastructure

Use of PFI financing was particularly prevalent in Scotland between 1993
and 2006. Data published by the Scottish government show that the eighty
projects completed in Scotland during this period will cost the public
sector £30.2 billion over the coming decades – more than five times the
£5.7 billion initial estimate. As well as poor value for money, there is a
real concern that PFI projects may be low-quality and even dangerous: in
April 2016, seventeen PFI schools in Edinburgh were closed because of
safety concerns about construction defects.
In response to growing concerns about PFI, the Scottish government
developed after 2010 the Non-Profit Distributing (NPD) model to fund a
range of projects in three main sectors – education, health and transport. In
this new model, there is no dividend-bearing equity and private-sector
returns are capped; however, financing is still by private loan with the
expectation of a market rate of return. Projects funded under the NPD
model are therefore still significantly more expensive than they would be
if they were paid for by direct public borrowing.58 A recent study by the
New Economics Foundation found, for example, that between 1998 and
2015 the Scottish government would have saved a total of £26 billion if
the projects financed through the Private Finance Initiative (PFI) and Non-
Profit Dividend (NPD) schemes had instead been funded directly through a
Scottish public investment bank.59
As we have seen, outsourcing often increases costs and is a form of
monopoly. Social Enterprise UK, which promotes organizations such as
the Big Issue, Cafédirect and the Eden Project, has referred to the
oligopoly of outsourcing providers as the ‘Shadow State’. Capita, G4S and
Serco continue to win contracts in both the UK and US, even though they
have all been fined for improper management.60 In 2016, for example, an
investigative article revealed that G4S has been fined for at least 100
breaches of prison contracts between 2010 and 2016, including ‘failure to
achieve search targets, smuggling of contraband items, failure of security
procedures, serious cases of “concerted indiscipline”, hostage taking, and
roof climbing. Other cases include failure to lock doors, poor hygiene and
a reduction in staffing levels.’61
The fines, however, are minuscule in proportion to the profits made by
both Serco and G4S – and such companies, rather than being penalized for
carelessness and reckless cost-cutting, are being rewarded with more
contracts. The applications procedures for Obamacare were outsourced in
2013 to Serco in a $1.2 billion contract.62
Indeed, US Federal government outsourcing contracts to such
companies are rapidly rising. A recent GAO report shows that in 2000
contract spending was $200 billion, while in 2015 it was $438 billion.63
This amount represented almost 40 per cent of government’s discretionary
spending. The GAO report also distinguished spending on contracts for
goods from contracts for services. Among civilian agencies, 80 per cent of
contractor expenditures were for services, of which ‘professional support
services’ was the largest category. The GAO report notes that ‘contractors
performing these types of services are at a heightened risk of performing
inherently governmental work’. Indeed, one of the most worrying aspects
is probably not the amount of money spent on contractors, but that such a
big proportion of it is for ‘professional support services’. This often means
that inherently governmental work has been contracted out.
The cost to the taxpayer of all the contract workers is double that of civil
servants, not because contract workers are paid better – they often have to
put up with low wages and poor conditions – but because the contractors’
fees, overheads and profit margins, and the ratio of the number of contract
workers to the number of civil servants is sometimes as high as four,
revealing how bloated and inefficient the outsourcing process can
become.64 A recent study shows that the ‘federal government approves
service contract billing rates – deemed fair and reasonable – that pay
contractors 1.83 times more than the government pays federal employees
in total compensation, and more than 2 times the total compensation paid
in the private sector for comparable services’.65 Again, it is not the
contracted workers who get the higher amounts, but the firms that win the
public contracts.
The mantra of higher efficiency through privatization, therefore, is
unsupported by the facts – if you can get hold of them, that is. Such facts
can be hard to ferret out, despite claims of greater transparency in the
private sector. Rather than increase competition through more consumer
choice, privatization has often resulted in less choice and less democracy –
as is clearly evidenced by the above description of the outsourcing of
many NHS services and the high cost of PFI contracts to build and
maintain hospitals.66 What the public gets is frequently less transparency,
lower quality, higher costs and monopoly – exactly the opposite of what in
theory privatization (poorly justified as it was in the first place) is
supposed to achieve.

Good Private, Bad Public

What is also striking is the commonplace assumption that when the public
does own something, it will privatize that asset by retaining in the public
hands the ‘bad’ company and selling off the ‘good’ company. The
narrative of good private versus bad public could not be more clear! A
salient example is the privatization of Royal Mail, which delivers post, and
runs a chain of some 11,000 post offices across the UK. But, as is well
known over the last two decades, email and the Internet have caused a
dramatic fall in the level of postal traffic. In 2008 an independent review
commissioned by the government, led by Richard Hooper CBE (the
former Deputy Chairman of the government’s competition authority,
Ofcom), concluded that the Royal Mail and the post offices be split into
two separate private companies. Five years later, the Conservative-led
government privatized Royal Mail by floating it on the London Stock
Exchange, while retaining a 30 per cent stake. The now separate Post
Office Ltd remains wholly in public ownership. But the government was
strongly criticized for selling Royal Mail at too low a price: on the day of
flotation the share price rocketed from the official price of 330p a share to
455p within hours. According to some critics, the flotation valuation of
£3.3 billion should have been more like £5.5 billion. Moreover, fees to
banks, lawyers, accountants and other advisers came to £12.7 million. The
sweetener that greatly added to the attraction of the privatization for
investors was that the Treasury took responsibility for the Royal Mail
Pension Plan, the biggest in the country, which covers workers in both
Royal Mail and the post offices. This was to all intents and purposes the
‘bad company’ dumped on the taxpayer.
Similar situations have occurred with banks which are affected by bad
loans, such as RBS in the UK. Such banks end up with balance sheets full
of worthless loans that then prevent the banks in question from making any
further loans. The default answer in such cases has often been to take out
all the toxic assets from the ‘good’ part of the bank, and to put them in a
government-run ‘bad bank’. The idea is that doing so will allow the private
bank to get back on its feet, with the taxpayer taking on the responsibility
of managing or selling off the bad assets. But this has resulted in the
socialization of risks and privatization of rewards that we examined in
Chapter 7: in the same way that the US government picked up the bill for
the failed Solyndra, and let the profits from the similar investment made in
Tesla go private, the taxpayer picks up the bill for those parts of public
assets that are less efficient, and sells off the better bits to the private
sector – and often at a garage sale discount. Similar examples have
occurred in non-financial companies: in 2014 Italy’s national airline
Alitalia was split into a good company, sold privately, and a bad company
which remained in government hands.
The use of the words good versus bad in the above examples could not
be more stark: private is good, public is bad. If you are constantly told that
you are an impediment to dynamism and competition, you might begin to
believe it.

REGAINING CONFIDENCE AND SETTING MISSIONS

Public Choice theory’s interpretation of government failures as worse than

market failures, and the drive towards making government ‘efficient’, has
had the effect of eroding the ethos and purpose of public services. It has
also reduced government capacity and confidence (gaslighting), and
eroded civil servants’ ability to ‘think big’.
The epigraph opening this chapter, in which Keynes argues the need for
governments to think big – to do what is not being done – shows that he
believed that government needs to be bold, with a sense of mission, not
merely to replicate the private sector but to achieve something
fundamentally different from it. It is wrong to interpret him as believing
that what is needed from policy is to simply fix what the private sector
does not do, or does badly, or at best invest ‘counter-cyclically’ (i.e.
increase investments during the downside of the business cycle). After the
Great Depression, he claimed that even paying men simply to dig ditches
and fill them up again could revive the economy – but his work inspired
Roosevelt to be more ambitious than just advocating what today would be
called ‘shovel-ready projects’ (easy infrastructure). The New Deal
included creative activities under the Works Progress Administration, the
Civilian Conservation Corps and the National Youth Administration.
Equally, it is not enough to create money in the economy through
quantitative easing; what is needed is the creation of new opportunities for
investment and growth – infrastructure and finance must be embedded
within the greater systemic plans for change.
President John F. Kennedy, who hoped to send the first US astronaut to
the moon, used bold language when talking about the need for government
to be mission-oriented. In a 1962 speech to Rice University he said:
We choose to go to the moon in this decade and do the other things, not because they
are easy, but because they are hard, because that goal will serve to organize and measure
the best of our energies and skills, because that challenge is one that we are willing to
accept, one we are unwilling to postpone, and one which we intend to win, and the
others, too.67

In other words, it is a government’s duty to think big and confront

difficulties – exactly the opposite of the facilitating role predicated by
Public Choice theory, the inevitable result of which is timid and lacklustre
public agencies which will be easier to privatize later.
Replacing these bold ambitions with financial cost-benefit analysis has
dismissed the public value that governments can create. Civil servants are
told to step back, minimize costs, think like the private sector and be
fearful of making mistakes. Government departments are ordered to cut
costs, inevitably also diminishing the skills and capacity of the public
structures in questions (departments, agencies, etc.). When government
stops investing in its own capacity, it becomes more unsure of itself, less
able, and the probability of failure increases. It becomes harder to justify
the existence of a particular government function, leading to further cuts or
eventually to privatization. This lack of belief in government thereby
becomes a self-fulfilling prophecy: when we don’t believe in
government’s ability to create value, it eventually cannot do so. And, when
it does create value, such value is treated as a private-sector success or
goes unnoticed.
In Chapter 7 we saw the importance of government in developing the
key infrastructure and technology upon which twentieth-century capitalism
was built, even though it has received inadequate recognition for doing so.
Of course, the story is not always positive. The Concorde aircraft did not
result in a commercialized plane. Most R&D in new drugs leads to
nothing. And guaranteed loans are made to companies which fail, a recent
example, as we have seen, being the $528 million provided by the US
Department of Energy to the company Solyndra in 2005 for the production
of solar cells. When the price of silicon chips fell dramatically soon after,
Solyndra went bankrupt, leaving the taxpayer to pick up the bill.68
Yet any venture capitalist will say that innovation involves exploring
new and difficult paths, and that occasional failure is part of that journey.
The guaranteed loan ($465 million) provided to Tesla for the development
of the Model S electric car was, as we saw in Chapter 7, a success. This
trial-and-error process is accepted in the private sector – but when
governments experience failure they are regarded as incompetent and are
accused of being unable to ‘pick winners’. As a result, public
organizations are frequently told to stick to the straight and narrow, to
promote competition without ‘distorting’ the market by choosing specific
technologies, sectors or companies in which to invest.69
To limit government in this way is to completely ignore its track record,
from the development of touchscreen technology to innovation in the
renewables sector. Government has often been at its best when mission-
oriented – precisely because, as President Kennedy said, it is hard.
Doing ‘hard’ things means being willing to explore, experiment, make
mistakes and to learn from those mistakes. But this is almost impossible in
a context in which government ‘failure’ is deemed the worst of all sins,
and in which the guns are loaded, waiting for government to make the
slightest mistake.
This does not of course mean that mistakes should be welcome under
any conditions. Mistakes that arise from rent-seeking behaviour can lead to
vested interests influencing government. As we know, rent occurs when
value is extracted through special privileges, for example a subsidy or tax
break, and when a company or individual grabs a large share of wealth
without having created it. Profit-maximizing firms can try to increase their
profits by soliciting special policy-related favours, and are often successful
because politicians and policymakers are open to influence and even
corruption. The possibility of this sort of capture (of government by vested
interests) is a problem, but it becomes even more acute when there is no
clear appreciation of government value. If the state is seen as irrelevant, it
will over time also become less confident and more easily corrupted by the
so-called ‘wealth creators’ – who can then convince policymakers to hand
out favours which increase their wealth and power.
Lazy assumptions about the role of public investment are misleading.
Business investment is mainly driven by perceptions of future
opportunities, whether these be in a new sector (the emergence of
nanotechnology), or in a region that is perceived as an exciting place for
new ideas. As we have seen, such opportunities have historically been
funded directly by governments, whether by DARPA-type investments in
what later became the Internet, or the Danish government’s investment in
renewable energy. All of which means that policies constructed on the
assumption that business always wants to invest, and simply needs a tax
incentive to do so, are simplistic, not to say naïve. The incentives (indirect
spending through a tax cut), unless complemented by strategic direct
investment by government, will rarely make things happen that would not
have happened anyway (in economics speak, there is no ‘additionality’).
As a result, a company or individual will often experience an increase in
profits (through a tax cut) without increasing investment and without
generating any new value. And the primary objective of the policymaker
should be to increase business investment, not profits. Indeed, as seen
earlier the relationship between profits and wages is at record levels. There
is no profits problem, but an investment problem.70

PUBLIC AND PRIVATE JUST DESERTS

Once we recognize that the state is not just a spender but an investor and
risk taker, it becomes only sensible to ensure that policy leads to the
socialization not only of risks but also of rewards. A better realignment
between risks and rewards, across public and private actors, can turn
smart, innovation-led growth into inclusive growth.
As we have seen, neoclassical value theory for the most part disregards
the value created by government, such as an educated workforce, human
capital and the technology which ends up in our smart products.
Government is ignored in microeconomics – the study of production –
except in regulating the prices of inputs and outputs. It plays a bigger part
in macroeconomics, which deals with the economy as a whole, but at best
as a redistributor of the wealth created by companies and an investor in the
‘enabling’ conditions companies need – infrastructure, education, skills
and so on.
The marginal theory has fostered the idea that collectively produced
value derives from individual contributions. Yet, as the American
economist George Akerlof, who shared the Nobel Prize in Economics in
2001, said: ‘Our marginal products are not ours alone’71 – they are the
fruits of a cumulative process of learning and investment. Collective value
creation entails a risk-taking public sector – and yet the usual relationship
between risks and rewards, as taught in economics classes, does not seem
to apply. So the crucial question is not just about accounting for
government value but also rewarding it: how should rewards from
investment be divided between the public and private sectors?
As Robert Solow showed, most of the gains in productivity of the first
half of the twentieth century can be attributed not to labour and capital but
to the collective effort behind technical change. And this is due not only to
improved education and infrastructure, but also, as discussed in the
previous chapter, to the collective efforts behind some of the most radical
technical changes where the public sector has historically taken a lead role
– ‘the entrepreneurial state’.72 But the socialization of risks has not been
accompanied by socialization of rewards.
The issue, then, is how the state can reap some return from its successful
investments (the ‘upside’) to cover the inevitable losses (the ‘downside’) –
not least, to finance the next round of investments. This can be done in
various ways, as discussed in Chapter 7, whether through equity-holding,
conditions on reinvestment, caps on prices, or the need to keep patents as
narrow as possible.

FROM PUBLIC GOODS TO PUBLIC VALUE

In this chapter we have considered the biased way in which government

activity in the economy is viewed. The role of government is often limited
to ‘fixing problems’; it must not over-reach itself, government failures
being regarded as worse than market failures. It should have a light touch
on the economic tiller and fix the basics by investing in areas like skills,
education and research, but not go as far as to produce anything. And
should government be productive, as state-owned enterprises are, our way
of accounting for GDP does not recognize it as public production.
Indeed, almost nothing that government does is considered to fall within
the production boundary. Government spending is seen purely as
expenditure and not as productive investment. While that spending might
be regarded by some as socially necessary and by others as unnecessary
and better done by the private sector, neither side has made a robust case
for government activity as productive and essential to creating a dynamic
capitalist economy. Too often ideology has won over experience.
Keynes was critical in showing the dynamic role of public expenditure
in creating a multiplier effect that can lead to higher growth. Yet there is
still debate as to whether the multiplier exists at all, and advocates of
government economic stimulus are often on the defensive. Part of the
problem is that the argument for fiscal spending continues to be tied
mainly to taming the business cycle (through counter-cyclical measures),
with too little creative thinking about how to direct the economy in the
longer term.
It is especially important to rethink the terminology with which we
describe government. Portraying government as a more active value
creator – investing, not just spending, and entitled to earn a rate of return –
can eventually modify how it is regarded and how it behaves. All too often
governments see themselves only as ‘facilitators’ of a market system, as
opposed to co-creators of wealth and markets. And, ironically, this
produces exactly the type of government that the critics like to bash: weak
and apparently ‘business-friendly’, but open to capture and corruption,
privatizing parts of the economy that should be creating public and
collective goods.
A new discourse on value, then, should not simply reverse the
preference for the private sector over the public. What is required is a new
and deeper understanding of public value, an expression found in
philosophy but almost lost in today’s economics. This value is not created
exclusively inside or outside a private-sector market, but rather by a whole
society; it is also a goal which can be used to shape markets. Once the
notion of public value is understood and accepted, reappraisals are
urgently required – of the idea of public and private and of the nature of
value itself. ‘Public values are those providing normative consensus about
(1) the rights, benefits, and prerogatives to which citizens should (and
should not) be entitled; (2) the obligations of citizens to society, the state,
and one another; (3) and the principles on which governments and policies
should be based.’73
The idea of public value is broader than the currently more popular term
‘public good’. The latter phrase tends to be used in a negative way, to limit
the conception of what governments are allowed to do, rather than to
stimulate the imagination to find the best ways to confront the challenges
of the future. So the state-owned BBC is thought to serve the public good
when it makes documentaries about giraffes in Africa, but is questioned if
it makes soap operas or talk shows. State agencies can often fund basic
science due to the ‘positive externalities’, but not downstream
applications. Public banks can provide counter-cyclical lending, but they
cannot direct their lending to socially valuable areas like the green
economy. These arbitrary distinctions reflect a narrow view of the
economy which often results in a public actor being accused of ‘crowding
out’ a private one – or, worse still, delving into the dangerous waters of
‘picking winners’: the state is only supposed to do what the private sector
does not want to do, rather than have its own vision of a desirable and
achievable future.
Public institutions can reclaim their rightful role as servants of the
common good. They must think big and play a full part in the great
transformations to come, squaring up to the issues of climate change,
ageing populations and the need for twenty-first-century infrastructure and
innovation. They must get over the self-fulfilling fear of failure, and
realize that experimentation and trial and error (and error and error) are
part of the learning process. With confidence and responsibility, they can
expect success, and in so doing will recruit and retain top-quality
employees. They can change the discourse. Instead of de-risking projects,
there will be risk-sharing – and reward-sharing.
It might also make sense for private enterprises – which benefit from
different types of public investments and subsidies – in return to engage in
a fair share of activities which are not immediately profitable. There is
much to be learned from the history of Bell Labs, which was born out of
the US government’s demand that the monopolist AT&T invest its profits
rather than hoard cash, as is so common today. Bell Labs invested in areas
that its managers and its government contractors thought could create the
greatest possible public value. Its remit went well beyond any narrow
definition of telecommunications. The partnership of purely government-
funded research and work co-financed by Bell Labs and agencies like
DARPA led to phenomenal tangible results – many found in our handbags
and pockets today.74
A bold view of the role of public policy also requires a change in the
metrics used for evaluation of those policies. Today’s typical static cost-
benefit analysis is inadequate for decisions which will inevitably have
many indirect consequences. A much more dynamic analysis, one which
can capture more of the market-shaping process, is urgently required. For
example, any measure of the success of a government project to organize a
charging infrastructure for electric cars must try to take into account the
opportunities offered for further technical development, the reduction of
pollution and the political and ecological gains of lessening reliance on
non-renewable oil from countries with objectionable governments.
It is crucial to find metrics which favour long-run investments and
innovation. In the 1980s, it was not cost-benefit analysis that encouraged
the BBC to establish a dynamic ‘learning programme’ to get kids to code.
The activity led to the development of the BBC Microcomputer, which
found its way into all British classrooms. While the Micro did not itself
become a commercial success, procurement for its parts supported Acorn
Computers and eventually led to the creation of ARM Holdings, one of the
most successful UK technology companies of recent decades. Similarly,
there would almost certainly be more European high-tech successes if
there existed greater interaction between innovation systems and public
procurement policies. However, to recognize that the public sector creates
value we must find ways to assess that value, including the spillovers from
this sort of ambitious public funding. The BBC initiative helped kids learn
to code and increased their interest in socially and economically beneficial
new technologies. It also had direct and indirect effects in different sectors,
helping new companies to scale up and bringing new investors into the UK
tech landscape. Similarly, there would almost certainly be more European
high-tech successes if there existed greater interaction between innovation
systems and public procurement policies. However, to recognize that the
public sector creates value we must first find ways to assess that value,
including the spillovers from this sort of ambitions public funding.

Governing Public Value

The work of Elinor Ostrom (1933–2012), an economist from Indiana
University who received the Nobel Prize in 2009, helps clarify the richness
of the way in which new metrics can affect behaviour and vice versa, in
defusing the conflict between government and market. Ostrom shows how
the crude state–private divide that dominates current thinking fails to
encapsulate the complexity of institutional structures and relationships –
from non-partisan government regulators to state-funded universities and
state-run research projects – that span this divide. Rather, she emphasizes
common pooled resources, and the shaping of systems that take into
account collective behaviour.
Ostrom’s work supports Polanyi’s historical conclusion in The Great
Transformation: governments, along with the many institutions and
traditions of a society, are the womb in which markets are nourished, and
later the parent which helps them serve the common good. One vital
government responsibility in the modern economy – which Ostrom also
finds in successful pre-industrial economies – is to limit the amount of rent
that emerges from any non-collective approach to wealth creation. This
brings us back to Adam Smith’s definition of the ‘free market’ as being
free from rent.
 Today, these ways of thinking could significantly benefit many crucial
institutions which are neither fully private nor fully public. Universities
could proudly promote the pursuit of knowledge, without having to worry
about generating immediately profitable patents and spin-off companies.
Medical research institutes could expect strong funding, with much less
pressure to fight for attention. Think tanks could shake off the taint of
lobbying, once they present their work as being supportive of common
values. And co-operative, mutual and other not-for-profit enterprises could
flourish without having to decide which side of the great private–public
divide they are really on.
In the new discourse, there would certainly be no more talk of the public
sector interfering with or rescuing the private sector. Instead, it would be
widely accepted that the two sectors, and all the institutions in between,
nourish and reinforce each other in pursuit of the common goal of
economic value creation. The sectors’ interactions would be less marked
by hostility, and more infused with mutual respect.
Once the story telling about value creation is corrected, changes can
embolden private institutions as well as their public partners. The private
sector can be transformed by the simple but profound expedient of
replacing shareholder value with stakeholder value. This idea has been
around for decades, most countries continue to have companies run by
shareholder value focused on maximizing quarterly returns. Stakeholder
value recognizes that corporations are not really the exclusive private
property of one group of providers of profit-sharing financial capital. As
social entities, companies must take into account the good of employees,
customers and suppliers. They benefit from the shared intellectual and
cultural heritage of the societies in which they are embedded and from
their governments’ provision of the rule of law, not to mention the state-
funded training of educated workers and valuable research; they should in
return deliver benefit to all these constituencies. Of course, there is no easy
way to agree on the right balance, but a lively discussion is far preferable
to the current practice of maximizing profits for shareholders. Indeed, the
presence of co-operatives run on a stakeholder understanding of value
creation, such as John Lewis in the UK or Mondragon in Spain, should
serve as evidence that there is more than one way to govern a business.
And governments that want to achieve innovation-led growth should ask
themselves whether employees are more likely to share great ideas in
businesses in which they are valued, or in ones where they are simply
appendages to a profit-making machine that is then siphoned off to a few
shareholders.
 This is no easy task, but one that will not even begin without a new
positioning of all actors as being central to the collective value creation
process.
In sum, it is only by thinking big and differently that government can
create value – and hope.
 9
The Economics of Hope

The global financial crisis, which began in 2008 and whose repercussions
will continue to echo round the world for years to come, has triggered
myriad criticisms of the modern capitalist system: it is too ‘speculative’; it
rewards ‘rent-seekers’ over true ‘wealth creators’; and it has permitted the
rampant growth of finance, allowing speculative exchanges of financial
assets to be compensated more than investments that lead to new physical
assets and job creation. Debates about unsustainable growth have become
louder, with concerns not only about the rate of growth but also its
direction.
Recipes for serious reforms of this ‘dysfunctional’ system include
making the financial sector more focused on long-run investments;
changing the governance structures of corporations so they are less
focussed on their share prices and quarterly returns; taxing quick
speculative trades more heavily; legally and curbing the excesses of
executive pay.
In this book, I have argued that such critiques are important but will
remain powerless – in their ability to bring about real reform of the
economic system – until they become firmly grounded in a discussion
about the processes by which economic value is created. It is not enough to
argue for less value extraction and more value creation. First, ‘value’, a
term that once lay at the heart of economic thinking, must be revived and
better understood.
Value has gone from being a category at the core of economic theory,
tied to the dynamics of production (the division of labour, changing costs
of production), to a subjective category tied to the ‘preferences’ of
economic agents. Many ills, such as stagnant real wages, are interpreted in
terms of the ‘choices’ that particular agents in the system make, for
example unemployment is seen as related to the choice that workers make
between working and leisure. And entrepreneurship – the praised motor of
capitalism – is seen as a result of such individualized choices rather than of
the productive system surrounding entrepreneurs – or, to put it another
way, the fruit of a collective effort. At the same time, price has become the
indicator of value: as long as a good is bought and sold in the market, it
must have value. So rather than a theory of value determining price, it is
the theory of price that determines value.
Along with this fundamental shift in the idea of value, a different
narrative has taken hold. Focused on wealth creators, risk taking and
entrepreneurship, this narrative has seeped into political and public
discourse. It is now so rampant that even ‘progressives’ critiquing the
system sometimes unintentionally espouse it. When the UK Labour Party
lost the 2015 election, leaders of the party claimed they had lost because
they had not embraced the ‘wealth creators’.1 And who did they think the
wealth creators were? Businesses and the entrepreneurs leading them.
Feeding the idea that value is created in the private sector and redistributed
by the public sector. But how can a party that has the word ‘labour’ in its
title not see workers and the state as equally vital parts of the wealth
creation process?
Such assumptions about the generation of wealth have become
entrenched, and have gone unchallenged. As a result, those who claim to
be wealth creators have monopolised the attention of governments with the
now well-worn mantra of: give us less tax, less regulation, less state and
more market.
By losing our ability to recognize the difference between value creation
and value extraction, we have made it easier for some to call themselves
value creators and in the process extract value. Understanding how the
stories about value creation are around us everywhere – even though the
category itself is not – is a key concern of the book, and essential for the
future viability of capitalism.
To offer real change we must go beyond fixing isolated problems, and
develop a framework that allows us to shape a new type of economy: one
that will work for the common good. The change has to be profound. It is
not enough to redefine GDP to encompass quality-of-life indicators,
including measures of happiness,2 the imputed value of unpaid ‘caring’
labour and free information, education and communication via the
Internet.3 It is also not enough to tax wealth. While such measures are
important in themselves, they do not address the greatest challenge:
defining and measuring the collective contribution to wealth creation, so
that value extraction is less able to pass for value creation. As we have
seen, the idea that price determines value and that markets are best at
determining prices has all sorts of nefarious consequences. To sum up,
four stand out.
First, this narrative emboldens value extractors in finance and other
sectors of the economy. Here, the crucial questions – which kinds of
activities add value to the economy and which simply extract value for the
sellers – are never asked. In the current way of thinking, financial trading,
rapacious lending, funding property price bubbles are all value-added by
definition, because price determines value: if there is a deal to be done,
then there is value. By the same token, if a pharma company can sell a
drug at a hundred or a thousand times more than it costs to produce, there
is no problem: the market has determined the value. The same goes for
chief executives who earn 340 times more than the average worker (the
actual ratio in 2015 for companies in the S&P 500).4 The market has
decided the value of their services – there is nothing more to be said.
Economists are aware that some markets are not fair, for example when
Google has something close to a monopoly on search advertising; but they
are too often enthralled by the narrative of market efficiency to worry
whether the gains are actually justly earned profits, or merely rents.
Indeed, the distinction between profits and rents is not made.
Price-equals-value thinking encourages companies to put financial
markets and shareholders first, and to offer as little as possible to other
stakeholders. This ignores the reality of value creation – as a collective
process. In truth, everything concerning a company’s business – especially
the underlying innovation and technological development – is intimately
interwoven with decisions made by elected governments, investments
made by schools, universities, public agencies and even movements by
not-for-profit institutions. Corporate leaders are not telling the whole truth
when they say that shareholders are the only real risk takers and hence
deserve the lion’s share of the gains from doing business.
Second, the conventional discourse devalues and frightens actual and
would-be value creators outside the private business sector. It’s not easy to
feel good about yourself when you are constantly being told you’re
rubbish and/or part of the problem. That’s often the situation for people
working in the public sector, whether these be nurses, civil servants or
teachers. The static metrics used to measure the contribution of the public
sector, and the influence of Public Choice theory on making governments
more ‘efficient’, has convinced many civil-sector workers they are second-
best. It’s enough to depress any bureaucrat and induce him or her to get up,
leave and join the private sector, where there is often more money to be
made.
So public actors are forced to emulate private ones, with their almost
exclusive interest in projects with fast paybacks. After all, price determines
value. You, the civil servant, won’t dare to propose that your agency could
take charge, bring a helpful long-term perspective to a problem, consider
all sides of an issue (not just profitability), spend the necessary funds
(borrow if required) and – whisper it softly – add public value. You leave
the big ideas to the private sector which you are told to simply ‘facilitate’
and enable. And when Apple or whichever private company makes
billions of dollars for shareholders and many millions for top executives,
you probably won’t think that these gains actually come largely from
leveraging the work done by others – whether these be government
agencies, not-for-profit institutions, or achievements fought for by civil
society organizations including trade unions that have been critical for
fighting for workers’ training programmes.
Third, this market story confuses policymakers. By and large,
policymakers of all stripes want to help their communities and their
country, and they think the way to do so is to put more trust in market
mechanisms, with policy just a matter of tinkering at the edges. The crucial
thing is to be seen as progressive while also ‘business-friendly’. But with a
very limited understanding of where value comes from, politicians and all
too many government employees are like putty in the hands of those who
claim to be value creators. Regulators end up being lobbied by businesses
and induced to endorse policies which make incumbents even richer –
increasing profits but with little effect on investment. Examples include
ways in which governments across much of the Western world have been
persuaded to reduce capital gains tax, even though there is no reason to do
so if the aim is to promote long-term investments rather than short-term
ones. And lobbyists with their innovation stories have pushed through the
Patent Box policy, which reduces tax on the profits generated from 20-year
patent-based monopolies – even though the policy’s main impact has been
merely to reduce government revenue, rather than increasing the types of
investments that led to the patents in the first place.5 All of which serves
only to subtract value from the economy and make for a less attractive
future for almost everyone. Not having a clear view of the collective value
creation process, the public sector is thus ‘captured’ – entranced by stories
about wealth creation which have led to regressive tax policies that
increase inequality.
Fourth, and last, the confusion between profits and rents appears in the
ways we measure growth itself: GDP. Indeed, it is here that the production
boundary comes back to haunt us: if anything that fetches a price is value,
then the way national accounting is done wont be able to distinguish value
creation from value extraction and thus policies aimed that the former
might simply lead to the latter. This is not only true for the environment
where picking up the mess of pollution will definitely increase GDP (due
to the cleaning services paid for) while a cleaner environment won’t
necessarily (indeed if it leads to less ‘things’ produced it could decrease
GDP), but also as we saw to the world of finance where the distinction
between financial services that feed industry’s need for long-term credit
versus those financial services that simply feed other parts of the financial
sector are not distinguished.
Only with a clear debate about value can rent-extracting activities in
every sector, including the public one, be better identified and deprived of
political and ideological strength.

MARKETS AS OUTCOMES

Redefining value must start with a deeper interrogation of the concepts on

which much of today’s policy is based. First and most fundamental, what
are markets? They are not things-in-themselves. They are shaped by
society, and are outcomes of multi-agent processes in a specific context. If
we regard markets this way, our view of government policy changes too.
Rather than a series of intrusive ‘interventions’ in an otherwise free-
standing market economy, government policy can be seen for what it is:
part of the social process which co-shapes and co-creates competitive
markets. Second, what are private–public partnerships? Or, more precisely,
what kinds of private–public partnerships will provide society with its
desired outcomes? To answer that question economists should abandon
their desire to think like physicists and turn instead to biology, and
consider how functional partnerships are those that emulate a mutualistic
eco-system rather than a parasitic or predator–prey one.
As Karl Polanyi wrote, markets are deeply embedded in social and
political institutions.6 They are outcomes of complex processes, of
interactions between different actors in the economy, including
government. This is not a normative point but a structural one: how new
socio-economic arrangements come about. The very fact that the market is
co-shaped by different actors – including, crucially, policymakers – offers
hope that a better future can be constructed. We can fashion markets in
ways that produce desirable outcomes such as ‘green growth’ or a more
‘caring’ society with care influencing the type of social and physical
infrastructure that is built. By the same token, we can allow speculative
short-term finance to triumph over long-term investment. As we have
already seen, even Adam Smith was of the opinion that markets needed to
be shaped. Contrary to the modern interpretation of his work as ‘laissez-
faire’ (leave the market alone), he believed that the right kind of freedom
is not the absence of government policy, but freedom from rent extraction.
Smith would have been baffled by the current understanding of economic
freedom as a minimum of non-private activity. His Wealth of Nations is a
huge book, largely because even in that simpler economic world there
were so many varieties of rent-seeking to discuss. He devoted many pages
to productive and unproductive activities, often simplistically putting some
inside the production boundary and some outside. Karl Marx was subtler:
it was not the sector itself that mattered, but how exactly it interacted with
the creation of value and the important concept in his analysis of surplus
value.
Polanyi helps us to go beyond both Smith and Marx. Rather than
focusing on which activities are inside or outside the production boundary,
today we can work to ensure that all activities – in both the real economy
and in the financial sector – promote the outcomes that we want: if the
quality and characteristics of an activity in question help deliver true value,
then it should be rewarded for being inside the boundary. Policymakers
must be emboldened to broker ‘deals’ that generate symbiotic public–
private partnerships. In the case of finance, it would mean favouring long-
term investment over short-term (through measures like a financial
transaction tax), but, even more, founding new financial institutions (like
mission-oriented state investment banks) that can provide the strategic,
long-term finance crucial to the high risk investments required for
exploration and research underlying value creation.
Beyond the financial sector, patent law and regulation should encourage
big pharma to foster research into needed essential drugs rather than, as is
currently so often the case, block competition and innovation through the
use of strong and wide patents used to block competitors. One possibility
is to grant fewer patents upstream, leaving the tools for research open-
access. And the prices of the drugs should reflect the overall ‘deal’
between public and private actors, not force the taxpayer to pay twice.
Furthermore, the high level of share buybacks in the sector should be
questioned before government handouts are provided. In general,
government support should be made conditional on an increase in
committed investment by business – reducing the trends of hoarding and
financialization.
In the ICT and digital sectors, more thinking is required about the
appropriate tax system for companies like Uber and Airbnb, which would
never have existed without publicly funded technology such as GPS and
the Internet and which exploited network effects to create their potentially
highly profitable first-mover advantages. It should be clear that many
people – not just company employees – have contributed to their
competitive advantage. How we govern technology affects who shares in
the benefits. The digital revolution requires participatory democracy,
keeping the citizen, not big business or big government, at the centre of
technological change. Take smart meters, for example; Morozov argues
that if they are closed boxes transferring information, ‘what we are doing
is essentially introducing more and more closed systems which simply
seek to capture rent from infrastructure that has been funded by us, without
letting us the citizens take advantage of the same infrastructure for our
own purposes and our own monitoring of the government, whether it is the
city, or the national government’.7
With this in mind, we can move beyond the idea of public goods as
‘corrections’, that is being limited to areas that need fixing (due to positive
externalities that they generate), to being ‘objectives’. This requires a new
understanding of policy as actively ‘shaping’ and ‘creating’ markets that
achieve public value, benefitting society more widely.
Making public value better justified, appreciated and evaluated would
potentially open up a new vocabulary for policy makers. Rather than being
mere ‘regulators’ of health care or the digital agenda, as co-creators of that
care and digital transformation policymakers would have a more justifiable
right to make sure that the benefits are accessible to all. A different
vocabulary, and a new policymaking framework, would also reduce the
timidity which has kept politicians from funding much-needed
infrastructure investments for decades, and which led to a bare-minimum
fiscal and legislative response to the 2008 financial crisis and subsequent
recession. Once the potential of the executive and legislative branches to
promote the good of society is fully recognized, then elected officials can
start to live up to higher, but still realistic, expectations. Young, ambitious
people might start choose electoral politics, or careers in the civil service,
over jobs in the City or business – but only if they see that such choices are
valuable and valued.
 TAKING THE ECONOMY ON A MISSION

The question remains: what direction should the economy take if it is to

benefit the greatest number of people? Maximum GDP growth, one
standard answer these days, is far too crude to be helpful: it sweeps away
all the serious questions about value. Another common answer is fiscal
probity, governments running balanced budgets or even, as in Germany, a
surplus. This, however, is not only crude but wrong-headed. The drive to
reduce government deficits after the 2009 recession continues to impede a
proper European economic recovery. A low fiscal deficit is a misplaced
target. The real question is how government spending and investment can
create long-term growth. And while such investments might require short-
term deficits to increase, in the long term by raising GDP, the debt–GDP
ratio will be kept in check by the effects of such value-creating
investments. This is indeed why so many countries that continue to have
modest deficits might also have a high debt–GDP ratio.
The question of growth must thus focus less on the rate of growth and
more on its direction. A more open discussion of economic value could, I
believe, also help shape discussions about directionality. Progressive
arguments against fiscal austerity too often default to a cry for investing in
infrastructure (or ‘shovel ready’ projects) as though that were a panacea.
That is a very modest demand. The discussion of the kind of infrastructure,
and its relationship to greater social goals, has been puerile. Just roads and
bridges? Public investment that is driven by ambition and a vision cannot
be limited to a laundry list of traditional physical infrastructure projects.
The first step should be to think seriously about the problem in question. A
green transformation requires not only green infrastructure but a clear
vision of what living a green life means. It means transforming all sectors,
including traditional ones like steel to lower its material content.
Indeed, a key way to tackle some of society’s most pressing problems
today is to learn lessons from historical periods in which bold ambitions
were set to tackle difficult technological problems. Consider two lessons
from the man on moon mission. First, the agencies involved, from NASA
to DARPA, built up their own capacity and competences. They did not
outsource their tasks, or the resulting knowledge, to the private sector. This
practice should be borne in mind when considering the currently
fashionable public–private partnership arrangements. They will only
succeed as dynamic knowledge-intensive collaborations, with both sides
equally committed to investing in in-house competencies and capabilities.
Second, the Apollo mission required different types of actors and
sectors to collaborate, from aerospace to innovations in textiles. The focus
was not on subsidising a sector (aeronautics) but on solving problems
together, which required many sectors and different types of public and
private actors to collaborate – even those in low-tech sectors like textiles.
Similarly, today’s challenge to reverse human damage to the environment
is not something that can be solved solely by increased investment in
renewable energy – although that is already a daunting technological
challenge – but requires a societal commitment to new, less physically
materialist approaches to the way we live. Concrete missions that involve
different types of collaboration are required to drive the fight against
climate change or the fight to eradicate cancer – with clear targets, a
multitude of sectors and actors, co-investing and exploring new
landscapes, but also patience in achieving long-term goals. Past periods of
technological upheaval have been associated with changes in lifestyle,
such as the connection between mass-production and suburbanization.8 A
green revolution will require deliberate and conscious changes in social
values: a redirection of the entire economy, transforming production,
distribution and consumption in all sectors.

A BETTER FUTURE FOR ALL

The concept of value must once again find its rightful place at the centre of
economic thinking. More fulfilling jobs, less pollution, better care, more
equal pay – what sort of economy do we want? When that question is
answered, we can decide how to shape our economic activities, thereby
moving activities that fulfill these goals inside the production boundary so
they are rewarded for steering growth in the ways we deem desirable. And
in the meantime we can also make a much better job of reducing activities
that are purely about rent-seeking and calibrating rewards more closely
with truly productive activity.
I began the book stating that the goal was not to argue that one value
theory is better than another. My aim is for the book to stir a new debate,
putting value back at the centre of economic reasoning. This is not about
drawing firm and static fences around the production boundary, arguing
that some actors are parasitic or takers, while others are glorious producers
and makers. Rather we should have a more dynamic understanding of what
making and taking are in the context of the societal objectives we have.
Both objective and subjective factors will no doubt come into play, but the
subjective ones should not reduce everything to an individual choice,
stripped from the social, political and economic context in which decisions
are made. It is those very contexts that are affected by the (objective)
dynamics of technological change and corporate governance structures.
The latter will affect the way that income distribution is determined, as
will the strength of workers to bargain their share. These structural forces
are results of decision-making inside organizations. There is nothing
inevitable or deterministic about it.
I have tried to open the new dialogue by showing that the creation of
value is collective, that policy can be more active around co-shaping and
co-creating markets, and that real progress requires a dynamic division of
labour focused on the problems that twenty-first-century societies are
facing. If I have been critical, it’s because such criticism is badly needed;
it is, moreover, a necessary preliminary to the creation of a new
economics: an economics of hope. After all, if we cannot dream of a better
future and try to make it happen, there is no real reason why we should
care about value. And this perhaps is the greatest lesson of all.
 Notes

PREFACE

1. ‘I often hear references to higher compensation at Goldman,’ said Mr

Blankfein. ‘What people fail to mention is that net income generated
per head is a multiple of our peer average. The people of Goldman
Sachs are among the most productive in the world.’
http://www.businessinsider.com/henry-blodget-blankfeins-new-
defense-of-goldman-bonuses-goldman-employees-are-better-than-you-
2009-11?IR=T
2. Goldman Sachs Annual Report, 2010.
3. http://www.forbes.com/sites/mikecollins/2015/07/14/the-big-bank-
bailout/#66d600ee3723
4. Goldman Sachs Annual Report, 2016.
5. Goldman Sachs Annual Report, 2010.
6. GDP (Gross domestic product) superseded GNP as the standard
measure of output in the 1980s. The difference is not relevant to value
creation.
7. See for example B. E. Hilner and T. J. Smith, ‘Efficacy Does not
Necessarily Translate to Cost Effectiveness: A Case Study in the
Challenges Associated with 21st-Century Cancer Drug Prices’, Journal
of Clinical Oncology, 27(13) (2009).
8. Peter Bach’s interactive calculator can be accessed at
www.drugabacus.org
9. http://nymag.com/daily/intelligencer/2013/10/silicon-valleys-
secessionists.html
10. Plato, The Republic, translated and with an Introduction by H. D. P.
Lee (London: Penguin Books, 1955), p. 115.
11. http://www.multpl.com/us-gdp-inflation-adjusted/table.
12. http://www.epi.org/publication/stagnant-wages-in-2014/
13. http://www.forbes.com/sites/katiasavchuk/2016/05/25/mark-
zuckerberg-makes-18-billion-in-a-year-now-richest-person-in-
california-facebook-billionaire/#490a62e5479c
14. Forbes, 2017.
 INTRODUCTION: MAKING VERSUS TAKING

1. Bill Haywood, Bill Haywood’s Book: The Autobiography of Big Bill

Haywood (New York: International Publishers, 1929).
2. https://www.theguardian.com/business/2016/apr/25/bhs-philip-green-
family-millions-administration-arcadia
3. https://www.ft.com/content/cc58c190-6ec3-11e6-a0c9-1365ce54b926
4. https://www.ft.com/content/3e0172a0-6e1b-11e6-9ac1-1055824ca907
5. http://databank.worldbank.org/data/download/GDP.pdf
6. M. Mazzucato, The Entrepreneurial State: Debunking Public vs.
Private Sector Myths (London: Anthem Press, 2013).
7. W. Lazonick, M. Mazzucato and Ö. Tulum, ‘Apple’s changing
business model: What should the world’s richest company do with its
profits?’, Accounting Forum 37 (2103), pp. 249–67.
8. Oxfam, An Economy for the 99%, Oxfam Briefing Paper, January
2017:
https://www.oxfam.org/sites/www.oxfam.org/files/file_attachments/bp-
economy-for-99-percent-160117-en.pdf
9. And even conservative forces have liked to play with the takers versus
makers analogy, with Mitt Romney calling his private equity firm the
locus of ‘wealth creation’, while also making many remarks about
those parasitic elements of society that extract wealth through the
welfare state. G. Monbiot, ‘Mitt Romney and the myth of self-created
millionaires’, the Guardian, 24 September 2012:
https://www.theguardian.com/commentisfree/2012/sep/24/mitt-
romney-self-creation-myth
10. J. Stiglitz, The Price of Inequality: How Today’s Divided Society
Endangers our Future (London: Allen Lane, 2012).
11. A recent excellent book by the journalist Rana Foroohar, called
Makers and Takers, looks at the way in which productive industry has
been undermined by the growth of a financial sector that serves itself
and managers in industry that serve the objectives of finance rather
than long-term growth. R. Foroohar, Makers and Takers: The Rise of
Finance and the Fall of American Business (New York: Crown
Business, 2016).
12. While I was writing this book, Michael Hudson wrote a stinging
critique of modern finance, also building on this concept of unearned
income: M. Hudson, Killing the Host: How Financial Parasites and
Debt Bondage Destroy the Global Economy (Dresden: ISLET Verlag,
2015).
13. M. C. Jensen and W. H. Meckling, ‘Theory of the firm: Managerial
behavior, agency costs and ownership structure’, Journal of Financial
Economics 3(4) (1976), p. 308.
14. M. E. Porter and M. R. Kramer, ‘Creating shared value’, Harvard
Business Review, 89 (2011), pp. 62–77.
15. M. E. Porter, Competitive Advantage (New York: Free Press, 1985).
16. SNA 2008 (New York: United Nations, 2009), p. 6. Also discussion of
production boundary in D. Coyle, GDP: A Brief but Affectionate
History (Princeton: University Press, 2014), pp. 37–9. And a
discussion of the production boundary in H. H. Boss, Theories of
Surplus and Transfer: Parasites and Producers in Economic Thought
(Boston: Unwin Hyman, 1990).
17. It is fundamental not to interpret this statement as meaning that other
forms of discussion of value in economics are not crucial. (See B.
Bozeman, Public Values and Public Interest: Counterbalancing
Economic Individualism (Washington DC: Georgetown University
Press, 2007) for an excellent discussion about ‘public value’ in
economics; J. E. Stiglitz, A. Sen and J-P. Fitoussi, Mismeasuring Our
Lives: Why GDP Doesn’t Add Up (New York: The New Press, 2010)
for implications on GDP; and G. F. Gaus, Value and Justification: The
Foundations of Liberal Theory (New York: Cambridge University
Press, 1990) for issues of morality and ethics in liberal thought. But the
thesis of this present book is specific to the way that economic
measurements of value in production have fundamentally changed the
ability to differentiate value creators from value extractors, and
consequently the distinction between rents and profits which, as we
will see in Chapter 2, affects GDP in a different way from the
problems identified in Stiglitz.
18. https://www.usatoday.com/story/news/2017/08/22/breakthrough-
cancer-drug-astronomical-price/589442001/
19. European Commission Horizon 2020 agenda; OECD, UN.
20. W. J. Baumol, ‘Entrepreneurship: Productive, unproductive, and
destructive’, Journal of Political Economy 98(5) (1990), pp. 893–921.
 1. A BRIEF HISTORY OF VALUE

1. De Republica and Nicomachean Ethics.

2. Matthew 19:24.
3. E. S. Reinert, How Rich Countries Got Rich and Why Poor Countries
Stay Poor (London: Constable, 2008).
4. T. Mun, England’s Treasure by Forraign Trade (1664; London:
Macmillan, 1865), p. 7.
5. P. Studenski, Income of Nations (New York: University Press, 1958),
p. 27.
6. Ibid.
7. W. Petty, A Treatise of Taxes and Contributions, in C. H. Hull (ed.),
The Economic Writings of Sir William Petty (Cambridge: University
Press, 1899), vol. 1, p. 306: ‘Where a People thrive, there the income is
greater than the expence, and consequently the tenth part of the
expence is not a tenth part of the income.’
8. Petty, Verbum Sapienti, ibid., p. 105.
9. Petty, Several Essays in Political Arithmetick, ibid., p. 177.
10. Ibid., p. 267.
11. Ibid., p. 256.
12. Boss, Theories of Surplus and Transfer, p. 21.
13. A. Smith, The Wealth of Nations, Books I–III, ed. A. Skinner (London:
Penguin Classics, 1999), Book I, p. 180: ‘In 1688, Mr Gregory King,
whose skill in political arithmetic is much extolled by Doctor
Davenant, computed the ordinary income of labourers and out-servants
to be fifteen pounds a year to a family, which he supposed to consist,
one with another, of three and a half persons.’
14. King’s table redrawn in Boss, Theories of Surplus and Transfer, p. 20.
15. Ibid., p. 32.
16. In Quesnay’s own words: ‘Productive expenditure [which] is employed
in agriculture, grasslands, pastures, forests, mines, fishing etc., in order
to perpetuate wealth in the form of grain, beverages, wood, live-stock
raw materials for manufactured goods, etc.’ Quesnay in R. L. Meek,
The Economics of Physiocracy: Essays and Translations (London:
George Allen & Unwin, 1962), p. 128. The sterile class is outside the
production boundary; that is, the value production boundary. They
work but they do not increase the wealth. ‘Sterile expenditure [which]
is on manufactured commodities, house-room, clothing, interest on
money, servants, commercial costs, foreign produce, etc.’ Ibid., p. 128.
17. Notice also that the money for circulation is 2 billion and suffices to
exchange products worth 5 billion. The ‘velocity of money’ is 2.5;
money changes hands two and a half times per production period.
18. I. I. Rubin, A History of Economic Thought (1929; London: Pluto
Press, 1989), p. 135 and Meek, The Economics of Physiocracy, p. 158.
19. Turgot also distinguished between ‘necessary’ reproduction and luxury
production, a theme prominent in Ricardo and later the Italian-born
economist Piero Sraffa (1898–1983).
20. Smith, The Wealth of Nations, Book I, p. 110.
21. Ibid., p. 119.
22. A. Smith, The Wealth of Nations, Books IV–V, ed. A. Skinner
(London: Penguin Classics, 1999), Book IV, p. 30.
23. Smith does not ascribe any value to ‘capital’. This may have been
deliberate or may simply have been due to circumstances: capital was
not yet very important. The labour theory of value was only displaced
when neoclassical economists introduced ‘capital’ as another ‘factor of
production’, without any clear definition or measurement.
24. Smith, The Wealth of Nations, Introduction to Book IV.
25. The full quote is: ‘The labour of some of the most respectable orders in
the society is, like that of menial servants, unproductive of any value,
and does not fix or realize itself in any permanent subject; or vendible
commodity, which endures after that labour is past, and for which an
equal quantity of labour could afterwards be procured. The sovereign,
for example, with all the officers both of justice and war who serve
under him, the whole army and navy, are unproductive labourers. They
are the servants of the public, and are maintained by a part of the
annual produce of the industry of other people. Their service, how
honourable, how useful, or how necessary soever, produces nothing for
which an equal quantity of service can afterwards be procured. The
protection, security, and defence of the commonwealth, the effect of
their labour this year, will not purchase its protection, security, and
defence for the year to come. In the same class must be ranked, some
both of the gravest and most important, and some of the most frivolous
professions: churchmen, lawyers, physicians, men of letters of all
kinds; players, buffoons, musicians, opera-singers, opera-dancers, etc.
The labour of the meanest of these has a certain value, regulated by the
very same principles which regulate that of every other sort of labour;
and that of the noblest and most useful produces nothing which could
afterwards purchase or procure an equal quantity of labour. Like the
declamation of the actor, the harangue of the orator, or the tune of the
 musician, the work of all of them perishes in the very instant of its
production.’ Smith, The Wealth of Nations, Book II, pp. 430–31.
26. Ibid., p. 431.
27. Ibid., p. 447. The full quote is as follows: ‘A man of fortune, for
example, may either spend his revenue in a profuse and sumptuous
table, and in maintaining a great number of menial servants, and a
multitude of dogs and horses; or contenting himself with a frugal table
and few attendants, he may lay out the greater part of it in adorning his
house or his country villa, in useful or ornamental buildings, in useful
or ornamental furniture, in collecting books, statues, pictures; or in
things more frivolous, jewels, baubles, ingenious trinkets of different
kinds; or, what is most trifling of all, in amassing a great wardrobe of
fine clothes, like the favourite and minister of a great prince who died a
few years ago.’
28. ‘When the price of any commodity is neither more nor less than what
is sufficient to pay the rent of the land, the wages of the labour, and the
profits of the stock employed in raising, preparing, and bringing it to
market, according to their natural rates, the commodity is then sold for
what may be called its natural price’ (Smith, Wealth of Nations, Book
1, p. 158). Moreover, in Smith there is also market price. ‘The actual
price at which any commodity is commonly sold is called its market
price. It may either be above, or below, or exactly the same with its
natural price. The market price of every particular commodity is
regulated by the proportion between the quantity which is actually
brought to market, and the demand of those who are willing to pay the
natural price of the commodity, or the whole value of the rent, labour,
and profit, which must be paid in order to bring it thither’ (ibid., pp.
158–9). Finally, Smith affirms that there exists a process of gravitation
of the market prices to natural prices: ‘The natural price, therefore, is,
as it were, the central price, to which the prices of all commodities are
continually gravitating. Different accidents may sometimes keep them
suspended a good deal above it, and sometimes force them down even
somewhat below it. But whatever may be the obstacles which hinder
them from settling in this centre of repose and continuance, they are
constantly tending towards it […] But though the market price of every
particular commodity is in this manner continually gravitating, if one
may say so, towards the natural price, yet sometimes particular
accidents, sometimes natural causes, and sometimes particular
regulations of police, may, in many commodities, keep up the market
 price, for a long time together, a good deal above the natural price’
(ibid., pp. 160–61).
29. Ibid., p. 152.
30. C. Hill, The Century of Revolution 1603–1714 (London: Nelson,
1980), pp. 25–6.
31. D. K. Foley, Adam’s Fallacy: A Guide to Economic Theology
(Cambridge, MA: Belknap Press, 2006).
32. J. A. Schumpeter, History of Economic Analysis (New York: Oxford
University Press, 1954), p. 590.
33. ‘In every society the price of every commodity finally resolves itself
into some one or other, or all of those three parts; and in every
improved society, all the three enter more or less, as component parts,
into the price of the far greater part of commodities.’ Smith, The
Wealth of Nations, Book I, p. 153.
34. Foley, Adam’s Fallacy, p. 28.
35. T. R. Malthus, An Essay on the Principle of Population (1798; 2nd edn
1803; 3rd edn 1821); critical edn ed. P. James, 2 vols (Cambridge:
University Press, 1989).
36. D. Ricardo, On the Principles of Political Economy and Taxation
(Cambridge: University Press, 1951), ch. 5.
37. In other words, Ricardo did not believe that there would be enough
productivity increase in agriculture to keep the price of food down.
History so far has not confirmed Ricardo’s fear; there has been a lot of
improvement in agricultural productivity (at least from the point of
view of labour productivity), so food has not become a profit-choking
part of production costs. See also Foley, Adam’s Fallacy, for a concise
and illustrative discussion of Ricardo’s rent and population theory.
38. Ricardo, Principles of Political Economy, p. 71.
39. Another piece of Ricardian theory that has informed economics to the
present day is his theory of comparative advantage to explain trade
patterns.
40. M. Lavoie, Introduction to Post-Keynesian Economics (Basingstoke:
Palgrave Macmillan, 2009), pp. 1–24.
41. J. M. Keynes, The General Theory of Employment, Interest and Money
(London: Macmillan, 1936), ch. 24.
42. Ricardo, Principles of Political Economy, p. 150.
43. Ibid., p. 151 fn.
44. Ibid.
45. Ibid., p. 151.
46. This is the principle of primitive accumulation, the historical
discussion of which is full of details of chilling violence and cruelty in
Marx, Capital: A Critique of Political Economy, vol. 1 (London:
Penguin Classics, 2004), Part VIII: Primitive Accumulation.
47. Already mentioned in K. Marx, Economic and Philosophical
Manuscripts of 1844 (Amherst, NY: Prometheus Books, 1988).
48. Marx, Capital, vol. 1, ch. 1.
49. Ibid., ch. 8, p. 317.
50. Marx, Capital, vol. 3 (London: Penguin Classics, 1992), chs 38 and 39.
51. In vol. 3 of Das Kapital Marx built a theory of crises of capitalism
around the problem of a tendency of the average profit rate to fall as
capitalism developed. This is because the composition of capital –
variable and constant – tended to shift towards more constant capital
relative to variable capital. But that implied that there would be less
and less labour power to create the surplus value, so it would shrink
relative to the investments necessary on the part of the capitalist,
resulting in a falling rate of profit.
52. Ibid., ch. 10.
53. In Marx’s time, ‘transferring money’ could involve transporting gold
bullion from one country to another (Marx, Capital, vol. 3, ch. 19).
54. One of several passages to this effect in Marx (Capital, vol. 3, ch. 17)
reads: ‘Just as the labourer’s unpaid labour directly creates surplus-
value for productive capital, so the unpaid labour of the commercial
wage-worker secures a share of this surplus-value for merchant’s
capital.’ The difficulty lies here: ‘Since the merchant’s labour-time and
labour do not create value, although they do secure for the merchant a
share of already produced surplus-value, how does the matter stand
with the variable capital that the merchant lays out in purchasing
commercial labour-power?’
55. Marx, Capital, vol. 3, ch. 17.
56. Ibid.: ‘To industrial capital the costs of circulation appear as
unproductive expenses, and so they are. To the merchant they appear
as a source of his profit, proportional, given the general rate of profit,
to their size. The outlay to be made for these circulation costs is,
therefore, a productive investment for mercantile capital. And for this
reason, the commercial labour which it buys is likewise immediately
productive for it.’
57. Marx (Capital, vol. 3, ch. 23): ‘Money … may be converted into
capital on the basis of capitalist production, and may thereby be
transformed from a given value to a self-expanding, or increasing,
 value. It produces profit, i.e., it enables the capitalist to extract a
certain quantity of unpaid labour, surplus-product and surplus-value
from the labourers, and to appropriate it. In this way, aside from its
use-value as money, it acquires an additional use-value, namely that of
serving as capital. Its use-value then consists precisely in the profit it
produces when converted into capital.’
58. Marx, Capital, vol. 3, chs 21–36.
59. Marx, Capital, vol. 3, ch. 17: ‘All these [circulation] costs are not
incurred in producing the use-value of commodities, but in realizing
their value. They are pure costs of circulation. They do not enter into
the immediate process of production, but since they are part of the
process of circulation they are also part of the total process of
reproduction.’
60. See I. I. Rubin, Essays on Marx’s Theory of Value (1928; Detroit:
Black and Red Press, 1972), ch. 19 for a detailed discussion of how
labour is or is not productive depending on which function of capital it
is employed by.
61. H. P. Minsky, ‘The capital development of the economy and the
structure of financial institutions’ (1992), Hyman P. Minsky Archive,
paper 179.
62. A. Barba and G. de Vivo, ‘An “unproductive labour” view of finance’,
Cambridge Journal of Economics 36(6) (2012):
http://doi.org/10.1093/cje/ber022; Duncan K. Foley, ‘Rethinking
financial capitalism and the “information” economy’, Review of
Radical Political Economics, 45(3) (2013), pp. 257–68:
http://doi.org/10.1177/0486613413487154
 2. VALUE IN THE EYE OF THE BEHOLDER: THE RISE OF THE MARGINALISTS

1. J. B. Clark, The Distribution of Wealth: A Theory of Wages, Interest

and Profits (New York: Macmillan, 1899), p. v.
2. A. Roncaglia, The Wealth of Ideas: A History of Economic Thought
(Cambridge: University Press, 2005), ch. 4.
3. Léon Walras, Elements of Theoretical Economics, trans. and ed. by D.
A. Walker and J. van Daal (1883; Cambridge: University Press, 2014),
p. 5.
4. Roncaglia (Wealth of Ideas, p. 278) quoted Howey to say that
Wicksteed and Wieser were the first to use ‘marginal’ in 1884, and that
‘marginalism’ was not introduced until 1914.
5. Jeremy Bentham, A Fragment on Government (London: 1776),
Preface, p. ii. Niccolò Machiavelli, in his masterpiece The Prince
(1513), expressed similar reasoning.
6. Jean-Baptiste Say, Traité d’économie politique (Paris: 1803);
Roncaglia, Wealth of Ideas, p. 165.
7. ‘By utility is meant that property in any object, whereby it tends to
produce benefit, advantage, pleasure, good, or happiness (all this, in
the present case, comes to the same thing), or (what comes again to the
same thing) to prevent the happening of mischief, pain, evil, or
unhappiness to the party whose interest is considered.’ Bentham, An
Introduction to the Principles of Morals and Legislation (1789),
quoted in W. S. Jevons, The Theory of Political Economy, ed. R. D.
Collison Black (Harmondsworth: Penguin Classics, 1970), ch. 3.
8. L. Robbins, An Essay on the Nature and Significance of Economic
Science (London: Macmillan, 1932).
9. The classical economists were well aware that supply and demand
changed prices – for example, Marx in Part 1 of vol. 3 of Capital – but
saw this as fluctuations around the price determined by labour time.
10. P. Mirowski, ‘Learning the meaning of a dollar: Conservation
principles and the social theory of value in economic theory’, Social
Research 57(3) (1990), pp. 689–718.
11. Behavioural economics, which deploys psychology, sociology,
neuroscience and other disciplines to look at how individuals really
make choices, casts doubt on the simple assumptions of marginalism.
See A. Tversky and D. Kahneman, ‘Advances in prospect theory:
Cumulative representation of uncertainty’, Journal of Risk and
Uncertainty, 5 (4) (1992), pp. 297–323; doi:10.1007/BF00122574
12. Robbins, Essay on the Nature and Significance of Economic Science,
pp.73–4.
13. A term that Lerner actually picked up from Vilfredo Pareto, who first
set the proposition in 1894. V. Pareto, ‘Il massimo di utilità data dalla
libera concorrenza’, Giornale degli Economisti 9(2) (1894), pp. 48–66.
This proposition was further refined by other economists, among
whom we find Lerner, whilst nowadays the accepted proof is the one
elaborated by Kenneth Arrow in 1951: ‘An extension of the basic
theorem of classical welfare economics’, in Proceedings of the Second
Berkeley Symposium on Mathematical Statistics and Probability
(Berkeley and Los Angeles: University of California Press, 1951), pp.
507–32.
14. E. N. Wolff, Growth, Accumulation, and Unproductive Activity: An
Analysis of the Postwar U.S. Economy (Cambridge: University Press,
1987).
15. T. Veblen, ‘The Limitations of marginal utility’, Journal of Political
Economy, 17(9) (1909), pp. 620–36.
16. See Foley, ‘Rethinking financial capitalism and the “information”
economy’ for further examples.
17. ‘entrepreneur ne faisant ni bénéfice ni perte’; Walras quoted in J. A.
Schumpeter, History of Economic Analysis, p. 860.
 3. MEASURING THE WEALTH OF NATIONS

1. C. Busco, M. L. Frigo, P. Quattrone and A. Riccaboni, ‘Redefining

corporate accountability through integrated reporting: What happens
when values and value creation meet?’, Strategic Finance, 95(2)
(2013), pp. 33–42.
2. P. Quattrone, ‘Governing social orders, unfolding rationality, and
Jesuit accounting practices: A procedural approach to institutional
logics’, Administrative Science Quarterly, 60(3) (2015), pp. 411–45.
3. Studenski, Income of Nations, p. 127.
4. Ibid., p. 121.
5. Ibid., p. 20; J. Kendrick, ‘The historical development of national-
income accounts’, History of Political Economy, 2(2) (1970), p. 289.
6. A. Marshall and M. Marshall, The Economics of Industry, 4th edn
(London: Macmillan, 1909), p. 52.
7. Studenski, Income of Nations, chs 7, 8, 9.
8. A. C. Pigou, The Economics of Welfare (London: Macmillan, 1926),
Part 1, ch. 1, p. 5.
9. A. Vanoli, A History of National Accounting (Washington, DC: IOS
Press, 2005), p. 280.
10. Ibid.; and E. J. Mishan, The Costs of Economic Growth (New York:
Praeger, 1967).
11. S. Kuznets, National Income: A Summary of Findings (New York:
National Bureau of Economic Research, 1946), p. 122.
12. United Nations, A System of National Accounts and Supporting Tables,
Studies in Methods, series F, no. 2, rev. 1 (New York, 1953).
13. http://unstats.un.org/unsd/nationalaccount/docs/SNA2008.pdf
14. SNA 2008, p. 2.
15. Ibid.
16. P. S. Sunga, ‘An alternative to the current treatment of interest as
transfer in the United Nations and Canadian systems of national
accounts’, Review of Income and Wealth, 30(4) (1984), p. 385:
http://doi.org/10.1111/j.1475-4991.1984.tb00487.x
17. B. R. Moulton, The System of National Accounts for the New
Economy: What Should Change? (Washington DC: Bureau of
Economic Analysis, US Dept. of Commerce, 2003), p. 17:
http://www.bea.gov/about/pdf/sna_neweconomy_1003.pdf
18. The development of income and growth estimation is sometimes
depicted as a purely empirical affair that is barely influenced by theory
(R. Reich, The Work of Nations: Preparing Ourselves for 21st-Century
 Capitalism (New York: Knopf, 1991)). In fact, some histories of
estimating growth tend to break off the link with theory that they
acrimoniously depict up to Smith and Marx, and simply observe that a
‘comprehensive measurement concept’ prevailed in the capitalist world
at the end of the nineteenth century (Studenski, Income of Nations;
Kendrick, ‘The historical development of national-income accounts’).
Some individual estimators – such as Timothy Coughlan, an engineer
in Australia who might not have been closely acquainted with
economic theory – have seen themselves as neutral statisticians who
simply compiled what was ‘obviously’ or ‘common-sensically’ value.
However, these individuals – just like the politicians who demanded
the statistics – were probably the ‘slaves of some defunct economist’,
in this case the marginal economists, as the well-known quote by
Keynes reminds us.
19. Source: Bureau of Economic Analysis (2016), NIPA Tables 1.1.5:
GDP, 1.3.5: Gross Value Added by Sector, and 3.1: Government
Current Receipts and Expenditures.
20. https://www.gov.uk/government/publications/independent-review-of-
uk-economic-statistics-final-report
21. Ibid., p. 40.
22. Coyle, GDP, p. 14.
23. U. P. Reich and K. Horz, ‘Dividing government product between
intermediate and final uses’, Review of Income and Wealth, 28(3)
(1982), pp. 325–44.
24. SNA 2008, p. 583.
25. Ibid., p. 119.
26. B. R. Moulton, ‘The Implementation of System of National Accounts
2008 in the US National Income and Product Accounts’ (Eurostat
Conference: The Accounts of Society, Luxembourg, 12–14 June
2014), p. 4.
27. The full quote reads: ‘In studying the changes in the economic activity
of an advanced industrial country it is unnecessary to impute an
income to family services or to the services of household equipment
and may even prove an embarrassment to do so, since, not only are
there very little data in this field, but the principles on which such
imputations should be made are obscure. On the other hand, if a
comparison is to be made with a country in which subsistence and
family production are important, problems of imputation will have to
be faced squarely; indeed, for this purpose, it may be desirable to set
up the system of accounts in a different way.’ R. Stone, ‘Definition of
 the national income and related totals’, in Sub-committee on National
Income Statistics, Measurement of National Income and the
Construction of Social Accounts (Geneva: United Nations, 1947), p.
25.
28. SNA 2008, p. 99.
29. Ibid.
30. In the 1980s, a textbook on national income accounting boldly asserted
that because roughly half the female adult population is working in the
household, ‘anything up to one-quarter of all production does not get
recorded in the accounts’. G. Stuvel, National Accounts Analysis
(Basingstoke: Macmillan, 1986), p. 29. Stuvel argued that household
work is production and that something is missing. This raises a curious
point that is redolent of Marx. If a single man employs a houseworker,
her salary would, of course, be part of GDP (as long as it was paid
legally). However, if he married her and she continued doing exactly
the same work as before, but now as a married ‘housewife’, her work
would no longer contribute to GDP.
31. SNA 2008, p. 99.
32. The recommended method for imputing rents is given thus:
‘Households that own the dwellings they occupy are formally treated
as owners of unincorporated enterprises that produce housing services
consumed by those same households. When well-organized markets
for rented housing exist, the output of own-account housing services
can be valued using the prices of the same kinds of services sold on the
market in line with the general valuation rules adopted for goods or
services produced on own account. In other words, the output of the
housing services produced by owner occupiers is valued at the
estimated rental that a tenant would pay for the same accommodation,
taking into account factors such as location, neighborhood amenities,
etc. as well as the size and quality of the dwelling itself. The same
figure is recorded under household final consumption expenditures. In
many instances, no well-organized markets exist and other means of
estimating the value of housing services must be developed.’ (SNA
2008, p. 109.)
33. For the US, this can be seen by comparing growth rates of GDP and of
imputed rental of owner-occupied housing (Bureau of Economic
Analysis, US Department of Commerce, ‘Imputed rental of owner-
occupied housing’, table 7.12, line 154, last revised on 3 August 2016;
accessed 13 March 2017).
34. SNA 2008, p. 48.
35. https://www.istat.it/it/files/2015/12/Economia-non-osservata.pdf?
title=Economia+non+osservata+-+04%2Fdic%2F2015+-
+Testo+integrale+con+nota+metodologica.pdf
36. S. Merler and P. Hüttl, ‘Welcome to the dark side: GDP revision and
the non-observed economy’, Bruegel, 2 March 2015:
http://bruegel.org/2015/03/welcome-to-the-dark-side-gdp-revision-
and-the-non-observed-economy/
37. SNA 2008, p. 150.
38. Quoted in P. A. Samuelson and W. D. Nordhaus, Economics, 13th edn
(New York: McGraw-Hill, 1989), p. 75.
 4. FINANCE: A COLOSSUS IS BORN

1. R. Sahay, M. Cihak, P. N’Diaye, A. Barajas, R. Bi, D. Ayala, Y. Gao,

A. Kyobe, L. Nguyen, C. Saborowski, K. Svirydzenka and S. Reza
Yousefi, ‘Rethinking financial deepening: Stability and growth in
emerging markets’, IMF Staff Discussion Note SDN/15/08 (May
2015): https://www.imf.org/external/pubs/ft/sdn/2015/sdn1508.pdf
2. C. W. Park and M. Pincus, ‘Internal versus external equity funding
sources and early response coefficients’, Review of Quantitative
Finance and Accounting, 16(1) (2001), pp. 33–52:
https://doi.org/10.1023/A:1008336323282; T. Hogan and E. Hutson,
‘Capital structure in new technology-based firms: Evidence from the
Irish software sector Centre’, Financial Markets Working Paper series
WP-04-19 2004, University College Dublin School of Business, Centre
for Financial Markets.
3. C. Furse, ‘Taking the long view: How market-based finance can
support stability’, speech at Chartered Institute for Securities and
Investment, 28 March 2014:
http://www.bankofengland.co.uk/publications/Documents/speeches/2014/speech718
Z. Moradi, M. Mirzaeenejad and G. Geraeenejad, ‘Effect of bank-
based or market-based financial systems on income distribution in
selected countries’, Procedia Economics and Finance, 36 (2016), pp.
510–21; B-S. Lee, ‘Bank-based and market-based financial systems:
Time-series evidence’, Pacific-Basin Finance Journal, 20(2) (2012),
pp. 173–97.
4. R. Bacon and W. Eltis, Britain’s Economic Problem Revisited
(Basingstoke: Macmillan, 1996), pp. 15–33.
5. H. Oliver Horne, A History of Savings Banks (Oxford: University
Press, 1947), pp. 118–67.
6. M. da Rin and T. Hellmann, ‘Banks as catalysts for industrialization’,
William Davidson Working Paper 443 (October 2001):
https://deepblue.lib.umich.edu/bitstream/handle/2027.42/39827/wp443.pdf?
sequence=3
7. J. Schumpeter, ‘The theory of economic development’, Harvard
Economic Studies, 46 (1934); A. Gerschenkron, Economic
Backwardness in Historical Perspective (Cambridge, MA: Belknap
Press, 1962).
8. L. Akritidis, ‘Improving the measurement of banking services in the
UK national accounts’, Economic & Labour Market Review, 1(5)
(2007), pp. 29–37.
 9. L. Fioramonti, Gross Domestic Problem (London: Zed Books, 2013),
p. 111.
10. B. Sturgess, ‘Are estimates of the economic contribution of financial
services reliable?’, World Economics 18(1) (2017), pp. 17–32.
11. The seller hopes that by the time he or she has to deliver the securities
to the buyer the price will have fallen. The securities can then be
bought at the new (lower) price and sold to the buyer at the contracted
old (higher) price. The shorter pockets the difference between the two
prices.
12. J. Allen and M. Pryke, ‘Financialising household water: Thames
Water, MEIF and “ring-fenced” politics’, Cambridge Journal of
Regions, Economy & Society, 6 (2013), pp. 419–39.
13. L. A. Stout, ‘Why the law hates speculators: Regulation and private
ordering in the market for OTC derivatives’, Duke Law Journal, 48(4)
(1999), pp. 701–86.
14. S. Strange, International Monetary Relations (Oxford: University
Press, 1976), p. 180.
15. B. Eichengreen, The European Economy since 1945: Coordinated
Capitalism and Beyond (Princeton, NJ: University Press, 2008), p. 76.
16. C. A. E. Goodhart, ‘Competition and credit control’, Financial Markets
Group London School of Economics, special paper 229 (2014).
17. N. Ruggles and R. Ruggles, ‘Household and enterprise saving and
capital formation in the United States: A market transactions view’,
Review of Income and Wealth, 38(2) (June 1992), pp. 119–63.
18. M. McLeay, A. Radia and R. Thomas, ‘Money creation in the modern
economy’, Bank of England Quarterly Bulletin, Q1 2014, pp. 1–14.
19. Competition Commission, ‘The supply of banking services by clearing
banks to small and medium-sized enterprises: A report on the supply of
banking services by clearing banks to small and medium-sized
enterprises within the UK’ (2002), summary online at:
http://webarchive.nationalarchives.gov.uk/20111202184328/http://www.competitio
commission.org.uk/rep_pub/reports/2002/462banks.htm
20. B. Christophers, Banking Across Boundaries (Chichester: Wiley-
Blackwell, 2013), p. 38.
21. Eichengreen, The European Economy since 1945.
22. J. M. Keynes, The General Theory of Employment, Interest and Money
(London: Macmillan, 1936), p. 59.
23. J. M. Keynes, ‘Evidence to the Royal Commission on lotteries and
betting’ (1932), p. 400, quoted in Barba and de Vivo, ‘An
 “unproductive labour” view of finance’, p. 1492:
http://doi.org/doi:10.1093/cje/bes048
24. Ibid.
25. Keynes, General Theory of Employment, p. 159.
26. H. P. Minsky, ‘The Financial instability hypothesis: An interpretation
of Keynes and an alternative to “standard” theory” ’, Challenge, 20(1)
(1977), pp. 20–27.
27. L. Randall Wray and Y. Nersisyan, ‘Understanding Money and
Macroeconomic Policy’, in M. Jacobs and M. Mazzucato (eds),
Rethinking Capitalism: Economics and Policy for Sustainable and
Inclusive Growth (Chichester: Wiley-Blackwell, 2016).
28. H. P. Minsky, Stabilizing an Unstable Economy (New Haven and
London: Yale University Press, 1986), p. 369.
29. J. M. Keynes, ‘Proposals for an International Clearing Union’, April
1943, reprinted in J. K. Horsefield, The International Monetary Fund
1945–1965: Twenty Years of International Monetary Cooperation
(Washington, DC: IMF, 1969), pp. 19–36.
30. A. Turner, Economics After the Crisis: Objectives and Means (Boston,
MA: MIT Press, 2013), p. 18.
31. E. Fama, ‘Efficient capital markets: A review of theory and empirical
work’, Journal of Finance, 25(2) (1970).
32. M. Mazzucato and A. Shipman, ‘Accounting for productive investment
and value creation’, Industrial and Corporate Change, 23(4) (2014),
pp. 1059–85: http://doi.org/10.1093/icc/dtt037
33. B. Cournède and O. Denk, ‘Finance and economic growth in OECD
and G20 countries’, OECD Economics Department Working Papers
no. 1223 (2015).
34. P. Hill, ‘The Services of Financial Intermediaries, or FISIM Revisited’,
paper presented to the Joint UNECE/Eurostat/ OECD Meeting on
National Accounts, Geneva, 30 April–3 May 1996:
http://www.oecd.org/dataoecd/13/62/27900661.pdf
35. https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/
36. Bank of England, Financial Stability Report, 30 (December 2011), p.
16; available at
https:www.bankofengland.co.uk/media/boe/files/financial-stability-
report/2011/december-2011
37. Ibid.
38. Lavoie, Introduction to Post-Keynesian Economics.
39. http://www.bbc.co.uk/news/uk-37873825
40. Using OECD data we can see that the budget surplus in the UK was
0.72 in 1990; 1.11 in 2000; and 0.39 in 2001. In the US it was 0 in
1999, 0.8 in 2000.
41. C. Borio, M. Drehmann and K. Tsatsaronis, ‘Anchoring
countercyclical capital buffers: The role of credit aggregates’, BIS
Working Paper no. 355 (November 2011).
42. See A. Glyn, Capitalism Unleashed: Finance, Globalization and
Welfare (Oxford: University Press, 2006), p. 53; almost 80 per cent of
the total increase in US demand from 1995 to 2000 is represented by
household spending on consumption and residential investment.
43. A. Barba and M. Pivetti, ‘Rising household debt: Its causes and
macroeconomic implications – a long-period analysis’, Cambridge
Journal of Economics, 33(1) (2009), pp. 113–37.
44. Glyn, Capitalism Unleashed, p. 7.
45. T. Piketty, Capital in the Twenty-First Century (Cambridge, MA:
Belknap Press, 2014), p. 438.
46. Source: A. Haldane, Labour’s Share (London: TVC, 12 November
2015), p. 32, adapted from J. P. Pessoa and J. Van Reenen, ‘The UK
productivity and jobs puzzle: Does the answer lie in labour market
flexibility?’, Centre for Economic Performance Special Paper 31
(2013), compared to 65–70 per cent during similar periods at the end
of the 1960s and during the 1980s.
47. Source: author’s elaboration from: piketty.pse.ens.fr/capital21c
48.
https://www.oxfam.org/sites/www.oxfam.org/files/file_attachments/bp210-
economy-one-percent-tax-havens-180116-summ-en_0.pdf
49. Source: author’s elaboration on OECD data.
50. See A. Greenspan and J. Kennedy, Estimates of Home Mortgage
Originations, Repayments, and Debt on One-to-Four-Family
Residences, Finance and Economic Discussion Series 2005-41
(Washington, DC: Board of Governors of the Federal Reserve System,
2005). Greenspan and Kennedy (p. 5) define mortgage equity
extraction as ‘the extraction of equity on existing homes as the
discretionary initiatives of home owners to convert equity in their
homes into cash by borrowing in the home mortgage market’.
51. https://www.cbo.gov/sites/default/files/110th-congress-2007-
2008/reports/01-05-housing.pdf
52. Source: adapted from Table 1 in Barba and Pivetti, ‘Rising household
debt’.
53. Source: Federal Reserve, 2004 Survey of Consumer Finances.
54. C. Crouch, ‘Privatised Keynesianism: An unacknowledged policy
regime’, British Journal of Politics and International Relations, 11(3)
(August 2009), pp. 382–99.
55. Ibid., p. 390.
 5. THE RISE OF CASINO CAPITALISM

1. H. Minsky, ‘Reconstituting the United States’ financial structure’,

Levy Economics Institute Working Paper no. 69 (1992).
2. http://www.economist.com/blogs/economist-
explains/2016/02/economist-explains-0
3. R. Foroohar, Makers and Takers (New York: Crown, 2016), p. 7.
4. H. P. Minsky, ‘Finance and stability: The limits of capitalism’, Levy
Economics Institute Working Paper no. 93 (1993).
5. F. Grigoli and A. Robles, ‘Inequality overhang’, IMF Working Paper
17/76, 28 March 2017; R. Wilkinson and H. Pickett, The Spirit Level
(London: Penguin, 2009).
6. W. Churchill, ‘WSC to Sir Otto Niemeyer, 22 February 1925’,
Churchill College, Cambridge, CHAR 18/12A-B.
7. Bank of England database, ‘Three centuries of macroeconomic data’:
http://www.bankofengland.co.uk/research/Pages/onebank/threecenturies.aspx
8. Data in this sentence from House of Commons Library reports –
Standard Note SN/EP/06193 (Gloria Tyler, 25.2.15) and Briefing
Paper 01942 (Chris Rhodes, 6.8.15). The exact figures in Eurostat for
Financial and Insurance Activities as a per cent of total value added are
as follows: 1995: 6.3 per cent; 2000: 5.1 per cent; 2009: 9.1 per cent;
2015: 7.2 per cent. Or as percentage of GDP: 1995: 5.7 per cent; 2000:
4.6 per cent; 2009: 8.3 per cent; 2015: 6.5 per cent.
9. Source: (2009–13 data extended by author) P. Alessandri and A.
Haldane, ‘Banking on the State’ (Bank of England, 2009):
http://www.bankofengland.co.uk/archive/Documents/historicapubs/speeches/2009/s
10. Source: Bureau of Economic Analysis, Matthew Klein’s calculations.
11. D. Tomaskovic-Devey and K. H. Lin, ‘Income dynamics, economic
rents, and the financialization of the U.S. economy’, American
Sociological Review, 76(4) (August 2011), pp. 538–59. The figure for
2014 is similar to what it was in 2009.
12. Source: Bureau of Economic Analysis, adapted from Tomaskovic-
Devey and Lin, ‘Income dynamics, ecnomic rents, and the
financialization of the U.S. economy’.
13. https://www.ici.org/pdf/2015_factbook.pdf
14. Asset Management in the UK, The Investment Association Annual
Survey:
http://www.theinvestmentassociation.org/assets/files/research/2016/20160929-
amsfullreport.pdf
15. http://www.bbc.co.uk/news/business-37640156
16. http://www.knightfrank.com/wealthreport
17. http://www.businessinsider.com/chart-stock-market-ownership-2013-
3?IR=T
18.
https://www.ons.gov.uk/economy/investmentspensionsandtrusts/bulletins/ownership
09-02
19. https://www.ft.com/content/14cda94c-5163-11e5-b029-b9d50a74fd14
20. http://www.agefi.fr/sites/agefi.fr/files/fichiers/2016/07/bcg-doubling-
down-on-data-july-2016_tcm80-2113701.pdf
21. http://uk.businessinsider.com/richest-hedge-fund-managers-in-the-
world-2016-3
22. G. Morgenson, ‘Challenging private equity fees tucked in footnotes’,
New York Times, 17 October 2015:
https://www.nytimes.com/2015/10/18/business/challenging-private-
equity-fees-tucked-in-footnotes.html
23. http://www.wsj.com/articles/kkr-to-earn-big-payout-from-walgreen-
alliance-boots-deal-1420068404
24. B. Burrough and J Helyar, Barbarians at the Gate: The Fall of RJR
Nabisco, rev. edn (New York: HarperCollins, 2008).
25. G. Moran, ‘Urine lab flaunted piles of gold’, San Diego Union-
Tribune, 24 October 2015; J. Montgomery, ‘Bankruptcy court must
clarify Millennium Labs fraud release’, Law 360, 20 March 2017.
26. Barba and de Vivo, ‘An “unproductive labour” view of finance’ p.
1491.
27. A. Hutton and E. Kent, The Foreign Exchange and Over-the-counter
Interest Rate Derivatives Market in the United Kingdom (London:
Bank of England, 2016), p. 225.
28. Bank for International Settlements, Basel III phase-in arrangements:
http://www.bis.org/bcbs/basel3/basel3_phase_in_arrangements.pdf
29. Jordan Weissmann, ‘How Wall Street devoured corporate America’,
The Atlantic, 5 March 2013:
https://www.theatlantic.com/business/archove/2-13/03/how-wall-
street-devoured-corporate-america/273732/
30. L. Randall Wray, Modern Money Theory (Basingstoke: Palgrave
Macmillan, 2012), pp. 76–87.
31. Empirical groundwork in Lester Thurow, Generating Inequality (New
York: Basic Books, 1975), ch. 6, pp. 129–54.
32. Source: Federal Reserve Bank of St Louis, author’s elaboration:
https://fred.stlouisfed.org/series/FBCOEPQ027S#0
33. Barba and de Vivo, ‘An “unproductive labour” view of finance’, pp.
1490–91.
34. Ibid., p. 1491.
35. Andy Verity, ‘Libor: Bank of England implicated in secret recording’,
BBC, 10 April 2017: http://www.bbc.co.uk/news/business-39548313
36. Barba and de Vivo, ‘An “unproductive labour” view of finance’, p.
1489.
37. T. Philippon, ‘Finance vs Wal-Mart: Why are financial services so
expensive?’, in A. Blinder, A. Lo and R. Solow (eds), Rethinking the
Financial Crisis (New York: Russell Sage Foundation, 2012), p. 13:
http://www.russellsage.org/sites/all/files/Rethinking-
Finance/Philippon_v3.pdf
38. John C. Bogle, ‘The arithmetic of “all-in” investment expenses’,
Financial Analysts Journal, 70(1) (2014), p. 18.
39. Ibid., p. 17.
40. John C. Bogle, The Clash of the Cultures: Investment vs. Speculation
(Hoboken, NJ: John Wiley and Sons, 2012), p. 8.
41. Ibid., p. 2.
42. https://www.ft.com/content/ab1ce98e-c5da-11e6-9043-7e34c07b46ef
43. https://www.nytimes.com/2016/12/10/business/dealbook/just-how-
much-do-the-top-private-equity-earners-make.html
44. A. Metrick and A. Yasuda, ‘The economics of private equity’, Review
of Financial Studies, 23(6) (2011), pp. 2303–41:
https://doi.org/10.1093/rfs/hhq020
45. If ratio of proceeds from PE investments to public investment is > 1,
PE is considered superior. Source: Journal of Finance, 69 (5) (October
2014), p. 1860.
46. J. M. Hill, ‘Alpha as a net zero-sum game: How serious a constraint?’,
Journal of Portfolio Management, 32(4) (2006), pp. 24–32;
doi:10.3905/jpm.2006.644189
 6. FINANCIALIZATION OF THE REAL ECONOMY

1. https://www.ft.com/content/294ff1f2-0f27-11de-ba10-0000779fd2ac
2. These figures give an approximate idea of the weight of large
companies in the economy. On the one hand, some companies do not
report their turnover, so total revenues are underestimated. On the
other hand, the list includes the biggest banks.
3. G. Mukunda, ‘The price of Wall Street’s power’, Harvard Business
Review, June 2014.
4. E. Hadas, ‘Seeing straight: Why buybacks should be banned’,
Breakingviews, 14 December 2014:
https://www.breakingviews.com/features/why-buybacks-should-be-
banned/
5. W. Lazonick, ‘Profits without prosperity’, Harvard Business Review,
September 2014.
6. Ibid.
7. http://online.wsj.com/public/resources/documents/blackrockletter.pdf
8. Source: Adapted from Lazonick, ‘Profits without prosperity’.
9. Jensen and Meckling, ‘Theory of the firm’, pp. 305–60.
10. Source: Bain & Co., Global Private Equity Report (2015), fig. 2, p. 43.
11. https://www.blackstone.com/the-firm/asset-management/private-equity
12. D. Burns, L. Cowie, J. Earles, P. Folkman, J. Froud, P. Hyde, S. Johal,
I. Rees Jones, A. Killett and K. Williams, Where Does the Money Go?
Financialised Chains and the Crisis in Residential Care, CRESC
Public Interest Report, March 2015.
13. G. Ruddick, ‘Four Seasons Health Care reports £264m annual loss’,
the Guardian, 27 April 2016.
14. K. Bayliss, ‘Case study: The financialisation of water in England and
Wales’, FESSUD (Financialisation, Economy, Society and Sustainable
Development), Working Paper series no. 52 (2014).
15. W. Lazonick, ‘Innovative enterprise or sweatshop economics? In
search of foundations of economic analysis’, ISIGrowth Working
Paper no. 17 (2016).
16. P. Aghion, J. Van Reenen and L. Zingales, ‘Innovation and
institutional ownership’, American Economic Review, 103(1) (2013),
pp. 277–304.
17. Bogle, The Clash of the Cultures.
18. J. M. Keynes, The General Theory of Employment, Interest and Money
(London: Macmillan, 1936), p. 154.
19. Ibid., p. 155.
20. S. Patterson, Dark Pools: The Rise of AI Trading Machines and the
Looming Threat to Wall Street (New York: Random House, 2012).
21. Amy Or, ‘Average private equity hold times drop to 5.5 years’, Wall
Street Journal, 10 June 2015.
22. D. Barton and M. Wiseman, ‘Focusing capital on the long term’,
Harvard Business Review, January–February 2014.
23. Ibid.
24. Keynes, General Theory of Employment, pp. 161–2.
25. Return on Invested Capital is a measure of profitability. It is calculated
by dividing net (after tax) operating profits by invested capital (less
cash and cash equivalents).
26. J. P. Morgan, ‘Bridging the gap between interest rates and
investments’, JPM Corporate Finance Advisory, September 2014.
27. K. J. Murphy, ‘Executive compensation: Where we are, and how we
got there’, in G. M. Constantinides, M. Harris and R. M. Stulz (eds),
Handbook of the Economics of Finance, vol. 2 (Amsterdam: Elsevier,
2013), pp. 211–356.
28. L. Mishel and J. Schieder, CEO Pay Remains High Relative to the Pay
of Typical Workers and High-wage Earners (Washington, DC:
Economic Policy Institute, 2017).
29. The Conference Board, CEO Succession Practices: 2017 Edition,
https://www.conference-board.org/publications/publicationdetail.cfm?
publicationid=7537
30. Fig. 26 depicts data retrieved from the Bureau of Economic Analysis
website.
31. J. Asker, J. Farre-Mensa and A. Ljungqvist, ‘Comparing the
investment behavior of public and private firms’, NBER Working
Paper No. 17394 (September 2011).
32. Author’s elaboration of data from the Bureau of Economic Analysis.
33. Author’s elaboration of data from the Bureau of Economic Analysis.
34. Bogle, The Clash of the Cultures, pp. 22–3.
35. M. Friedman, Capitalism and Freedom (Chicago: University Press,
1962), p. 133.
36. R. E. Freeman, J. S. Harrison, A. C. Wicks, B. L. Parmar and S. de
Colle, Stakeholder Theory: The State of the Art (Cambridge:
University Press, 2010), p. 268.
37. https://www.kfw.de/KfW-Group/About-KfW/Identität/Geschichte-der-
KfW/
38. C. Leggett, ‘The Ford Pinto case: The valuation of life as it applies to
the negligence-efficiency argument’, Law & Valuation, Spring 1999.
39. C. Perez, Technological Revolutions and Financial Capital: The
Dynamics of Bubbles and Golden Ages (Cheltenham: Edward Elgar,
2002).
40. C. Perez, ‘The Double bubble at the turn of the century: Technological
roots and structural implications’, Cambridge Journal of Economics
33(4) (2009), p. 801.
 7. EXTRACTING VALUE THROUGH THE INNOVATION ECONOMY

1. https://www.netmarketshare.com/search-engine-market-share.aspx?
qprid=4&qpcustomd=0
2. R. Solow, ‘Technical change and the aggregate production function’,
Review of Economics and Statistics, 39 (3) (1957), pp. 312–20: JSTOR
1926047; R. R. Nelson and S. G. Winter, An Evolutionary Theory of
Economic Change (Cambridge, MA: Harvard University Press, 2009).
3. D. J. Teece, ‘Profiting from technological innovation’, Research
Policy, 15(6) (1986), pp. 285–305.
4. https://www.theatlantic.com/magazine/archive/2015/11/we-need-an-
energy-miracle/407881/
5. https://www.washingtonpost.com/opinions/americas-miracle-machine-
is-in-desperate-need-of-well-a-miracle/2017/05/05/daafbe6a-30e7-
11e7-9534-00e4656c22aa_story.html?utm_term=.b38348fbc471
6. https://hbr.org/2014/05/why-germany-dominates-the-u-s-in-innovation
7. M. K. Block and F. Keller, ‘Explaining the transformation in the US
innovation system: The impact of a small government program’,
Socioeconomic Review 11(4) (2013), pp. 629–56:
https://doi.org/10.1093/ser/mws021
8. S. W. Leslie, The Cold War and American Science: The Military-
Industrial-Academic Complex at MIT and Stanford (New York:
Columbia University Press, 1993).
9. See W. Lazonick, Sustainable Prosperity in the New Economy?
Business Organization and High-Tech Employment in the United
States (Kalamazoo, MI: W. E. Upjohn Institute for Employment
Research, 2009), ch. 2: doi: https://doi.org/10.17848/9781441639851
10. Business Week, 1960, cited in H. Lazonick, Sustainable Prosperity in
the New Economy? Business Organization and High-tech Employment
in the United States (Kalamazoo, MI: Upjohn Press, 2009), p. 79.
11. W. Lazonick and M. Mazzucato, ‘The risk–reward nexus in the
innovation–inequality relationship: Who takes the risks? Who gets the
rewards?’, Industrial and Corporate Change, 22(4) (2013), pp. 1093–
128: https://doi.org/10.17848/9781441639851 The structure of this
market is particularly important in understanding where innovation risk
truly lies. Liquidity is provided by market makers, who underwrite
IPOs and ensure the instant sale and purchase of stock at close to
market prices. In this way, investor risk is transferred to market
makers. Market makers are backed by investment banks, which – as it
turns out – are underwritten by the government (K. Ellis, R. Michaely
 and M. O’Hara, ‘When the underwriter is the market maker: An
examination of trading in the IPO aftermarket’, Journal of Finance,
55(3) (1999), pp. 1039–74.
12. ‘I have worked with investors for 60 years and I have yet to see anyone
– not even when capital gains rates were 39.9 per cent in 1976–77 –
shy away from a sensible investment because of the tax rate on the
potential gain. People invest to make money, and potential taxes have
never scared them off. And to those who argue that higher rates hurt
job creation, I would note that a net of nearly 40 million jobs were
added between 1980 and 2000. You know what’s happened since then:
lower tax rates and far lower job creation.’, The New York Times, 14
August 2011: http://www.nytimes.com/2011/08/15/opinion/stop-
coddling-the-super-rich.html?_r=2&hp
13. Lazonick and Mazzucato, ‘The risk–reward nexus in the innovation–
inequality relationship’.
14. N. Henderson and M. Schrage, ‘The roots of biotechnology:
Government R&D spawns a new industry’, Washington Post, 16
December 1984:
https://www.washingtonpost.com/archive/politics/1984/12/16/government-
r38/cb580e3d-4ce2-4950-bf12-a717b4d3ca36/?
utm_term=.27fd51946872. I am grateful to William Lazonick for
pointing me to this article.
15. This section on the role of venture capital and the following section on
executive pay draw heavily on Lazonick and Mazzucato, ‘The risk–
reward nexus in the innovation–inequality relationship’.
16. Ibid.
17. Ibid.
18. P. A. Gompers and J. Lerner, The Venture Capital Cycle (Cambridge,
MA: MIT Press, 2002).
19. See S. Davidoff, ‘Why I.P.O.s get underpriced’, Dealbook, New York
Times, 27 May 2011; J. Ritter, IPO data website, 2012:
http://bear.warrington.ufl.edu/ritter/ipodata.htm; M. Gimein, E. Dash,
L. Munoz and J. Sung, ‘You bought. They SOLD’, Fortune, 146(4)
(2002), pp. 64–8, 72, 74.
20. Gary P. Pisano, Science Business: The Promise, the Reality, and the
Future of Biotech (Boston, MA: Harvard Business School Press,
2006).
21. W. Lazonick and Ö. Tulum, ‘US biopharmaceutical finance and the
sustainability of the US biotech business model’, Research Policy,
40(9) (2011), pp. 1170–87.
22. R. Fontana, A. Nuvolari, H. Shimizu and A. Vezzulli, ‘Reassessing
patent propensity: Evidence from a dataset of R&D awards, 1977–
2004’, Research Policy 42(10) (2013), pp. 1780–92.
23. More formally, a patent holder is awarded a ‘probabilistic’ right to
exclude others from using and commercializing an invention (M. A.
Lemley and C. Shapiro, ‘Probabilistic patents’, Journal of Economic
Perspectives, 19(2) (2005), pp. 75–98: doi:
10.1257/0895330054048650). The patentee must be willing and able to
enforce its rights against infringement of the patent. The patentee can
license others to use the invention in exchange for royalties.
24. The intensity of patenting activity and the importance of patents – both
in relation to appropriability and disclosure – varies in importance
across countries, sectors, technologies, and by firm size. Firms in
pharmaceuticals, biotechnology and ICT, for example, tend to patent
more than firms in other areas. Patents are the most important
appropriability mechanism for pharmaceutical companies, for example,
whereas in other sectors firms may rely more on secrecy, lead-times to
production, trademarks and additional complementary assets to gain
from their inventions. Similarly, patents play a far more important role
in the diffusion of information for R&D labs in manufacturing firms in
Japan compared with those in the US, where publication and informal
information exchange is more important (W. M. Cohen, A. Goto, A.
Nagata, R. R. Nelson and J. P. Walsh, ‘R&D spillovers, patents and the
incentives to innovate in Japan and the United States’, Research
Policy, 1(8–9) (2002), pp. 1349–67: doi: http://doi.org/10.1016/S0048-
7333(02)00068-9
25. According to M. A. Lemley, in ‘Software patents and the return of
functional claiming’, Wisconsin Law Review, 2013(4), pp. 905–64, the
costs of software innovation are lower than innovation in the life
sciences. Software is also protected by copyrights, which already
provide for effective prevention of copying by others. Network effects
may help innovators to capture returns regardless of intellectual
property protection (more on this later in this chapter). There is, in
addition, the open-source community, which suggests that patents may
not be a necessary condition for innovation in the sector. Finally,
software patentability varies across regions and countries (for example,
it is limited in Europe and India, and broad in the US), which also
suggests that patent protection may reflect a policy choice.
26. Baumol, ‘Entrepreneurship: Productive, unproductive, and
destructive’.
27. R. Mazzoleni and R. R. Nelson, ‘The benefits and costs of strong
patent protection: A contribution to the current debate’, Research
Policy, 27(3) (1998), pp. 273–84.
28. M. Kenney and D. Patton, ‘Reconsidering the Bayh–Dole Act and the
current university invention ownership model’, Research Policy, 38(9)
(2009), pp. 1407–22.
29. http://www.nybooks.com/articles/2004/07/15/the-truth-about-the-drug-
companies/
30. L. Burlamaqui and R. Kattel, ‘Development as leapfrogging, not
convergence, not catch-up: Towards Schumpeterian theories of finance
and development’, Review of political Economy, 28(2) (2016), pp.
270–88.
31. Mazzoleni and Nelson, ‘The benefits and costs of strong patent
protection’.
32. S. Haber and S. H. Werfel, ‘Why do inventors sell to patent trolls?
Experimental evidence for the asymmetry hypothesis’, Stanford
University Working Paper, 27 April 2015.
33. J. Bessen and M. J. Meurer, ‘The Patent Litigation Explosion’, Loyola
University Chicago Law Journal, 45(2) (2013), pp. 401–40:
http://lawecommons.luc.edu/luclj/vol45/iss2/5
34. J. E. Bessen et al., ‘Trends in private patent costs and rents for
publicly-traded United States firms’(March 2015). Boston University
School of Law, Public Law Research Paper no. 13–24: SSRN:
https://ssrn.com/abstract=2278255 or
http://dx.doi.org/10.2139/ssrn.2278255
35. C. V. Chien, ‘Startups and patent trolls’, Stanford Technology Law
Review, 17 (2014), pp. 461–506.
36. W. J. Baumol, Entrepreneurship, Management and the Nature of
Payoffs (Cambridge, MA: MIT Press, 1993), ch. 2, p. 25; see also ch.
4.
37. Foley, ‘Rethinking financial capitalism and the “information”
economy’.
38. The Economist, 8 August 2015:
http://www.economist.com/news/leaders/21660522-ideas-fuel-
economy-todays-patent-systems-are-rotten-way-rewarding-them-time-
fix
39. C. Forero-Pineda, ‘The impact of stronger intellectual property rights
on science and technology in developing countries’, Research Policy
35(6) (2006), pp. 808–24.
40. E. M. F. t’Hoen, The Global Politics of Pharmaceutical Monopoly
Power: Drug Patents, Access, Innovation and the Application of the
WTO Doha Declaration on TRIPS and Public Health (Diemen: AMB,
2009).
41. M. Mazzucato, The Entrepreneurial State: Debunking Private vs.
Public Sector Myths (London: Anthem Press, 2013).
42. Source: US Department of Health and Human Services:
http://www.hhs.gov/opa/reproductive-health/stis/hepatitis-c and World
Health Organization: http://www.euro.who.int/en/health-
topics/communicable-diseases/hepatitis/data-and-statistics
43. Sovaldi is, however, more costly than Harvoni overall, because it
needs to be taken in combination with other drugs.
44. The letter is available at
http://www.finance.senate.gov/imo/media/doc/Wyden-
Grassley%20Document%20Request%20to%20Gilead%207-11-
141.pdf
45. A. Hill, S. Khoo, J. Fortunak, B. Simmons and N. Ford, ‘Minimum
costs for producing hepatitis C direct-acting antivirals for use in large-
scale treatment access programs in developing countries’, Clinical
Infectious Diseases, 58(7) (2014), pp. 928–36: doi: 10.1093/cid/ciu012
46. M. Mazzucato, ‘High cost of new drugs’, British Medical Journal,
354: i4136 (2016):
http://www.bmj.com/cgi/content/full/354/jul2710/i4136
47. D. W. Light and J. R. Lexchin, ‘Pharmaceutical research and
development: What do we get for all that money?’, British Medical
Journal 345:e4348 (2012): http://dx.doi.org/10.1136/bmj.e4348
48. A. Swanson, ‘Big pharmaceutical companies are spending far more on
marketing than research’, Washington Post, 11 February, 2015:
http://www.washingtonpost.com/news/wonkblog/wp/2015/02/11/big-
pharmaceutical-companies-are-spending-far-more-on-marketing-than-
research/
49. Lazonick, ‘Profits without prosperity’.
50. Mazzucato, The Entrepreneurial State.
51. H. Kantarjian and S. V. Rajkumar, ‘Why are cancer drugs so expensive
in the United States, and what are the solutions?’, Mayo Clinic
Proceedings, April 2015, report that 85 per cent of basic cancer
research in the US is funded by the government.
52. J. Sachs, ‘The drug that is bankrupting America’, Huffington Post, 16
February 2015: http://www.huffingtonpost.com/jeffrey-sachs/the-drug-
that-is-bankrupt_b_6692340.html
53. V. Roy and L. King, ‘Betting on hepatitis C: How financial speculation
in drug development influences access to medicines’, British Medical
Journal, 354:i3718 (2016).
54. P. Barrett and R. Langreth, ‘Pharma execs don’t know why anyone is
upset by a $94,500 miracle cure’, Bloomberg Businessweek, 3 June
2015: https://www.bloomberg.com/news/articles/2015-06-
03/specialty-drug-costs-gilead-s-hepatitis-c-cures-spur-backlash
55. LaMattina’s article on Forbes is available at:
http://www.forbes.com/sites/johnlamattina/2014/08/04/politicians-
shouldnt-question-drug-costs-but-rather-their-value-lessons-from-
soliris-and-sovaldi/
56. R. Zirkelbach, ‘The five essential truths about prescription drug
spending’, March 2015, available on PhRMA website at:
http://catalyst.phrma.org/the-five-essential-truths-about-prescription-
drug-spending
57. See for example Hilner and Smith, ‘Efficacy does not necessarily
translate to cost effectiveness’.
58. Peter Bach’s interactive calculator can be accessed at
www.drugabacus.org
59. According to the ranking compiled by Forbes for 2014, on average the
ten largest pharmaceutical companies enjoy a 19 per cent net profit rate
– the highest of all industries included in Forbes’ worldwide analysis.
Pfizer leads the group with a remarkable 41 per cent net profit margin.
Only large banks, which are well known to enjoy rents because of their
size and political influence, earn a profit rate comparable to that of
large pharmaceutical companies, while for example the ten largest
automobile companies – also one of the most profitable industries in
the world – have on average a 6 per cent net profit rate.
60. P. David, ‘Clio and the Economics of QWERTY’, American Economic
Review, 75(2), Papers and Proceedings of the Ninety-Seventh Annual
Meeting of the American Economic Association (May 1985), pp. 332–
7; G. Dosi, ‘Sources, procedures, and microeconomic effects of
innovation’, Journal of Economic Literature, vol. 26 (1988), pp. 1120–
71.
61. According to its own mission statement, for example, ‘Facebook’s
mission is to give people the power to share and make the world more
open and connected’ (investor.fb.com/faq.cfm). Sergey Brin, one of
Google’s founders and President of its parent company Alphabet, has
often talked about Google as trying to be against evil, and a ‘force for
good’. http://www.businessinsider.com.au/best-quotes-google-sergey-
 brin-2014-7#to-me-this-is-about-preserving-history-and-making-it-
available-to-everyone-1
62. K. Kelly, ‘The new socialism: Global collectivist society is coming
online’, Wired magazine, 17 June 2009.
63. E. Morozov, ‘Silicon Valley likes to promise “digital socialism” – but
it is selling a fairy tale’, the Guardian, 28 February 2015.
64. Variously attributed. Common attribution is to Andrew Lewis, as
blue_beetle on MetaFilter 2010, ‘If you’re not paying for it, you’re not
the customer; you’re the product being sold’:
http://www.metafilter.com/95152/Userdriven-discontent#3256046
65. M. J. Sandel, What Money Can’t Buy: The Moral Limits of Markets
(London and New York: Allen Lane and Farrar, Straus and Giroux,
2013).
66. Evgeny Morozov, ‘Don’t believe the hype, the “sharing economy”
masks a failing economy’, the Guardian, 28 September 2014:
http://www.theguardian.com/commentisfree/2014/sep/28/sharing-
economy-internet-hype-benefits-overstated-evgeny-morozov; Evgeny
Morozov, ‘Cheap cab ride? You must have missed Uber’s true cost’,
the Guardian, 31 January 2016:
http://www.theguardian.com/commentisfree/2016/jan/31/cheap-cab-
ride-uber-true-cost-google-wealth-taxation
67. Evgeny Morozov, ‘Where Uber and Amazon rule: welcome to the
world of the platform’, the Guardian, 7 June 2015:
http://www.theguardian.com/technology/2015/jun/07/facebook-uber-
amazon-platform-economy
68. https://www.bloomberg.com/news/articles/2017-02-28/in-video-uber-
ceo-argues-with-driver-over-falling-fares
69. http://fortune.com/2016/10/20/uber-app-riders/
70. A useful distinction can be made between direct and indirect network
effects. When a higher number of participants increases the benefit to
each individual member – as in the case of Facebook – the effect is
direct. Where, instead, a higher number of members (for example,
buyers) increases the convenience of using the platform, not for the
members but for another group (for example, the sellers), we talk of
indirect network effects.
71. Source: Statista database (www.statista.com), and
http://uk.businessinsider.com/facebook-and-google-winners-of-digital-
advertising-2016-6?r=US&IR=T
72. Morozov, ‘Where Uber and Amazon rule’.
73. See note 70 for the distinction between direct and indirect network
effects.
74. Mazzucato, The Entrepreneurial State.
75. Foley, ‘Rethinking financial capitalism and the “information”
economy’.
76. See ibid. for a rigorous but accessible explanation of the classical
theory of surplus value and how it can be used to provide an alternative
interpretation of the so-called ‘new economy’.
77. https://www.theguardian.com/commentisfree/2016/dec/04/data-
populists-must-seize-information-for-benefit-of-all-evgeny-morozov
78. H. A. Simon, ‘Public administration in today’s world of organizations
and markets’, PS: Political Science and Politics, December 2000, p.
756.
79. https://www.theguardian.com/technology/2016/jun/09/uber-suffers-
legal-setbacks-in-france-and-germany
https://www.theguardian.com/technology/2016/jun/08/berlin-ban-
airbnb-short-term-rentals-upheld-city-court
https://www.theguardian.com/media/2016/may/25/netflix-and-amazon-
must-guarantee-20-of-content-is-european
80. For a discussion of the criteria and implementation issues behind
mission-oriented policies see my recent report, M. Mazzucato,
Mission-oriented research & innovation in the European Union – A
problem-solving approach to fuel innovation-led growth, European
Commission, 2018.
81. Such thinking is indeed what has inspired Mission Innovation (MI;
http://mission-innovation.net), an alliance of twenty-two ministers and
the European Union to combat climate change through national
commitments (around $20 billion) to invest in clean energy innovation.
The coalition was announced on 30 November 2015 during the COPS
meeting in Paris. On the private-sector side the Breakthrough Coalition
is committing an equal amount of money. Since 2014 I have been
leading a project on the need for such mission-oriented thinking in
innovation: http://marianamazzucato.com/projects/mission-oriented-
innovation-policy/
 8. UNDERVALUING THE PUBLIC SECTOR

1. https://www.gov.uk/government/speeches/mansion-house-2015-
speech-by-the-chancellor-of-the-exchequer
2. ‘The third industrial revolution’, The Economist, 21 April 2012:
http://www.economist.com/node/21553017
3. K. Polanyi, The Great Transformation: The Political and Economic
Origins of Our Time (1944; Boston MA: Beacon Press, 2001), p. 144.
4. C. M. Reinhart and K. S. Rogoff, ‘Growth in a time of debt’, American
Economic Review, 100(2) (2010), pp. 573–8.
5. Ibid., p. 573.
6. T. Herndon, M. Ash and R. Pollin, ‘Does high public debt consistently
stifle economic growth? A critique of Reinhart and Rogoff’,
Cambridge Journal of Economics, 38(2) (2014), pp. 257–79:
http://doi.org/10.1093/cje/bet075, p. 5.
7. Ibid., pp. 7–8.
8. Reinhart and Rogoff:
http://www.nytimes.com/2013/04/26/opinion/debt-growth-and-the-
austerity-debate.html?_r=0 and Reinhard and Rogoff:
http://www.nytimes.com/2013/04/26/opinion/reinhart-and-rogoff-
responding-to-our-critics.html
9. http://www.focus-economics.com/countries/italy
10. https://www.theguardian.com/business/2014/oct/01/austerity-
eurozone-disaster-joseph-stiglitz
11. Crowding out usually refers to the negative effect that government
spending or investment may have on private investment, primarily
because either government borrowing pushes up interest rates (making
it harder for business to take out loans) or because government moves
into activities that were in the private sector. Analyses on crowding out
have been problematic due to the lack of proper analysis of what the
private sector is willing to do.
12. A. Bergh and M. Henrekson, ‘Government size and growth: A survey
and interpretation of the evidence’, Journal of Economic Surveys,
25(5) (2011), pp. 872–97: http://doi.org/10.1111/j.1467-
6419.2011.00697.x
13. P. Steiner, ‘Wealth and power: Quesnay’s political economy of the
“Agricultural Kingdom” ’, Journal of the History of Economic
Thought, 24(1) (2002), pp. 91–110.
14. The ‘sterile class’ comprised city dwellers or artisans. In Schumpeter’s
History of Economic Analysis, p. 239, the same word is used to
 describe the ‘bourgeoisie’. ‘Disposable class’ is the name that Turgot
gave to the class of landowners (classe
propriétaire/souveraine/distributive).
15. Quesnay, quoted in Steiner, ‘Wealth and power’, p. 99.
16. Schumpeter, History of Economic Analysis, p. 230; Steiner, ‘Wealth
and Power’, p. 100.
17. Smith, The Wealth of Nations, Book IV, Introduction.
18. Ibid., Book I, ch. 1.
19. Ibid., Book V, ch. 1.
20. Ibid.
21. David Ricardo, The Works and Correspondence of David Ricardo, ed.
P. Sraffa with the collaboration of M. H. Dobb, vol. 1: On the
Principles of Political Economy and Taxation (Cambridge: University
Press, 1951), p. 150.
22. Ibid., p. 151.
23. Karl Marx and Friedrich Engels, The Communist Manifesto (1848;
London: Penguin Classics, 2010), ch. 1.
24. A. Marshall, Principles of Economics (1890; London: Macmillan,
1920), Book I, ch. 4, para. 4.
25. Ibid.
26. B. Snowdon and H. Vane, A Macroeconomics Reader (London:
Routledge, 1997), p. 3.
27. Keynes, The General Theory of Employment, Interest and Money, p.
249.
28. This and the following are from the Preface to the French edition of
The General Theory of Employment, Interest and Money.
29. R. Reich, ‘Economist John Maynard Keynes’, TIME magazine, 29
March 1999.
30. McLeay, Radia and Thomas, ‘Money creation in the modern
economy’, p. 14.
31. BEA, Measuring the Economy: A Primer on GDP and the National
Income and Product Accounts (Washington, DC: Bureau of Economic
Analysis, US Department of Commerce, 2014), pp. 9–4:
http://www.bea.gov/national/pdf/nipa_primer.pdf
32. T. Atkinson, Atkinson Review: Final Report. Measurement of
Government Output and Productivity for the National Accounts
(Basingstoke and New York: Palgrave Macmillan, 2005).
33. M. G. Phelps, S. Kamarudeen, K. Mills and R. Wild, ‘Total public
service output, inputs and productivity’, Economic and Labour Market
 Review, 4(10) (2010), pp. 89–112:
http://doi.org/10.1057/elmr.2010.145
34. ONS (Office for National Statistics), Public Service Productivity
Estimates: Total Public Services, 2012 (2015):
http://www.ons.gov.uk/ons/dcp171766_394117.pdf
35. The multiplier looks at how much total increase in GDP results from
an initial increase in government spending. The calculation assumes a
known marginal propensity to save and consume, i.e. how much of
every pound or dollar earned a consumer will spend and how much he
or she will save. If 80 per cent is consumed, then the GDP will increase
by an amount of 1/(1−0.8) multiplied by the stimulus; so if the initial
extra spending was £1 million, GDP will increase by £5 million.
36. ‘Fiscal policy as a countercyclical tool’, World Economic Outlook, ch.
5 (Washington DC: International Monetary Fund, October 2008); L.
Cohen, J. Coval and C. Malloy, ‘Do powerful politicians cause
corporate downsizing?’, Journal of Political Economy, 119(6) (2011),
pp. 1015–60: doi:10.1086/664820; R. J. Barro and C. J. Redlick,
‘Macroeconomic effects from government purchases and taxes’,
Quarterly Journal of Economics 126(1) (2011), pp. 51–102: doi:
10.1093/qje/qjq002
37. D. Leigh, P. Devries, C. Freedman, J. Guajardo, D. Laxton and A.
Pescatori, ‘Will it hurt? Macroeconomic effects of fiscal
consolidation’, IMF World Economic Outlook (Washington, DC:
International Monetary Fund, 2010), pp. 93–124.
38. D. Leigh and O. J. Blanchard, ‘Growth forecast errors and fiscal
multipliers’, Working Paper no. 13/1 (Washington, DC: International
Monetary Fund, 2013).
39. A. O. Krueger, ‘The political economy of the rent-seeking society’,
The American Economic Review, 64(3) (June 1974), pp. 291–303.
40. G. Tullock, A. Seldon and G. L. Brady, Government Failure: A Primer
in Public Choice (Washington, DC: Cato Institute, 2002).
41. B. M. Friedman, ‘Crowding out or crowding in? Economic
consequences of financing government deficits’, Brookings Papers on
Economic Activity, 3 (1979), pp. 593–654.
42. J. M. Buchanan, ‘Public choice: The origins and development of a
research program’, Champions of Freedom, 31 (2003), pp. 13–32.
43. J. E. Stiglitz, Economics of the Public Sector (New York: W. W.
Norton, 3rd edn, 2000).
44. National Audit Office, ‘Memorandum on managing government
suppliers’, 12 November 2013.
45. NHS, ‘Principles and values that guide the NHS’ (2018):
http://www.nhs.uk/NHSEngland/thenhs/about/Pages/nhscoreprinciples.aspx#
46. WHO, ‘The world health report 2000 – Health systems: improving
performance’ (2000): http://www.who.int/whr/2000/en/whr00_en.pdf?
ua=1
47. E. C. Schneider, D. O. Sarnak, D. Squires, A. Shah and M. M. Doty
(2017). Mirror, Mirror 2017: International Comparison Reflects
Flaws and Opportunities for Better U.S. Health Care, The
Commonwealth Fund.
48. OECD, ‘Health expenditure and financing’ (2017):
http://stats.oecd.org/index.aspx?DataSetCode=HEALTH_STAT
49. YouGov, ‘Nationalise energy and rail companies, say public’ (2013):
https://yougov.co.uk/news/2013/11/04/nationalise-energy-and-rail-
companies-say-public/
50. J. Lethbridge, Empty promises: The Impact of Outsourcing on NHS
Services, technical report, UNISON (London, 2012).
51. C. Crouch, ‘The paradoxes of privatisation and public service
outsourcing’, in Jacobs and Mazzucato (eds), Rethinking Capitalism.
52. G. Kirkwood and A. M. Pollock, ‘Patient choice and private provision
decreased public provision and increased inequalities in Scotland: A
case study of elective hip arthroplasty’, Journal of Public Health, 39(3)
(2017), pp. 593–60.
53. We Own It, ‘We love our NHS – keep it public’:
https://weownit.org.uk/public-ownership/nhs
54. A. Pollock, ‘This deadly debt spiral was meant to destroy the NHS:
There is a way to stop it’, the Guardian, 5 July 2016:
https://www.theguardian.com/commentisfree/2016/jul/05/debt-spiral-
destroy-nhs-health-social-care-act-bill
55. A. Pollock, ‘The NHS is about care, not markets’, the Guardian, 3
September 2009:
https://www.theguardian.com/commentisfree/2009/sep/03/nhs-
business-markets
56. J. Davis, J. Lister and D. Wringler, NHS for Sale: Myths, Lies &
Deception (London: Merlin Press, 2015).
57. N. Chomsky, ‘The state-corporate complex: A threat to freedom and
survival’, lecture given at the University of Toronto, 7 April 2011:
https://chomsky.info/20110407-2/
58. L. MacFarlane, Blueprint for a Scottish National Investment Bank
(New Economics Foundation, 2016):
 http://allofusfirst.org/tasks/render/file/?fileID=3B9725EA-E444-
5C6C-D28A3B3E27195B57
59. Ibid.
60. C. Crouch, The Knowledge Corrupters: Hidden Consequences of the
Financial Takeover of Public Life (Cambridge: Polity Press, 2016).
61. https://www.theguardian.com/society/2016/apr/15/g4s-fined-100-
times-since-2010-prison-contracts
62. https://www.washingtonpost.com/news/wonk/wp/2013/07/16/meet-
serco-the-private-firm-getting-1-2-billion-to-process-your-obamacare-
application/?utm_term=.0ffc214237a8
63. United States Government Accountability Office, ‘Contracting data
analysis; Assessment of government-wide trends’, March 2017:
https://www.gao.gov/assets/690/683273.pdf.
64. As reported in J. A. Sekera, The Public Economy in Crisis: A Call for
a New Public Economics (Springer International Publishing, 2016); J.
Dilulio, Bring Back the Bureaucrats: Why More Federal Workers Will
Lead to Better (and Smaller!) Government (West Conshohocken, PA:
Templeton Press, 2014); and Paul R. Verkuil, (2007) Outsourcing
Sovereignty: Why Privatization of Government Functions Threatens
Democracy and What We Can Do about It (Cambridge: University
Press, 2007), p. 128.
65. http://www.pogo.org/our-work/reports/2011/co-gp-
20110913.html#Executive%20Summary
66. Crouch, The Knowledge Corrupters.
67. https://er.jsc.nasa.gov/seh/ricetalk.htm
68. R. Wood, ‘Fallen Solyndra Won Bankruptcy Battle but Faces Tax
War’, Forbes, 11 June 2012.
69. G. Owen, Industrial Policy in Europe since the Second World War:
What Has Been Learnt? ECIPE Occasional Paper no. 1 (Brussels: The
European Centre for International Political Economy, 2012):
http://eprints.lse.ac.uk/41902/
70. J. M. Poterba, ‘Venture capital and capital gains taxation’, in L. H.
Summers (ed.), Tax Policy and the Economy, Vol. 3 (Cambridge, MA:
MIT Press, 1989), pp. 47–68.
71. G. Akerlof, ‘Comment’ on the chapter by William J. Baumol in G. L.
Perry and James Tobin (eds), Economic Events, Ideas, and Policies:
The 1960s and After (Washington, DC: Brookings Institution Press,
2010).
72. Mazzucato, The Entrepreneurial State.
73. See https://www.project-syndicate.org/onpoint/growth-and-public-
sector-investment-by-mariana-mazzucato-2017-12?
barrier=accesspaylog
74. J. Gertner, The Idea Factory: Bell Labs and the Great Age of American
Innovation (London and New York: Penguin, 2013).
 9. THE ECONOMICS OF HOPE

1. Both Tony Blair, the former British Prime Minister, and Chuka
Umunna, considered a rising star in the Labour Party, argued that the
Labour Party needed to embrace business, calling them the wealth
creators
https://www.theguardian.com/commentisfree/2015/may/09/tony-blair-
what-labour-must-do-next-election-ed-miliband and Chuka Umunna
https://www.theguardian.com/commentisfree/2015/may/09/labours-
first-step-to-regaining-power-is-to-recognise-the-mistakes-we-made
2.
http://ec.europa.eu/eurostat/documents/118025/118123/Fitoussi+Commission+repo
3. D. Elson, Macroeconomics and Macroeconomic Policy from a Gender
Perspective, Public Hearing of Study Commission on Globalization of
the World Economy-Challenges and Responses, Deutscher Bundestag,
Berlin, 18 February 2002.
4. https://www.theguardian.com/us-news/2016/may/17/ceo-pay-ratio-
average-worker-afl-cio
5. https://www.ifs.org.uk/publications/5362
6. P. Evans, Embedded Autonomy: States and Industrial Transformation
(Princeton, NJ: University Press, 1995).
7. E. Morozov, ‘Democracy, Technology and City’, transcript of CCCB
lecture, Barcelona, 2014.
8. C. Perez, ‘Capitalism, technology and a green global golden age: The
role of history in helping to shape the future’, in M. Jacobs and M.
Mazzucato (eds), Rethinking Capitalism: Economics and Policy for
Sustainable and Inclusive Growth (Chichester: Wiley-Blackwell,
2016).
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 Acknowledgements

In 2013 I wrote a book called The Entrepreneurial State. In it I debunked

how myths about lone entrepreneurs and start-ups have captured the theory
and practice of innovation, ignoring one of the key actors that has been an
investor of first resort: the state. Innovation is a collective process, with
different types of public institutions playing a pivotal role. That role is
ignored, so our theory of value creation is flawed. And this is a major
reason for wealth often being distributed in dysfunctional ways.
The book you have in your hand is a direct consequence of this early
reasoning. We cannot understand economic growth if we do not go back to
the beginning: what is wealth and where does value come from? Are we
sure that much of what is passing for value creation is not just value
extraction in disguise?
To write the book I needed to delve into the last 300 years of thinking
about value. No easy task, and made no easier by also having to grapple
with the application of these ideas to contemporary capitalism as a whole –
for example, financialization – and to particular sectors, from finance to
big pharma and IT.
Many people very kindly helped me achieve this daunting task – from
the deep dive into theory to swimming in the richness of industrial stories.
I would like to thank Gregor Semeniuk, who like me received a PhD
from the Graduate Faculty of the New School in New York – a rare place
that still teaches alternative theories of economic thought. He generously
shared his extraordinary knowledge about value theory, from the
physiocrats to the classicals. Gregor was a tremendous support in helping
me document, in a ‘user-friendly’ way, the debates between the
Physiocrats, Smith and Ricardo – and the strange fact that even Marx had
no real theory of the way in which the state can contribute to value.
Michael Prest provided expert and endlessly patient editorial assistance,
using his magic pen to make the often too dense material flow much better.
He cheerfully cycled to our meetings on even the hottest days of the year
and was not just a friendly editor but also a great companion, bringing
calm to what often felt like hectic months trying to finish a book while I
was raising a large family and starting up a new department at UCL. Our
weekly meetings in the Lord Stanley pub in Camden to pore over the
material often trailed off into a stream of consciousness dwelling on the
ills of modern capitalism – and were nothing but pure joy. With the
occasional pint (or two) to keep us going.
I would like to thank the following people for looking at particular
chapters in the book and double checking it for errors in its final stages,
selflessly offering their wisdom and care: (in alphabetical order) Matteo
Deleidi, Lukas Fuchs Tommaso Gabellini, Simone Gasperin, Edward
Hadas, Andrea Laplane, Alain Rizk, and Josh Ryan Collins.
My editor Tom Penn at Penguin was a great sounding board during our
endless coffee-filled meetings at the British Library – having the rare
qualities of a meticulous proofreader while also retaining a deep
engagement with the content, both economic and philosophical.
I also want to thank the excellent administrative assistance I have had
over the last four years, first at SPRU in the University of Sussex and now
in a new institute that I have founded at UCL, the Institute for Innovation
and Public Purpose IIPP). Gemma Smith in particular has helped me
always try to get messages across – whether on the 10 o’clock news or in a
policy brief – that could be understood by the general public. With the new
team at IIPP, I hope the book’s message about the need for revived debate
about key questions around value can be linked with the IIPP’s ambition to
redefine ways of conceptualizing public value in particular: how to create
it, nurture it and evaluate it.
Lastly, I want to thank Carlo, Leon, Micol, Luce and Sofia for putting
up with the many long nights and weekends that the book entailed – letting
me climb up the stairs and plop myself down to the most happy and
conversive dinner table a wife and mother can ask for – putting life back at
the centre, where it should be.