The Major Fallacy of the Political Economists.
Pivotal, as the fountainhead of analytical fallacy, was
an apparent mental fixation on labor as alone really
productive. (The idea came from folklore; cf. Genesis
3:19.) Smith began his book with the statement that
“The annual labor of every nation [italics added]...
originally supplies it with all the necessaries and con-
veniences which it annually consumes....” He at once
qualified this to read “useful” labor—a part of that
performed by the fraction of the people who work at
all—later defined in a confusing way. The main deter-
minant of the productivity of labor is the proportion
of those who perform useful labor. His first chapter
is to deal with the “greatest improvement,” which is
specialization (he calls it “division of labor,” though
other means of production are as much specialized).
This, he says, works in three ways: to increase skill,
to save the time of shifting from one task to another,
and to increase the application of proper machinery.
(This is a main component of “capital,” but generations
were required to correct the classical view of that
concept—and much of the world still views “property”
as a means for exploiting workers; even the free nations
commonly impute all “productivity” to labor.) “Stock”
(capital) is the subject of Book II; it is defined as sup-
port for laborers, chiefly food, “advanced” by persons
who have a surplus beyond their own needs for con-
sumption. Book III (“Of the Different Progress of
Opulence in Different Nations”) is short and chiefly
historical and propagandistic.
The main thesis of the whole work is found in Book
IV, on “Systems of Political Economy,” and is practical,
not analytical. Two systems, the commercial or mer-
cantile, and the agricultural, are considered and con-
demned, on vague grounds, so that “the obvious and
simple system of natural liberty establishes itself of its
own accord” (Modern Library [1937], p. 651). How-
ever, Smith at once introduces three qualifications, as
tasks (and “expenses”) of the sovereign: “defense,” an
exact system of justice, and maintaining certain public
works. These might be construed to allow an indefinite
scope of public action, but the author's long discussions
need not be considered in detail. (Especially note-
worthy is an eloquent, almost florid plea for a little
rudimentary education, by local parishes, to offset the
evil effects on human beings of extreme specialization.)
Returning to Book I, Chapters II and III continue
with the division of labor. Chapter IV treats the “origin
and use of money,” but is chiefly remarkable because
the author turns abruptly at the end to discuss exchange
value, and introduces the labor theory. Contrasting
exchange value and use value, he rejects the latter as
a cause, noting that things which have the greatest
value in use have frequently little or no value in ex-
change (and conversely), illustrated by the famous
contrast between water and diamonds. And his polit-
ical-economist followers followed this lead for nearly
a century. “Utility” was held to be a condition of value,
but not a cause—or measure, two things which were
badly confused. Ignored were the two essential and
obtrusive facts: first, that prices pertain to units of
goods, which men buy and sell, not whole categories;
and secondly, that the use value of a unit decreases
as the quantity of the good increases. A buyer adds
and a seller subtracts an “increment” of a stock (per-
haps beginning or ending with none). The comparison
is between having a little more or less of one good
and of the other, making incremental utility relative.
However, but for the fact of separately diminishing
marginal utility, one's purchasing power would all be
spent on the good with the greatest initial appeal.
Furthermore, the law of decrease holds under any
realistic conditions; the want for (satisfying power of)
any good is progressively satiable. Discovery (effective
recognition) of this obvious fact came nearly a century
after Smith. It will be stressed as the pivotal idea
marking the break from political economy to econom-
ics, and still later it was gradually seen that a parallel
principle holds for applying resources in production.
Smith's Chapter V of Book I—on “Real and Nominal
Price”—constantly asserts the labor theory, and con-
fuses value measurement with its causality. “Equal
quantities of labor,” we read, are of equal value to
the laborer. This is false for exchange value and hardly
makes sense. One might rate two tasks as (about)
equally irksome, but could hardly pronounce one a
numerical multiple of the other in that respect; and
where different workers are involved, any comparison
becomes dubious. However, there is sense in Smith's
proposal to take the customary day's wage for common
labor as indicating the relative value of money in
comparable situations separated in space or time. A
statistical tabular standard (index number) of prices was
suggested after Smith's death in 1790, but was rejected
by David Ricardo (Smith's most famous follower) as
not measuring production cost (in labor or wages), by
which he practically measured and defined economic
value.
To Smith's credit, his further discussion of value
(Book I, Chapters VI, VII) though imputing the whole
product to labor, with other shares as deductions,
qualifies labor cost for differences in irksomeness and
skill and also restricts the labor theory of value to a
(fictitious) primitive society. Then, when “stock” has
accumulated and land been appropriated, the product
must be shared with their owners, and these payments
enter into exchange value. (Of course it is the scarcity
of land and competition between uses, not private
ownership, which makes rent a cost.) The view of labor
as the essence of value is replaced by the more realistic
one that the precise worth of a thing is its real cost,
consisting of the rent, wages, and profit that must be
paid to bring it to market (op. cit., p. 55). This is the
“natural” price, which Smith indicates (correctly and
pivotally, if not too clearly) will in fact be set in the
long run by movement of some resources from uses
of less to greater yield. Demand and supply may tem-
porarily fix a “market” price somewhat lower or
higher. Or a “monopoly” may exist, always charging
“the highest price which can be got” (op. cit., p. 61).
This “pivotal absurdity” was repeated by Ricardo, who
added two others (Principles, Groffa and Dorr ed., I,
249).
A pivotal error in the labor-cost theory (and others)
is the failure to see that no cost directly affects price,
if men act with economic rationality. Cost enters into
price only as limiting supply and is the value of re-
sources for other uses, including direct enjoyment out-
side the market; this is the meaning of the irksomeness
of work, and it applies also to nonhuman agents. The
true relation between cost and price, a pivotal idea,
was stressed in general terms by N. W. Senior, in his
Outline of Political Economy, in 1836. Senior also
stated the underlying pivotal idea of “diminishing util-
ity,” but these insights were not recognized until much
later. Senior became famous for introducing the idea
of “abstinence” as a “subjective cost,” along with labor,
to explain profit, and this was endorsed by J. S. Mill.
Both used it to define “capital,” but did not treat it
as a determinant of the supply of the latter and the
price of its use. This came much later, and gradually—
perhaps most clearly stated by Irving Fisher.
“Abstinence” tended to be replaced by “waiting”
(notably with Alfred Marshall). This implies two fal-
lacies: first, that of a “production period”—meaning
that an investment regularly is returned at a later date,
with an increase; and second, that production goods
are produced by primary factors—labor and capital.
People more typically save as social accumulation
requires—for an increased future income of indefinite
duration; thus the waiting is perpetual, i.e., is absti-
nence. Further analysis of these phenomena belongs
to a later point. Senior gave a brief and general state-
ment, correct as far as it goes, of the role of capital
as the use of the produce of industry to increase pro-
duction in the future.
Returning to Smith, it is to be noted that he turned,
in Book I, Chapters VI to XI, to a general discussion
of his “component parts of price” (the costs of produc-
tion): wages, profits, and rent. Some advance toward
analytical economics is made in his Chapter X, “Wages
and Profits in Different Employments of Labor and
Stock.” Here he makes his nearest approach to a theory
of “distribution” as now conceived, but he strangely
fails to consider rent. His short Book II deals with the
Nature, Accumulation, and Employment of Stock.
First, under “Divisions,” he distinguishes arbitrarily
between “Circulating” and “Fixed” capital. The for-
mer consists of goods for the owner's consumption, or
purchased for sale at a profit or for productive use by
employing workers. The second includes improvement
of land, and all instruments of production, including
buildings which yield revenue, and also the “acquired
and useful abilities” of the population. Circulating
capital further includes money—specie or paper, sepa-
rately discussed at length in Chapter II—with “provi-
sions,” and partial or complete manufactures.
Especially interesting, and historically pivotal, is
Chapter III, “Of the Accumulation of Capital or of
Productive and Unproductive Labor” [italics added].
Smith states clearly that productive and unproductive
do not mean useful and useless, but refer only to
whether the worker reproduces the “capital” he con-
sumes. (The importance of maintaining capital is well
emphasized in this fallacious view of it.) The main
concern is with the amount of “circulating” capital—
an aspect of the fallacious view just noted—and with
the increase of this through saving (“frugality”). “The
uniform, constant and uninterrupted effort of every
man to better his condition” (op. cit., p. 326) is stressed
as an offset to the extravagance of government and
errors of administration, and also the inclination of the
rich to spend on luxuries (especially on “menial serv-
ants,” rather a pet aversion of his). The “pivotal fal-
lacy” that a given amount of capital in any form can
maintain a definite amount of labor or industry, reflects
an assumption that workers have a fixed living require-
ment; and also the “Malthusian” population theory,
which implied that their numerical increase keeps
wages at this level, regardless of the amount assigned
to their support. (And this was sometimes fallaciously
treated as a fixed “wages fund.”) Diminishing returns
to labor and capital applied to land was also assumed—
perhaps first explicitly stated by Malthus. Only genera-
tions later it was recognized as valid only if technolog-
ical advance is ignored, also that such a law holds for
the use of any factor in increasing ratio to others. The
historical fact has of course been a vast rise of wages,
in spite of redoubling of numbers of workers.
Adam Smith's treatment of prices as in effect ex-
plained by money cost of production—composed of
wages, profit, and rent—implies relations so obvious
for a modern reader that it is rather his failure to state
them clearly that seems to call for explanation. When
we turn to the treatment of these incomes themselves
and look for a tenable view of “distribution,” there
is little to be found. Again to Smith's credit, there is
little of the absurdity introduced by Ricardo (taken
from Malthus and others) that became a cornerstone
of classical political economy—the “residual” or sur-
plus view of rent, with the idea that the main problem
is “to determine the laws which regulate the distribu-
tion” of the social product among three “classes,”
landlords, owners of capital, and laborers (Ricardo,
Principles, original Preface). Smith does speak of dis-
tribution among “ranks and conditions of men” (Part
I, v. iii) and later of the “three great constituent orders
... of every civilized society (op. cit., p. 248). Such
statements shed no light on the distribution that is of
interest today—payments for productive agents, which
are incomes to their owners, and determine their scale
of living.
The “class” distribution idea may derive in part from
the French “Physiocratic” school. It calls for mention
here because it was taken over from Ricardo or his
followers as the basis of Marxism. Marx's pivotal
idea, quite logical, is that since only labor produces,
receiving income from property is robbery of the
workers—Proudhon's famous dictum that property
is “theft.”
The Marxist (pseudo) economic analysis follows
Ricardo logically, drawing the opposite policy impli-
cation, the attack on versus the support of property
and market freedom. Both ignored the distinct role of
the “entrepreneur,” imputing it to owners of wealth.
Both held a subsistence theory of wages and a Malthus-
Ricardo view of land and its rent (but for Marx all
property income is filched from laborers). Profit (in-
cluding interest) arises because labor produces more
than is required for its support. This was most clearly
stated by J. S. Mill (Principles of Political Economy,
Ashley edition, p. 416). By Mill's time, “rent” was
under fire; Mill called it a “surplus,” but opposed
current confiscation yet favored that of future in-
crease—a palpably absurd distinction. Land value is
speculative; any prospect of increase enters into pres-
ent value, and as in gambling, is generally overesti-
mated, so that on the whole losses exceed gains.
The treatment of income distribution in the polit-
ical-economy classics consists of chapters on the three
“shares,” which have little bearing on people's relative
means of support or provision for the future. The dis-
tinction between income and wealth was ignored or
confused; only J. S. Mill discussed “property.” The
three kinds of income were wrongly conceived though
at the time they bore a vague relation to population
sectors with some “class” attributes; and they mean
even less today. As with water and diamonds, land,
labor, and capital are not marketed as categories, but
by bits and discrete items which differ vastly within
each class.
No orderly relation among the shares appears; that
inferred now by analysis centers in a few dogmas—first,
the three “factors,” implicitly distinct and homogene-
ous. Labor, applied to land, is supported by “capital”
as provisions advanced—at a subsistence level, due to
the “Malthusian” pressure of population, and “dimin-
ishing returns.” Machinery and other forms of capital
were mentioned—chiefly by Smith and J. S. Mill, but
never fitted into the concept. (By Ricardo, machinery
is mentioned in a puzzling chapter, XXXI, added in
his third edition; and his Chapter XX on Value and
Riches also defies interpretation.) A generous reading
assigns to wages-and-profit what would now be called
their (joint) “marginal” product, of which labor gets
subsistence, capital the rest, and land (the owners en
bloc) take the “surplus.” As simple economic analysis
shows, this is the marginal product of the land, taken
empirically, in small units; and in production land
stands in a symmetrical relation with other kinds of
agents (as does any kind with all others). The chapters
dealing with the “shares” state various conditions
tending to make each larger or smaller (logically in
varying degree).
