The Inflationary Budget

The nation’s budgeting process is in need of significant restructuring. The current offering prevents the nation from properly managing the money supply. Current policy lacks the ability to directly influence this pivotal economic indicator, but setting the US economy onto a better path will be no small task. Not only do tactical operations reinforce misguided policies, but the strategic direction is also profoundly off course. Imagining that wealth hoarders are sacrosanct and require special considerations leads us down the wrong path. It is within this context that a fresh look at money supply management is necessary. A better understanding of how economies work may be a good place to start.

The current strategy administers the economy based upon microeconomic principles. National economies, however, do not respond to efficiencies or the profit motive. They respond to an “effective demand” for goods and services, a term first made prominent by John Maynard Keynes in the 1930s. Without an effective demand for their product or service, most business firms will fail. This is where proper management of the money supply becomes necessary. The appropriate level of demand is put at risk when the money supply is left to chance. Proper management of this key indicator is the necessary objective, but to be sustainable, economic policies must be couched within societal objectives.

To achieve the social objective of improving humanity’s well-being, democracy and the rule of law must be protected. To protect democracy and the freedom it bestows, social and economic objectives must address human shortcomings by limiting unhealthy concentrations of private wealth that will attempt to influence public policy in a self-serving direction. Initiating a Sufficiently Progressive Tax Code and a wealth tax is necessary as a starting point, but this, of course, is no easy task in an environment where money and politics have been engrained in our system of governance. Proper management of the money supply must begin with an equitable distribution of the burden. Assuming a more level playing field is in the offing, the following will attempt to uncover the benefit of moving away from a microeconomic financial budget at the national level and toward a truly economic budget by focusing on the prospects of inflation within the context of the money supply.

                                                                    Fiat (Sovereign) Currency

With centuries in development, our current economic budgetary process has evolved little. It remains captive to the “supply creates its own demand” mantra. The current economic financial budgetary process, however, is no longer appropriate for a country that enjoys a sovereign currency such as we have in the US. Managing to a financial budget assumes too much. It assumes a level playing field where revenue is reintroduced into the economy by way of tax collection at appropriate levels. Given the current tax structure, this assumption is not warranted. Managing to a financial budget also assumes the appropriate level of funding can be determined as the annual budget is finalized. The appropriate level of funding (revenue creation or revenue withdrawn) will keep an economy from running too hot or too cold and is, in fact, a moving target unlikely to be arrived at annually. The ability to adjust spending as the situation arises is lost in the current budgeting process.

A fiat currency allows for more flexibility. It allows policy makers the ability to fund socially useful initiatives up to the point where the prospect of accelerating inflation becomes apparent. In an inflationary budget regime, an across-the-board adjustment to the rate of taxation is initiated once the appropriate economic indicators appear. Tax rates are either increased to slow consumer buying power or, in the case of high unemployment, lowered to increase demand. The distraction of deficit financing is put to rest. A fiat currency allows for this greater versatility.

Managing to a financial budget may be reassuring to those on the profit motive, but economies do not operate on the profit motive. A national economy operates on the principles of price stability and full employment, that is, within the context of the social goods it can produce. Because future optimum money supply levels cannot be known in a world full of contingencies, discovering inflationary trends must now become the focus. An inflationary budget that projects the likelihood of accelerating inflation allows for a more robust economy, one not constrained by artificial limits. An inflationary budget can allow for policies that better administer to the needs of all stakeholders. Constraints must be put on the money supply by way of an inflationary budget with less self-defeating intrusions.

                                                                    Appropriate Tools

The authority to manage the money supply has been delegated by Congress to the Federal Reserve (Fed). To influence this key economic indicator, the Fed raises or lowers interest rates. It is felt here that this is the wrong approach to managing the money supply. While the Fed has the ability to act decisively, results of interest rate adjustments are often less than optimal and sometimes even harmful as the recent banking crisis has shown. A more appropriate approach would be to use Fiscal Policy to effect changes to the money supply when necessary. Fiscal policy has the advantage of adding or withdrawing revenue directly from the economy and not having to wait for the private sector to perform this function by way of increased or decreased lending. Moving from a central bank (private) focus to a Congressional (public) focus presents major obstacles but is necessary for a more rational approach to economic policy.

In the fight against inflation, Congress has the ability to raise taxes or suspend non-essential governmental spending to reduce the money supply and lessen demand. It can better target a money supply that produces an economy that runs neither too hot nor too cold. This “Goldilocks economy” is in a sense the objective of good economic policy. Adjusting the money supply to prevent inflation while providing for full employment should be left to those with the appropriate tools.

The unfortunate reality, however, is that Congress has been designed to be deliberative, which can be a significant disadvantage when fighting inflation. Quick action is typically needed to prevent the snowball effect inflation can sometimes elicit. When inflation appears in the data, raising personal income tax rates must be initiated to maintain the economic sweet spot. Producing an economy that runs neither too hot nor too cold is a daunting task when faced with the headwinds of windfall profits, barriers to entry, monopolistic power, managing expectations, and other exogenous variables.

                                                                    Congress

Along with tax considerations mentioned earlier, one of the most challenging obstacles to the creation of an inflationary budget is Congress itself. As is commonly understood, when fighting inflation, time is of the essence. Because our elected representatives are tied to the mainstream narrative, heroic efforts must be taken to ensure a timely response to inflationary pressure once Congress reassumes responsibility for price stability. This response will require authority only big data can provide. Advances made in the field of machine intelligence must be considered as a tool to make the deliberative process a matter of acquiescence on the part of Congress and not one of research. Deep Learning, a subset of Machine Learning, shows the power of pattern recognition and the ability to serve a designed purpose. We must develop a tool that can recognize all contributions to inflation and recommend a path forward to mitigate perceived ill effects. Factoring in a policy to optimize private enterprise performance vs. societal well-being will undoubtedly be a stumbling block, but a well-designed tool should be able to provide supportable data that ensures integrity. This tool must be a bipartisan government funded basic research project that can predict the likelihood of inflation (undoubtedly using much of the same data the Congressional Budget Office and the Fed’s 400 or so PhD scholars use to make projections) and then recommend appropriate Fiscal Policy adjustments when inflationary trends are found.

                                                                    Conclusion

While an inflationary budget process makes good economic sense, current obstacles to good money management must be overcome before a useful budgetary process of this sort can be properly administered. Profound obstacles stand in the way of creating the level playing field necessary for an inflationary budget to work properly. Asking the economic community of scholars to abandon 150 years of the financial economy in favor of a more wholistic approach to wealth creation will not be easily overcome. The challenge is probably analogous to the centuries long struggle to unseat the Catholic Church as the supreme arbiter of morality.

Before an inflationary budget can be seriously considered, a Sufficiently Progressive Tax Code, based upon one’s saving behavior, and a wealth tax must be in place to avoid fueling our current march toward oligarchical rule. A recognition that Fiscal Policy, administered by Congress, is the more appropriate tool for addressing the money supply can then be entertained. Finally, because of the nature of politics, the use of Machine Learning must be developed to minimize the obstruction politics will have on good economic policy.

A financial budget has the presumed benefit of fiscal responsibility. The inflationary budget approach must be couched in similar terms. We do ourselves a disservice by ignoring the possibility of greater social well-being by way of proper economic tools. We must begin to better focus on economic and social objectives by moving economic policies into the twenty-first century.

How Economies Work - draft

Sufficiently Progressive: >>>>>> Part Two – The Method

Fiscal policy has been and continues to be underutilized as a policy tool. Because of that, the purchasing power of the middle class goes untapped, and the ability to provide for full employment is lost. There is a lack of understanding on how an economy works.

An economy is like a pressure cooker.  A pressure cooker works its magic by forcing increased interaction. Allow too much steam to escape, and it becomes less effective. Economies also work best under pressure. When pressure to produce goods and services lessens, economies weaken. It is beholden upon policy makers to ensure that the purchasing power of the middle class be maintained and pressure business to produce.

Saving that is out of proportion to the value it represents removes pressure from an economy and presents a danger. Saving becomes excessive not unlike the point where overweightness becomes obesity. Excessive saving, when allowed to persist, poses a threat to our economic health and ultimately to our way of life.

Political control by the wealthy few, compromises democratic action. Great wealth is no friend of democracy. The wealthy have their own agenda. While most wage earners are focused on obtaining wealth and security, the wealthy are concerned with maintaining their wealth. Democratic action in their view can interfere with this objective.

Measures to safeguard our way of life begin with limiting the ability of the wealthy few to subvert democratic intent. A consensus of the electorate must be maintained. Preserving the democratic process must limit excessive wealth. A sufficiently progressive tax code will help to do this.

A sufficiently progressive tax code attempts to minimize excessive saving by setting tax rates in relation to one’s saving behavior. Tax rates are set higher for high rates of saving, and lower for low rates of saving. A tax strategy based upon saving behavior has the benefit of maintaining pressure within the business community to produce by ensuring that disposable income is available to all income levels. Revenue no longer pools at the top. When revenue continues to flow to rich and poor alike, tangible benefits take place, such as the possibility of full employment.

Parity of Saving Strategy

A sufficiently progressive tax code is proposed to ensure the purchasing power of the middle class. A sufficiently progressive tax code puts money into the hands of those who would spend it. A sufficiently progressive tax code promotes both fairness and the health requirements of an economy. The process that uses saving behavior to bring about a sufficiently progressive tax code can be referred to as a “Parity of Saving” strategy.

A parity of saving strategy requires an examination of saving behavior at all levels of income. This examination must look at all income levels uniformly. It cannot use existing income tax brackets. Existing income tax brackets are largely the result of political pressures. The process of setting income tax rates must be divorced from political considerations.

A uniform examination of all income levels and corresponding saving rates can be done by dividing all household incomes into deciles (ten equal parts) by number of households.  Since there are approximately 140 million households in the U.S., each decile would be made up of approximately 14 million households.  For each decile, the average rate of saving would then be determined based upon the previous year's financial data.  The average rate of saving for deciles five and six (the middlemost groups) are then compared to rates of saving for higher income groups.  Where the saving rate for the middlemost groups differ from the saving rate of the higher income groups, adjustments to the tax rate are necessary.

For example, if it is found the saving rate of the median income group is 3% and the saving rate of the highest decile is 25%, the tax rate for median income groups is to be lowered and the tax rate for higher income groups is to be raised.  Lowering the tax rate on median income groups results in more discretionary income and more ability to save.  At the same time, by raising the tax rate on higher income groups, less saving will result. This  would be an interactive process. As tax rates are adjusted incrementally over time, perhaps annually, the top half of all income groups (deciles 6 through 10) will achieve a type of saving parity (saving equality).  When saving parity has been achieved within these deciles, excessive saving will have been squeezed out of the economy resulting in more money in circulation, more demand for products and services, and eventually more growth.

A parity of saving strategy produces the slope line of a Tax Rate by Income Distribution graph (Figure 1). The slope line represents the ideal rate of taxation for each income group based upon that group’s saving behavior. Once tax rates are adjusted to reflect comparable levels of saving for median and high-income earners, the tax code is deemed to be sufficiently progressive. With a sufficiently progressive tax code, excessive saving is minimized, and more money continues to flow within an economy.

                        

It must be noted that in this strategy, most income taxes are paid by the top half of all income earners, but sales tax, property tax, payroll tax, and excise tax, which the poor pay at a higher rate, remain in place. The bottom half pay income tax in relation to the slope line produced by the top half of all income earners. Income tax rates for deciles 1 through 5 are derived proportionately, based upon the results of higher deciles. Income tax rate for the bottom half would likely fall to zero for some.

The use of the tax code for good economic policy does not end with stamping out excessive saving. The other problem good tax policy must address is how to guard against an overheated economy that produces inflation. With a full employment objective, it is not appropriate to slow the economy by way of adjustments to the Federal Funds rate. Slowing the economy by raising interest rates creates unemployment, which is counterproductive. Inflation results from too much money chasing too few goods. Raising interest rates on business to slow the economy is just the opposite of what is required. Business must be encouraged to produce in order to lessen demand pressures. To fight inflation, the buying power of the consumer must be addressed. This is done by adjusting income tax rates uniformly, that is, by moving the slope line from right to left in this now sufficiently progressive tax regime.

Adjustments to  the tax rates are monolithic once saving parity has been achieved. (Figure 2). It is here the progressive nature of the tax code (the slope line) remains the same but moves 

        

proportionately from right to left in an overheated economy (income tax rates are collectively raised) and, if necessary, from left to right in an underperforming economy (income tax rates are collectively lowered).

A Parity of Saving strategy has a two-fold purpose. It will prevent the accumulation of excessive wealth, and it will allow the economy to maintain full employment, even in the face of inflationary headwinds. The intent of this strategy is to keep revenue flowing within an economy. Fiscal policy, in the form of income tax policy, is a necessary first step toward economic health and, in the process, toward a democracy that is better protected against undue influence.

Conclusion

An economy is a force of nature. We can influence it, but we cannot change the way it works. It is incumbent on all of us, at least all economists, to get it right. We ask a lot of our economy: ensure full employment, maintain price stability, allow democracy to flourish. A parity of saving strategy makes this possible.

We have it within ourselves to create a more just society, but thoughtful action is required.  As Frederick Douglass once said, "Power concedes nothing without a demand." To put an end to the suffering an out of balance economic system makes certain, we must demand that a sufficiently progressive tax code be put in place and allow the economy to work for all.  A parity of saving strategy will move us in that direction. Creating a financially strong middle class is the recipe.  Squeezing out excessive saving is the secret sauce.

Sufficiently Progressive >>>>>> Part One – The Case

“Yes, there's class warfare, all right, but it's my class, the rich class, that's making war, and we're winning.” Few have articulated shortcomings of today’s economy better and with more credibility than Warren Buffett, a financial genius and one of the world’s richest men. By way of shrewdness and cunning, wealth and income inequality have reached staggering proportions. Mr. Buffett’s side is clearly winning, but the stakes are not always clear.

What is at stake is not merely a life of luxury for some. What is at stake is our way of life. Democracy and our form of government is at risk. With inequality left unchecked, the ability to demand justice is lost. Self-rule is in jeopardy. For some, the peculiarities of human nature will not stop at garnering most of the wealth. Victory will be won with total control. We face this threat not simply because there are evil men and women but because it is in the nature of some to win at all cost.

Wealth and income inequality, of course, is not new. One form of class struggle or another has existed throughout history and will continue to exist far into the future. What is different now is that the threat to our well-being is more pernicious. The danger is not found in the divine right of kings or the autocratic rule of dictators. The danger is found in the influence excessively large concentrations of wealth have in the hands of the unknown few. The influence this wealth brings to bear within the walls of Congress will rob us all of our well-being if not challenged.

Publicly funded electoral campaigns would help to mitigate the effects of money in politics, but this must not be relied upon as it only addresses electoral politics. We must address the more systemic issue of buying influence. The accumulation of excessive wealth itself must be dealt with directly.

Almost all developed countries in the Western world incorporate a progressive income tax. A progressive income tax, where the greater one’s income, the higher the rate of taxation, addresses the issue of wealth accumulation and is deemed to be the most-fair. Unfortunately, a simple progressive income tax code fails in two important areas. Firstly, it consistently has failed to prevent the accumulation of excessively large concentrations of wealth on the part of a few. Every week there are more and more billionaires created worldwide. Secondly, concentrated wealth in the hands of a few, stifles economic performance. Wealthy individuals alone cannot sustain an economy.

Safeguarding Democracy

The current progressive tax code has failed miserably. In the U. S., the top 1% of all wage earners account for about 20% of all income. The bottom 25% account for less than 4%. Currently, in the U. S. the top 400 individuals own more wealth than the bottom half of the population, all of this with, ostensibly, a progressive income tax code in place.

As has been stated by others, when it comes to wealth accumulation, the tax code has been the weapon of choice. Through mismanagement and neglect we have abandoned our right to provide for the common good. We have failed to to reclaim the economic, cultural, and ethical investments we make daily. Perhaps we have failed to understand the nature of the problem.

To fully grasp the issue, however, one needs to look no further than human nature. There is a point in the accumulation of wealth at which safeguarding one’s financial future turns into ensuring one’s status. The objective pivots away from survival and comfort to one of dominance. While status is part of human nature and should not be denied, allowing this condition to be purchased and acquired outside of strength of character is a danger to us all. For this reason, a wealth tax as defined by Saez & Zucman (2019) and others must be part of the solution. History has shown money begets power and as Lord Acton has stated, power when absolute, tends to corrupt absolutely.

Economic Performance

The other area where extremely large concentrations of wealth in the hands of a few relates to economic performance.  The ability of policy makers to influence economic performance is compromised when forced to confront excessive wealth. Excessive saving represents a hit upon an economy. Money poured into tax shelters and government securities extracts revenue from circulation resulting in less value to society. Revenue that no longer circulates and no longer works toward a sustained demand for goods and services slows production and affects levels of employment.

The goal of any economy must be full employment. All stakeholders must be able to participate as a fully functioning member of the economic community or they will be a drag on economic performance. A tax regime that more equitably administers the tax burden helps to ensure a contribution by keeping money in circulation and creating an effective demand for goods and services. By preventing excessive saving, a more equitable tax burden allows revenue to flow at a greater rate within the economy.

Excessive wealth results in a high propensity to save. Too much saving in relation to income dampens economic performance by withdrawing money from circulation. The possibility for an effective demand is then lost leading to higher rates of unemployment. Spending must be in proportion to income for an economy to operate efficiently. The wealthy cannot spend their money fast enough to support the needs of the economy.

As the levels of the wealthiest have continued to rise, it’s clear they cannot even give it away fast enough. Large fortunes continue to grow. To break the cycle of greater and greater wealth accumulation, a sufficiently progressive tax code must be initiated.

Sufficiently Progressive

A sufficiently progressive tax code is  not the same as a merely progressive tax code. A sufficiently progressive tax code is designed to ensure that excessive levels of saving do not accumulate. A sufficiently progressive tax code will prevent hoarding. It does this by tying income tax rates to saving behavior. The greater the rate of saving, the higher the rate of taxation.

Just as growth measures economic productivity, it can be argued one’s ability to save measures an individual’s or a corporation’s viability and, therefore, one’s value to society. One’s ability to save signals a fully functioning and successful member of an economic community. It is suggested here, this signal can be used to apportion fairness and ensure sustainability among all economic stakeholders in such a way as to meet the needs of the individual taxpayer and the needs of the economy. Developing sufficiently progressive income tax rates, based upon one’s ability to save, will be the task ahead and the subject of Part Two of this essay.

Conclusion

As has been duly noted by others, a billionaire is a sign of policy failure. To form a ‘more perfect union’, we need to mitigate the effects of extreme wealth. When wealth is warehoused above its useful purpose, revenue sits idle, and the seeds of autocratic rule are sewn. It is beholden upon us all to recognize the threat excessive saving has upon our way of life and to act accordingly. We owe it to posterity to develop a viable course of action. As one of our Founding Fathers cautioned at the establishment of the constitution, “We have a republic, as long as we can keep it”.

The Sovereign Currency Advantage

When Thomas Huxley heard about Darwin’s “Theory of Evolution by Means of Natural Selection”, he is reported to have said, "How extremely stupid not to have thought of that!" The mechanics of Modern Monetary Theory (MMT) merits a similar response. A sovereign and free-floating currency allows spending prior to taxation. How is it that we have not seen this before? We in the U. S. are free to take advantage of this ability, and yet, our good fortune remains largely untapped.

Infrastructure is badly in need of attention. Many suffer homelessness and others face food insecurities. We tilt toward authoritarianism in hopes of finding peace. We defer a response to environmental warnings. Leadership disappoints.

Centuries of indoctrination have left us blind to the possibilities our economy holds. We submit to the rich and powerful, who have their own agenda. We do not question those who say we’re out of money. We are blind to the ability we possess. We fail to recognize the power a sovereign currency grants to its stakeholders.

Balancing the Budget

Our economy is run as if it were still on the gold standard. Governmental services, we’re told, must be paid for in cash. Congress imagines the budget to be like a household budget. It assumes tax revenue must be available prior to spending. As the proponents of MMT have made clear, this has never been the case, and this should have been made even more clear once we were taken off the gold standard in 1971. Because the U. S. issues its own currency, the dollar, we have almost always been able to fund worthwhile projects at the national level as the need arose.

Being a currency issuer grants one the privilege to fund social and economic interests outside of taxation policies. With this ability, it is neither necessary nor advisable to tax prior to paying for socially useful initiatives. Revenue is available for projects that require attention. With increased economic activity, full employment becomes possible. Taxes are necessary but not for the reason we have all come to accept. Leadership can direct spending on what is deemed prudent up to the point where inflation becomes a possibility.

Thin Air

It’s not that we in the U. S. have been totally unaware of the ability to leverage currency outside of first taxing it into existence. In recent memory, Quantitative Easing made large sums of money available during the Great Recession in a failed attempt to stoke the economy, and the Cares Act created trillions of dollars overnight in reaction to the Corona pandemic. Where did that money come from? It came from the same place that all money that’s available within the economy comes from in this country. It was produced as a journal entry on the books of the Federal Reserve System, or as some like to say, it was created out of thin air.

What happens when we do this? We add to the Gross Domestic Product. Once this money is put into circulation, it becomes income for some, and we expand the economy. More money in circulation means a higher level of economic activity which benefits everyone.

When does this money get paid back? It doesn’t get paid back. It is not a loan. Money created out of thin air and put into circulation is not debt in the traditional sense. It becomes income to someone. This revenue becomes part of the economy and the Gross Domestic Product. It’s one way in which an economy grows. New money introduced by the Fed that gets spent by consumers is like food for an economy. It nourishes. New money introduced into the economy allows firms to do what they do best. Until it gets withdrawn by way of taxation, this revenue continues to be a part of the now larger economy.

Inflation

With great sums of money available in this new environment, how do we protect against inflation? How do we slow an economy where production is not keeping pace with spending? With this new way of viewing fiscal policy, a more robust solution to an overstimulated economy must be put in place.

The Federal Reserve is currently charged with fighting inflation, but their tools will be of limited use in this new environment. The Fed has inflation targets that normally get met by keeping the economy functioning at less than full capacity. Fighting inflation by way of higher levels of unemployment will no longer be an option. An economy that seeks full employment, and not merely maximum employment, will require a new approach to fighting inflation and tools that the Fed does not possess.

Congress will be required to address inflation by way of income tax policy. Congress will be required to target buying power and raise taxes on consumers when the economy begins to overheat. But this is only half of the technical solution. The supply chain must be addressed by way of both fiscal and monetary policy adjustments. To ensure that the supply of goods and services keep up with demand, income taxes and interest rates must be adjusted to induce firms to increase production.

Given that Congress is a political animal, any new legislative requirement will be a challenge and will require some ingenuity. We must find a way to insulate Congress from the political sphere as it attempts to prevent harm. The mandate for Congress to address the issue of inflation will be challenging in its design but not an impossible task. Inflation is in the interest of no one. (See pamphlet: Inflation)

Protecting Democracy

So, are we ready to begin funding much neglected needs once we can be assured proper inflationary controls have been put in place? The answer to this question is, unfortunately, no. Not yet. Besides first putting in place a failsafe mechanism to guard against inflation, there is one additional consideration to address before we are ready to use the newfound power inherent within a sovereign currency. We must take measures to protect our way of life.

Before we can seriously entertain notions of removing excess capacity and running our economy to produce full employment, we must ensure that democracy remains intact. We must recognize the problem human nature poses for us all. We must recognize that, on the part of a small minority, the need to amass wealth has no limit. More money than can be spent in a hundred lifetimes is no reason to pull back for some, and this can be dangerous for us all. We must recognize that at the highest levels, excessive wealth can be a problem, as great wealth is no friend to democracy. We must protect ourselves against those who would enshrine their status as the benefactors of humankind and attempt to gain total control of the political process.

With almost half of all new income currently going to the top one percent, increased economic activity will make financial inequalities worse. We must initiate an income tax code that lessens the likelihood of excessive wealth concentrations. That is to say, the tax code must protect against hoarding. We must create a tax code that is sufficiently progressive. We must ensure everyone pays their fair share. Before we unleash the power of a sovereign currency, we must ensure our system of government remains intact by tying income tax rates to saving behavior. We must use the tax code to lessen the possibility of losing our democracy entirely to the rich and powerful.

Conclusion

For most of human history, taxes were seen as funding governmental activities. This perception has been shown to be without merit as the proponents of MMT have made clear. We currently have the ability to address large systemic problems without a disruption to the economy. We must educate ourselves to a broader perspective of monetary systems.

This new appreciation for the power of a sovereign currency begins with a challenge to protect against the inherent evil that large sums of money enlist. We may be able to remove the shackles of long-ago economic doctrines, but this act requires more than just tearing down. We must prepare for this new beginning. We must first build necessary safeguards. Let’s start this journey to a new prosperity with eyes wide open and put the proper guardrails in place before we begin and before it’s too late.

The Factors of Production: A 21st Century View

Noted economist, N. Gregory Mankiw states, “The factors of production are the inputs used to produce goods and services. Economic history tells us land, labor, and capital are the most important factors of production”. Seemingly useful for centuries, it is long past time to revisit this dictum. Do the factors of land, labor, and capital speak to the world we know? Do they encompass economic and financial reality? Is the production process wholly contained within the mind of the capitalist? These and other questions must be addressed when identifying factors of production.

Society

The production process begins long before machines are set in motion. When the capitalist initiates his or her enterprise, the production process transcends the factory floor. The production process begins with the culture, ethos, customs, laws, and organizations that have evolved within any given society over time. The production process is, of necessity, dependent collectively on the persistent social interactions that define a population and that which reinforces its values and beliefs.

The benefits a well-structured society affords is where the interests of labor and capital take root. The persistent interactions of a well-functioning society, therefore, must be recognized as a viable force in the production of goods and services. When identified as a factor of production, it becomes obvious that society plays a crucial role within the flow of commerce. If it were necessary for the capitalist to educate, refine, literate, instruct, guide, inculcate, indoctrinate, and otherwise edify each of his or her many workers, the entrepreneur might think twice about the business venture. In most parts of the world, this convention is already in place. Almost all of today’s societies recognize the importance of a well-educated and value-laden populous. It’s part of the role that society plays in one’s culture. Without a properly funded judiciary, military, police department, educational  system, treasury department, health department, and the list goes on, the most gifted entrepreneur and the most willing of workers would be compromised in their abilities to produce. If we are to inspire a more enlightened brand of capitalism, the interplay of capital, labor, and society is where the story must begin.

Misidentification of the three major factors of production has the effect of misallocating costs associated with a given enterprise. John Maynard Keynes refers to these as factor costs and defines them as the amount the entrepreneur pays out to the factors of production for their current services. Within this context it’s easy to see how a publicly built and maintained road represents a service that private capital must contribute to and help to maintain. When that road is viewed as a component of the production process, it becomes even more clear that tax evasion is not only  unethical (and perhaps illegal) but that this strategy potentially interferes with the production process.

Labor and Capital

When early political economists first identified land as a factor of production centuries ago, most economic participants were tied to the land for subsistence. Their very survival centered around the ability to work the land. Thanks largely to the industrial revolution, this is no longer the case. In today’s world, land, whether rented or owned,  can no longer be distinguished from capital. It may still be a factor of production, but land, by all measures, is a tool of the capitalist.

In more recent years entrepreneurship has been identified as a factor of production. While intelligence precedes action, distinguishing entrepreneurship as a factor is redundant. Capital assumes leadership. Parsing out entrepreneurship as a factor does not add value. If entrepreneurship is to be defined as a factor, then union leadership must be considered in that trade unions or the threat of trade unions influence corporate strategies and the production process.

It might also be noted that factors of production are not truly economic principles. They are financial principles. It is firms who produce, and firms are not governed by economic principles. Factors of production have long been associated with the discipline of economics due to it being conceived of at a time when the practices of economics were indistinguishable from financial practices. As economic theory becomes more refined, what we call factors of production will likely cease to exist in economic textbooks.

Conclusion

Major factors of production begin their influence long before the wheels of production are set in motion. When setting the corporate agenda, we must strive to properly identify and protect all that contribute and brings value to the production process. We must pay homage to the gift of a well-functioning and resilient society in which commerce takes part.

The current production framework sends the wrong message. Ignoring the contributions of a value laden populous distorts reality. A necessary first step is ignored. Those who write the textbooks must recognize commerce is not a solitary pursuit. It is part of our social firmament. The short-term corporate interests inherent in a capitalistic economy are only available with the help of others. Teaching new students of economics ideas which have, at best, outlived their usefulness does a disservice to the student and to the profession of economics itself.

Identifying the three-legged stool upon which the factors of production rest is important for its implications. Imagining that the production process exists outside of the society in which it operates is myopic. To do so overlooks the glue that binds. Objectively identifying critical factors of production will ensure capitalism serves people instead of the other way around. Correcting this misalignment will allow a proper focus on what really matters and allow both capitalism and democracy to flourish.

The Macro / Micro Legacy

Introduction

John Maynard Keynes is credited with discovering the principles of macroeconomics in the 20th Century. This recognition is insufficient and needs to be clarified. It must be acknowledged that Keynes, in effect, discovered the core principles of economics, itself. Up to that point an economy was treated as a governmental business enterprise. Keynes was the first to give evidence that economies operate on principles of their own and outside of market forces.

Keynes turned Say’s Law of the 19th Century on its head to show that demand creates its own supply. He was able to demonstrate that a minimum level of demand was necessary for an economy to produce the economic goal of full employment. He referred to this minimum level as the point of effective demand. Keynes further postulated that producers of goods and services cannot always provide for this effective demand on their own. The only actor available to ensure sufficient demand, in times of economic downturn, for example, was the national government.

Keynesian insights were not welcomed news by all. Entrenched interests saw his work as a threat to their position of authority. Managing an economy outside of financial principles was unacceptable to those benefiting from current policies. This led to a disunity in the profession. Eventually financial interests were successful in dividing the discipline of economics into two competing interests: microeconomics and macroeconomics.

Macro / Micro

In 1941, Pieter De Wolff presented a paper that gave mainstream economists a strategy to remain relevant. He interpreted the mechanics of an economy to be comprised of both a macro level and a micro level dynamic. His paper, "Income Elasticity of Demand, a Micro-Economic and a Macro-Economic Interpretation" set the stage for the bifurcation of the discipline. This was to become the original sin of the newly formulated economic profession.

Up to this point it was assumed that an economy needs little in way of management. Balancing the budget was sufficient for an economy to find its own level of equilibrium. A hands-off approach to economic policy was thought to result in equilibrium and produce full employment or what was thought to be maximum possible employment. The newly revealed need for oversight that Keynes brought forward was seen as heretical, and it tarnished the crown of traditional doctrine.

With the publication of the General Theory in 1936, the economic assumption of a guaranteed equilibrium was dismissed. Keynes was able to show with this publication that economies cannot recover from low demand endogenously without inflicting great harm. Keynes held and was able to show that for economies to maintain full employment, an effective demand must be ensured either by way of business investment and wages or, when necessary, by way of government intervention.

Social vs. Corporate Policy

Having experienced the devastation of the Great Depression and the successes of Keynesian type economics in its mitigation of the devastation, financiers scrambled to remain relevant with a redefinition of the discipline. Introducing the tenets of microeconomics as a viable economic strategy, however, put the camel’s nose under the tent. It allowed financial principles to be subsumed under the banner of economics. In this alternative economic theory, the principle of laissez-faire was to be sold as a public good. The invisible hand of the market was deemed to constitute obligatory public policy. The law of supply and demand was to be taught as a core economic principle. Local competitive advantage and global comparative advantage were to be offered as prudent economic policy.

None of these microeconomic principles, however, apply to good economic policy. They are all financial principles best managed by business firms for their own benefit. An economy may rest upon a bed of strategic financial principles, but it is, itself, not subject to or governed by those same principles. Teaching these and other principles of finance has compromised the discipline of economics and has required the profession to become something it is not.

When policy makers take their collective eye off the stated goal of full employment, the less organized become the victim and, ultimately, we all lose. Fighting inflation by way of increased unemployment, for example, results in our cities become blighted with people experiencing homelessness. The historical inequities of racism are not addressed properly when full employment becomes a nice-to-have. Allowing great wealth to set social policy depletes financial resources needed to mitigate social inequities and, perhaps in the process, compromises democratic institutions.

Passing the Torch

Giving the classical doctrine of laissez-faire stature gave false equivalency to radically different approaches to public policy. It caused confusion and allowed the loudest voice  to set the agenda. Imagining that economies can be managed both with governmental involvement and with a hands-free approach set the stage of bitter acrimony and worse.

Budding economists are caught in the lurch. Prospective economists are taught that an economy is both a market that required freedom from governmental constraints in order to work its magic and that an economy is not a market and required occasional intervention on the part of government. Students are taught conflicting theories with no resolution.

In his General Theory, Keynes cites what came to be known as microeconomics as a special case. He says that when effective demand is generated from business investments and from consumer activity, the economy is in equilibrium and is positioned for growth. He goes on the say, however, that tacit assumptions of classical economics “are seldom or never satisfied, with the result that it cannot solve the economic problems of the actual world’. In other words, there are times within the business cycle where an effective demand cannot be maintained and that financial principles alone are inadequate for maintaining full employment.

Conclusion

Microeconomics sets the corporate agenda. Allowing the financial community to set social policy has compromised our nation’s ability to meet societal goals and objectives. It has prevented the profession from engaging in a meaningful dialog with critical stakeholders and processes necessary to maintain full employment. Incorporating the principles of microeconomics into the discipline of economics has stultified the profession into a non-working whole.

Conflating finance with economics muddies the water. The financial community must give the profession of economics back to the economists. The discipline of economics is a social science and must be taught within the liberal arts curriculum. The profession of economics must attract public minded individuals who intend to advance the public good and not one’s own personal gain.

A Chinese proverb holds that the beginning of wisdom is to call things by their right name. Giving voice to financial principles under the banner of microeconomics does a disservice to the profession. We must reclaim the profession of economics from the corporate interests.