Capitalism is an economic system where wealth is supposedly accumulated via the ownership of capital. This essay looks at what capital actually is, and whether the return on a capital investment is really generated by the capital itself, or through the cynical exploitation of workers and consumers.
Some basic business economics are touched upon, along with Capital Theory, the Cambridge Capital Controversy, the Labour Theory of Property, and the essay even rounds out with a brief introduction to the Exergy Theory of Value. Everything is presented in very simple terms, and anyone with decent arithmetic skills should be capable of following the thrust of it.
Imagine that you are someone with money to invest in a small business, in exchange for a share of the company, in the hope that this will produce a financial return.
You hook up with a guy called Billy who has £5,000 to start a landscaping business, but who needs a total of £10,000 to purchase the equipment (capital goods). The banks wont lend to him because no credit rating. You see Billy as a good risk, so you invest £5,000 in exchange for a 51% share of the landscaping business. One of the conditions in the shareholder’s agreement, is that the business will pay Billy wages at the market rate for whatever labour he performs, and that any surplus achieved beyond that is divested as profit by way of share dividend.
NOTE – a 51:49% split in favour of investors who are contributing at least half the startup capital is standard practice in order to safeguard their interests. Under the shareholder’s agreement Billy will be reimbursed in wages for any labour he contributes, before the profit is apportioned. If you feel that this is wrong, then feel free to adjust the terms however you see fit, as this largely irrelevant to the matter at hand.
Here’s what all this means in simple terms: if Billy charges a customer £100 per hour to landscape, which incurs costs of £10 (on stuff like fuel), and sets aside £5 against the business’ fixed overheads (stuff like the telephone bill)… then he can pay himself £50 for an hours labour… leaving a profit of £35 to be split 49/51 between Billy and yourself, netting you a return of £17.85 with Billy receiving a further £17.15 by way of his own dividend in addition to his £50 of wages (meaning Billy receives a combined £67.15 in respect of his wages and share of the business).
The landscaping business averages revenues of £800 per day, 5 days a week, 45 weeks of the year – that’s £180,000 per annum. This provides you with an annual return of £32,130. At a 5x PE (price to earnings) ratio (a basic measure of how businesses are valued) your share capital in the landscaping business is now worth £160,650 – and that’s in the ballpark of what Billy would have to offer in order to buy you out and keep all future earnings for himself.
This is what it means to be a capitalist. An absentee investor need only stay alive to collect the return on their investment. In order to comprehend the nature of capital, we need to look at what actually funds those returns. Is this money for old rope, or is there actual substance to it?
The (mostly) Orthodox View
All economists agree on three primary factors of production: land, labour, and capital.
Orthodox Neoclassical and heterodox Austrian also advance the existence of a fourth factor – entrepreneurship – which encompasses risk, organisation and coordination (and by the Neoclassical definition intellectual property).
All capitalist economists agree that profit either arises from the supply of natural resources that the capitalist owns, from efficiencies derived from the use of equipment that the capitalist owns, and in the case of Neoclassical and Austrian economists, from the positive action of entrepreneurship. Furthermore they advance the notion that the buyers and sellers must be mutually profiting from any voluntary trade otherwise they would be unable to agree a price.
All capitalist economists argue that profit cannot be attributable to waged labour since said wages compensate each worker for their labour.
Returning now to Billy’s Landscaping, what is the source of your return. Well Billy is the one supplying the labour and you’ve both agreed that he will be remunerated for that prior to the division of profit. You aren’t suppling any natural resources, and in terms of entrepreneurship the funds that you risked were invested in capital goods, therefore your return must arise from the machinery making Billy’s labour more efficient than it would otherwise be. And even though the tools purchased with your original £5,000 stake will eventually wear out, the gross profit generated by the use of those tools will cover the cost of their replacement, meaning that your capital will persist for as long as the business remains solvent.
While that might appear perfectly reasonable, it’s also dependent on capital being an actual thing in its own right, so precisely what is capital? This subject has been tackled by notable economists such as Eugen von Böhm-Bawerk of the Austrian School. Briefly, capital is a factor that facilitates the production of wealth, through the creation of value. Here’s a good summary on the nature of capital from Mises.org, which includes this quote:
“What is capital, then? It is composed of three things:
First, of the materials upon which men operate, when these materials have already a value communicated by human effort, which has bestowed upon them the property of exchangeability — wool, flax leather, silk, wood, etc.
Second, instruments that are used for working — tools, machines, ships, carriages, etc.
Third, provisions that are consumed during labor — victuals, fabrics, houses, etc.
Without these things the labor of man would be unproductive and almost void; yet these very things have required much work, especially at first. This is the reason that so much value has been attached to the possession of them, and also that it is perfectly lawful to exchange and to sell them, to make a profit off them if used, to gain remuneration from them if lent.”
“From the notion of capital goods one must clearly distinguish the concept of capital. The concept of capital is the fundamental concept of economic calculation, the foremost mental tool of the conduct of affairs in the market economy. Its correlative is the concept of income”.
Carefully set aside each of the following bulleted points regarding the nature of capital:
The value of capital can be extrapolated from its rate of profit. If a machine costs £100,000, has an operational lifespan of 10 years, and incurs £50,000 of running, maintenance and insurance costs over that time period, but its use produces £500,000 of goods or services, then (roughly speaking) its rate of profit is £500,000 goods less £100,000 purchase price less £50,000 operating costs = £350,000 profit over 10 years = ~£35,000 per year.
- The value of capital can be extrapolated from its rate of profit.
That doesn’t mean that the machine should sell for £350,000 – after all even when brand new it only retailed at £100,000. Instead the rate of profit offers a means of objectively comparing that machine against all other machines, including machines that produce different things, because capital goods are heterogeneous (meaning they don’t all produce the same stuff). Two machines with the same rate of profit are deemed to possess the same quantity of capital. Likewise a particular mechanical digger may represent a quantity of capital equivalent to that encapsulated by ten picks combined with ten shovels (thus enabling one man to perform the work of twenty).
- Capital is heterogenous (like apples and pears).
We measure the value of capital in units of money, so £1 would represent one unit of capital.
- The value of capital is quantified in monetary terms.
The rate of profit on capital is dependent on the quantity of capital. This means that £10,000 of capital will produce 10x the rate of profit that £1,000 worth of capital does.
- The rate of profit is dependent on the quantity of capital.
Collating each of those points on the nature of capital:
- The value of capital can be extrapolated from its rate of profit.
- Capital is heterogenous.
- The value of capital is quantified in monetary terms.
- The rate of profit is dependent on the quantity of capital.
Aah but… there’s a problem…
When we try combining those points on the nature of capital into a cohesive and definitive statement, we arrive at something like this:
“The monetary value of capital, can be extrapolated from its rate of profit, which is in turn dependent on the quantity of said capital as measured in money.“
Hmm… that’s circular reasoning; we’re trying to calculate the value of capital, from its rate of profit, which then turns out to be dependent on the quantity of the aforementioned capital. Both are also quantified in monetary terms, so we’re left trying to measure money with… money.
Capital appears to be an invalid concept, since there doesn’t seem to be any way of quantifying it. Given that capital goods are only capable of production in the presence of labour, in the absence of any way to measure the value produced by a unit of capital, the capital itself cannot be verified as the source of any returns being generated from its use in production. Uh oh…
The Cambridge Debates
This conundrum is known as the Cambridge Capital Controversy. Esteemed economists from the neoclassical and post-Keynesian (aka neo-Ricardian) schools, including Robert Solow, Nobel Laureate Paul Samuelson, Joan Robinson, and Piero Sraffa, spent over a decade arguing about whether or not capital was perhaps analogous to ectoplasm… and failed to resolve the issue. In the end they just gave up, swept the issue under the rug, and carried on as if nothing whatsoever had happened.
Does any of this even matter though? Well let’s return to Mises’ description of capital, but replace the word “capital” with the phrase “circular reasoning”:
“The concept of circular reasoning is the fundamental concept of economic calculation, the foremost mental tool of the conduct of affairs in the market economy”. Oh dear… that’s really not a good look!
This also has some serious implications when its logic is applied to the aforementioned landscaping business, wherein it becomes clear that capital cannot be generating the return, since the capital is measured by its rate of return, and that rate of return is dependent on the quantity of capital. There’s simply no way of quantifying the capital beyond the original £5,000 that was invested, so that investment cannot be shown to be “making money” in and of itself. In other words, the notional return is actually being justified by [cue horror music]: circular reasoning.
This leads us to the only other logical conclusion – that the value of the original £5,000 capital investment, was worth just that, £5,000… meaning that someone is somehow being ripped off in order to fabricate returns for the investor.
Here’s a nice easy to grasp summary of the capital debates (scroll down past the links at the top).
A Dialectic Theory of Value
A mathematically sound theory of capital had already been devised decades earlier by Karl Marx, but since his solution undermined the philosophical basis of Marxism… he chose to ignore his own reasoning. Here’s a paper detailing this by Australian economist Steve Keen.
Property is Theft!
Murray Rothbard had an interesting take on capital by reinterpreting John Locke’s Labour Theory of Property weirdly bereft of Locke’s Proviso. He postulated that property was essentially the original labour of the capitalist, which then somehow persisted eternally.
A worker can dig 50KGs of soil each day using just his or her bare hands, this is worth £80 per day. This is the value of that person’s labour.
An entrepreneur spends their £500 of their earnings buying up 10 picks and 10 shovels. This entrepreneur then employs 20 workers to dig on their behalf using those tools. Thus a new capitalist is born. Each pair of workers now manages to dig 500KG of soil each day, which is around a fivefold increase. Since the workers’ raw labour would only amount to 50KG of production, the additional 200KG of production per worker can therefore be attributed to those tools, which remain the property of the capitalist. Thus the £6,400 of earnings each day from this increased productivity must ‘rightfully’ belong to the capitalist.
After 4 weeks the capitalist invests £100,000 in a mechanical digger. The capitalist is now able to dismiss 14 workers, since only 6 workers are needed to operate that digger 24×365. The digger is able to dig through 5,000KG per 8 hour shift, equating to extra production of 4,950KG, for a gross profit of £166,320 per week of operation, from which £16,320 of operating costs are subtracted, creating a return of £160,000 for the capitalist… and so forth.
NOTE – The perceptive will have noted that these figures trend towards the unrealistic. That’s because the example doesn’t account for free market competition from other digger owners driving those prices down. This is irrelevant to the problem itself, but feel free to change the numbers if doing so makes you feel better.
Yup – Capital is Just Ectoplasm
Rothbard’s fantastical narrative still fails to navigate around the problem highlighted by the Cambridge Capital Debates. The notion that the value of someone’s ‘original labour’ can be magically multiplied by investing it in capital goods does nothing to alter the ectoplasmic nature of capital – it merely provides a fairytale as the backstory.
We’re still left with the aforementioned circular reasoning: “The monetary value of capital, can be extrapolated from its rate of profit, which is in turn dependent on the quantity of said capital as measured in money.“
An Energy Theory of Value
At the root of the Cambridge problem is the notion that money can make money, but let’s look at the actual physics involved. All energy used in production can ultimately be measured in joules. The raw materials used in production, the worker’s bodies, the food they consume in order to replenish the energy being expended as they labour, even planet Earth itself… all these things were ultimately created by, and depend upon, solar energy. The Sun can (as near as damnit) be viewed as the primary source of all energy used in human production, meaning economics is subject to the same laws of physics as everything else (shock horror), including “Conservation of Energy“. Production doesn’t create new energy, it simply repurposes energy originally radiated by the Sun.
Goods & services are in fact repackaged matter and energy, and their value ultimately arises from the Sun, rather than from capital. What economists think of as units of capital are in fact joules of energy, and as such each joule can be assigned a monetary cost/value. The notion of capital as a source of energy that can make more energy, which can be then translated back into money, therefore contradicts the First Law of Thermodynamics. Hence the entire economic basis of capitalism is false.
Capitalism is Exploitation
In the absence of any weird ectoplasm, workers and consumers (who are for the most part the same group of people), are being ripped off by the capitalist, who is likely charging more than the value of the good, whilst paying the workers less than the value of their labour, in order to carve out a living from money. The capitalist is in effect an energy vampire.
Capitalism is de facto the exploitation of the working class by a dominant capitalist class. This can be confirmed by incorporating thermodynamics into economics equations, effectively grounding the social science in actual physics, and thus proving that capital itself does not magically generate a return.
This essay was debated in Ancap vs Ancom Debate Group (Facebook 14th & 15th August 2020), with Bill Orton arguing for cap and Craig Adams arguing for com.
Bill>> “The example of the lawn mowing enterprise is very good. The author asks where profits come from…”
Essay> “The basic premise of capitalism is that the substance is the capital itself.”
Bill>> “This is a glaring error. “Capitalist” economic theory posits that there are four factors of production: land, labor, capital, and entrepreneurship.”
Bill>> “The answer to the question “How is the profit generated?” is: By combining the four factors of production efficiently.”
Craig>>> “Profit is in fact the portion of revenue that’s leftover once all costs have been accounted for. Efficiency is important in that it ensures that none of those costs are greater than they need to be… but efficiency cannot generate gross profit in and of itself; it only maximises the net profit available for distribution. It’s always amusing when ancaps demonstrate a fundamental lack of understanding of very basic business economics.”
Craig>>> “By claiming that gross profit arises purely from efficiency, Bill is unwittingly inferring that capitalism is somehow possible without capital goods… so let’s examine that premise. I want a hole dug, and am willing to pay Bill to do it. Since there are no capital goods, he would have to dig it with his bare hands. The source of the hole is Bill’s labour. If Bill charges me more than he believes his labour is worth then in his mind he’s gained from this deal. If I pay Bill less than I think his labour is worth then in my mind I’ve gained from this deal. In fact we could each believe that we have ‘gained’ from this deal. This is the basis of the Subjective Theory of Value. Bill would probably choose to refer to his gain as “profit”. However the bottom line is that Bill dug a hole, and the market decided how much his labour was worth. Perhaps Bill believes that he dug that hole a smarter way, generating an efficiency gain by getting the job done more easily than someone else might have. The thing is we could also view this from the opposing perspective, whereby unless a worker is operating at maximum efficiency they are merely generating unnecessary costs. Ultimately this boils down to the amount of energy a worker expends on a task. Spending less energy is more efficient, but it isn’t actually giving rise to costless energy. This sort of efficiency gain is not “profit” per se; it’s just working smarter instead of working harder. This deserves a name, so I’m going to christen it the Burma Railway Fallacy: that working more efficiently magically generates a gain in excess of the energy being expended.”
Craig>>> “There is no “glaring error here”. The entire economic premise of capitalism is that capital goods create efficiency gains that exceed their operating costs. The more efficient a capital good is, the more valuable it is. This enables an entrepreneur to make objective and rational comparisons of capital goods based on their rate of profit.”
Craig>>> “Conversely the entire economic premise of Marxism is that all revenue is ultimately a product of labour, therefore profit does not exist (as I’ve just shown, this would indeed be true in the absence of capital goods). This is important because Bill is attempting to show that the essay is putting a Marxist spin on capitalism, when clearly this isn’t the case at all.”
Bill>> “The article commits a fallacy when it tries to answer the question, by assuming (without reason) that only one factor can be responsible for the profit. That would be an easy error for a socialist to make! It is a common socialist dogma that there can be only one factor – labor. So by transference, the author assumes that all his readers have the same false assumption. Saying that only one single factor explains profit is like saying that only one single ingredient in a cake accounts for the good flavor.”
Craig>>> “Oh look… as anticipated Bill is attempting to twist this around and has already referred to the Labour Theory of Value, and resorts to a feeble analogy since there’s no mathematical basis for his claim.”
Bill>> “Of the answers given in the article, #4 is closest to the truth: “The tools (capital goods) that Billy uses to landscape, make him more efficient.” That is a true statement, but really doesn’t explain where profits come from. It does explain one motivation for Billy to seek an investor, and one motivation for the investor to risk his capital.”
Craig>>> “That’s because from a capitalist perspective this is ‘true’. Returning to the hole: if Bill possessed a mechanical digger, and used this to dig the hole, but I still paid Bill the same amount as before (what the hole was worth to me), then Bill would have indeed made a profit, provided the costs attributed to the digger amounted to less than the gain attributed to it. This is because from a capitalist perspective the digger (with Bill operating it) somehow did most of the work, for just a fraction of the cost.”
Bill>> “The article quotes Mises correctly but misleadingly. It uses the same font for Mises quotes and the dubious “bulleted points regarding the nature of capital.” Needless to say, Mises did not write the bullet points – the socialist author of the article did.”
Craig>>> “What’s most revealing here is that for whatever reason Bill has chosen to skip the entire section on Austrian economist Eugen von Böhm-Bawerk and Austrian Capital Theory that immediately preceded this. I’m going to hazard a guess that this might be because Austrian Capital Theory inconveniently contradicts Bill’s claims up to this point:”
Eugen von Böhm-Bawerk> “Without [capital goods] the labor of man would be unproductive and almost void; yet these very things have required much work, especially at first. This is the reason that so much value has been attached to the possession of them, and also that it is perfectly lawful to exchange and to sell them, to make a profit off them if used, to gain remuneration from them if lent.”
Craig>>> “The thing with ancaps is that they only go along with the Austrian School when it suits them…”
Craig>>> “Outside of that Bill’s objective seems to be around the Ludwig von Mises quote and the bullet points that follow both being italicised. This is weak sauce indeed given the quote is clearly presented in quotation marks. There’s no intention here to deceive anyone; each of the bullet points is simply stating a basic axiom of capital.”
Essay> “1. The value of capital can be extrapolated from its rate of profit.”
Bill>> “The author notes that value here does not refer to market value, but only as a way to compare the productivity of different capital goods.”
Craig>>> “Bill is correct. This isn’t getting into STV, rather it’s highlighting the objective basis used by [an] entrepreneur to make rational decisions on which capital goods to invest in.”
Craig>>> “What Bill does next is a little sneaky though, he skips a couple of the bullet points in order to give the impression that the essay is somehow drawing an erroneous conclusion.”
Essay> 4. The rate of profit is dependent on the quantity of capital.”
Bill>> “The author takes (1) and (4) and draws the erroneous conclusion that:
Essay> “The monetary value of capital, can be extrapolated from its rate of profit, which is in turn dependent on the quantity of said capital as measured in money.”
Bill>> “Do you see the problem? The author forgot his own caveat, and mistook “the value of capital” for a measure of profit, rather than merely a method for comparing the efficiency of capital goods. No, the efficiency of a machine is NOT dependent on the quantity of capital. In short, the circular reasoning is due to the author’s misunderstanding of his own bullet points.”
Craig>>> “Err no. When an entrepreneur evaluates capital goods according to their rate of profit, he or she is measuring that rate of profit in money, therefore assigning a monetary value to the capital encapsulated in each capital good. A crucial point being that capital goods are heterogenous (not all of the same type), and the essay is actually discussing the abstract concept of capital. Bill is of course conflating the stuff of capital goods with the abstract concept of capital. Capital goods are an expression of capital, they can be classed as “capital”, but they are not the essence of capital. Bear in mind that Bill already skipped over the section of Austrian Capital Theory, which laid the basis for this. Now let’s just look at that Ludwig von Mises quote again in this context:”
Ludwig von Mises> “From the notion of capital goods one must clearly distinguish the concept of capital. The concept of capital is the fundamental concept of economic calculation, the foremost mental tool of the conduct of affairs in the market economy. Its correlative is the concept of income”.
Craig>>> “Can you see where Bill is getting all muddled? That’s not actually his fault; the essay is delving into the Cambridge Capital Controversy, something that the world’s top economists spent over a decade arguing about, before deciding that it was better to simply deny the issue existed. If Bill were able to address the CCC then he’d be awarded a Nobel Prize.”
Essay> “Capital appears to be an invalid concept, since there doesn’t seem to be any way of quantifying it.”
Bill>> “Sure there is: The market value of currently owned capital goods, plus saved wealth available for investment. And it is quantifiable in money, obviously.”
Craig>>> “And just to illustrate my point, Bill again conflates types of capital with the concept of capital.”
Bill>> “Part of the dishonesty in the critique of Mises is that Mises himself gave his definition of capital, in the same article cited and quoted. All the socialist contortions are unnecessary.”
Craig>>> “Bill now quotes Ludwig von Mises in order to support his own confusion.”
Ludwig von Mises> “The calculating mind of the actor draws a boundary line between the consumer’s goods which he plans to employ for the immediate satisfaction of his wants and the goods … which he plans to employ for providing by further acting, for the satisfaction of future wants.”
Craig>>> “There’s nothing whatsoever wrong with this quote, it just doesn’t live up to Bill’s claim that it somehow defines capital. What it does do is delineate the boundaries of capital… but the essay isn’t disputing those. This quote is entirely consistent with the essay’s narrative.”
Bill>> “Capital is all wealth that is not intended for consumption.”
Craig>>> “Correct. That delineates capital in absolute terms, but fails to define the actual essence. Bill is defining capital in the negative sense, by excluding all the things we do know the essence of, and stating that capital is what’s leftover. This is where an analogy is appropriate, since the essay is arguing that the essence of capital cannot be defined, so here we go: “God is what’s left over when you subtract everything that isn’t about God.” OK, so we’re left with some churches and the bible… but that does nothing whatsoever to define the essence of God, rather basing the claim of God’s existence on the presence of stuff that God supposedly had a hand in. It’s circular reasoning.”
Bill>> “Moving on, the author notes that Murray Rothbard reinterpreted Locke’s Labor Theory of Property. Rothbard dropped the weird and perverse “Lockean proviso.” The author is mistaken in his claim that Rothbard’s sticky property “persisted eternally.” Even anarcho-capitalists have abandonment criteria, obviously. Cf: Kevin Carson, “Are We All Mutualists?””
Craig>>> “Well it’s little wonder that Bill seeks to move on, and move on he does, ironically skipping over the Cambridge Capital Controversy, and ignoring the sections covering DTV… which was one of the things he queried that led to this essay being posted in the comments. No matter, Bill is safely back on his home patch with Murray Rothbard. His criticism here is limited to a technical detail around the abandonment criteria for sticky property, and it’s totally valid, it just happens to have no bearing at all on the thrust of the argument, but point taken.”
Bill>> “The author does give some beautiful illustrations of how productive capital can be, with his example comparing workers digging by hand, with shovels, and with a mechanical digger. He proves that the labor had little to do with the productivity and profits, but capital had a lot to do with it. Good example, especially coming from a socialist.”
Craig>>> “Yes, exactly! In capitalist economic theory, capital is the source of profit. This is what Bill has been focusing most of his attack on, and now he unintentionally concedes that point.”
Craig>>> “Although the author is a socialist, the essay has thus far dealt with capitalism almost exclusively from the capitalist perspective. It hasn’t been making any meaningful socialist arguments. In the lawnmower example it gave the reader a choice between the gain arising from 1) labour, 2) grifting, 3) a combination of labour & grifting; or 4) by the action of capital goods. It didn’t attempt to argue to case for 1), 2), or 3). It based it’s argument solely on 4). Bill then carelessly argued for a combination of 3), and 4)… unwittingly conceding the argument to Marx right from the get-go. He did this because he hasn’t fully grasped capitalist economic theory. Many ancaps are unwitting Marxists. The author of the essay is not a Marxist though, and the essay comes down solidly in favour of the Exergy Theory of Value.”
Bill>> “The labor theory of value LTV has the fatal problem of assuming that there is a “true” market value for things. This medieval notion of a “just price” is superstitious and has no objective foundation. It is amusing that, as a replacement theory of value, they offer yet another Just Price Doctrine – this time based on joules of energy. Why would counting joules of energy give a good measure of market value or productivity? Apollo the Sun God said so?”
Craig>>> “At no point does the essay argue in favour of LTV. The closest it came was mentioning Locke’s Labour Theory of Property. There is no argument being made for LTV. The basis of LTV is dismissed right from the get-go. Bill is reintroducing this as a straw man that he can argue against, because he’s out of his depth with Capital Theory, CCC, DTV, and ETV.”
Bill>> “Finally, out of the blue, the author claims that “capitalism is exploitation.” He has not given any argument for this. All he has done is misunderstand what capital is to come up with a circular statement. But I suppose the article is by and for socialists, people remarkably ignorant in economics.”
Craig>>> “I guess this would be “out of the blue” if you’d skipped over the whole section on the Exergy Theory of Value.”
Craig>>> “Bill wraps up by accusing the author of being “ignorant of economics”, apparently on the basis that the author is a socialist. This is rich coming from someone who has just demonstrated a grasp of economics that extends no further than maginalism and STV. To resort to another analogy (since that which is self-demonstrable doesn’t require an argument), this is like reading a beginners guide to Einstein and grasping the basics of gravity and relativity… then attempting to use that to argue that electromagnetism, thermodynamics, and the Standard Model aren’t valid physics.”