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the origins of profit, part 4

So, our hunt for the origins of profit has led us to the question of where interest rates come from... and one answer to that question is that they are simply dictated by the Federal Reserve. But it's not quite that simple because even if they are adjusted in the short term to boost the economy or to ward off inflation, maybe in the long run they try to set them to some kind of objectively determined rate that depends on economic growth. And maybe if they didn't set them approximately right, the whole economy would break down? We're getting into territory where I don't have enough knowledge to say much and I suspect asking different economists would give you very different answers depending on what school of thought they subscribe to. Nevertheless, I will continue along my train of thought, making the best guesses I can.

Interest rates are closely connected to the amount of money in circulation. And by money I don't mean the M1 supply (physical money) but all of the money in the economy, most of which is created by commercial banks through fractional reserve banking and the practice of lending out money that then gets deposited in another bank and then lent out again, multiplying the base currency by the "money multiplier" that's determined by the reserve requirement. The bigger the money supply is, the lower the "price" to borrow money is, ie the lower the interest rates. The smaller the money supply is, the higher the interest rates. This is how the Fed controls interest rates. Yes, they directly set the rates that they charge commercial banks for loans through the discount window, but the main way they achieve a targeted interest rate is by buying or selling government securities on the open market, pumping new money directly into the economy or extracting it out. So if you were to make some kind of objective assessment about what the interest rates "should" be it would have to depend on how big the money supply is, but that's what's controlled directly by the Fed.

Now let's return to the concept of "normal profit" for a moment. We've already seen that abnormal profits are unearned and simply due to someone being in a pre-existing position of privelege compared to someone else. But can normal profits be justified? They are typically justified by today's neoclassical economists by the concept of "opportunity cost". But if you think about it, this is somewhat of a circular justification. Let's assume company A returns a normal profit to their investors, that is 0 economic profit. If you ask what value it was that the investor added to the final goods the company produced and sold to its customers, the answer is supposedly "the investor could have used the money to invest in company B which also would have yielded a normal profit--the value added was that the investor gave up the right to invest in company B". But then if you ask what the value added was from an investor who did invest in company B, the answer is that the investor could have invested in company A which returns a similar profit. It all seems like a circular justification aside from the size of the money supply, which is set by government policy. If the money supply is large then interest rates are low and the bar for a "normal profit" correspondingly gets set lower, therefore more money is invested and more business ventures happen. If the money supply is small then the interest rates are high and the bar for a normal profit gets higher, so less business ventures happen and more people are laid off. Hence there is a constant struggle between wealthy investors who want profits to be as high as possible and therefore interest rates as high as possible, and employees who don't want to get laid off who want interest rates to be as low as possible which makes for more business ventures and less unemployment but thinner profit margins. Whoever can lobby the government more easily for their side of the story ends up winning out, and the interest rates get set somewhere in between.

I think the only other part of this whole thing I had intended to mention originally which I haven't yet is the idea of "economies of scale". I wrote an entry in April 2010 about the origins of profit and said that I thought "it takes money to make money" is a central principle behind it. You can see that with interest rates as well--if you have money, you get paid more on a regular basis for having it, even if it is just sitting in the bank.

I likened the principle of "it takes money to make money" to a group of bullies ganging up to have more leverage against smaller cliques on the playground. But defenders of capitalism would call the same thing "economies of scale". Sometimes it is cheaper to produce something when you are producing a whole lot of them than if you are just producing one. And this sounds reasonable, until you realize the connection between this and the idea of "barriers to entry" and the deviations from the perfectly competitive market we mentioned earlier. The more economies-of-scale come into play, the bigger the barrier to entry for other firms and hence the higher the profit margin. If anybody can produce each item at the same cost then the market is highly competitive. But the more it takes a huge amount of capital to get started, the closer the market becomes to a monopoly and the further it gets from the capitalist's ideal of free competition. So an economy of scale makes the capital the investors can raise more valuable, but only because it pushes the market further from free and more towards monopoly. So it's not clear that this is in the end any different from what I described initially, where pooling money together allows you to make more money in the same way that a group of people are stronger than an individual and therefore can more easily team up on smaller groups or individuals, having more bargaining power to get their way.

Bottom line is, our system of fractional reserve banking makes profits possible and economic growth possible, but maybe the Koran has it right in terms of fairness, and neither profits nor interest are really fair in any sense other than "might makes right". Which after all, is the basis for evolution. Is it really a surprise that capitalism, based on social Darwinism, has to rely on a similar justification? The fundamental paradox of capitalism seems to be that, if the market were free then there would be no economic profits, and yet the only thing that can convince people to start businesses and drive growth is economic profits. So capitalism necessarily involves coercion, and there is no such thing as a truly free or fair market where value is exchanged for value.

Comments

( 5 comments — Leave a comment )
sapience
Feb. 27th, 2012 11:04 pm (UTC)
I enjoyed reading these entries.

For me, the key consideration in the origins of profits is the exploitation of the underprivileged. You touched on this in the previous entry when mentioning the historical origins of land and wealth being in slavery and colonialism, but a big part of "economies of scale" isn't in the money saved by streamlining production, but rather by the power accumulated by large organizations that allow them to "save" money by severely undercompensating their workers, providing miserable working conditions, ignoring the environmental impact of their activities, etc. So the money being paid to investors is being stolen from workers and from the communities affected by their larger webs of business activities. That's why the staggering inequality in USian society is so devastating.
spoonless
Mar. 1st, 2012 05:02 am (UTC)
Thanks for the comment. Wow, I so miss the connections I used to have with people on livejournal. Have so little time these days to read or write but it's great to know you are still here and read my entries. =)

So long ago it seems that you took this picture of me in my icon.

And yes, good point about "economies of scale". That's sort of what I was getting at but didn't think it through in as much detail. I think that they use their power both to avoid paying workers full compensation, as well as to take advantage of consumers.
easwaran
Feb. 29th, 2012 10:48 pm (UTC)
I wonder how much of this analysis you could do while entirely ignoring money itself. Just track all the non-monetary sides of all transactions that a person/corporation takes part in over the course of a year, or something like that. See what goods and services they provide other people, and what goods and services they got. Liquid money is just a way to defer this kind of transaction, so if you look at things over the right window (essentially, a time interval in which the person ends up with approximately the same amount of money she started with) then you'll see all the real economic contributions and extractions that the person made.

Of course, one thing that makes the entire concept of "fairness" in economic transactions extremely questionable is the fact that most interactions are not zero sum (which of course is related to the fact about the subjectivity of value that you started with). If we trade, and you end up gaining more value than I do through the trade, there's some sense in which the transaction was unfair to me, but if I still gain a lot of value, then there's another sense in which it wasn't unfair, especially if I gain more value than I would have in doing a similar transaction with other people.

Also, one big question that all of this discussion seems to avoid is the issue of externalities. If there are costs or benefits that accrue to people who don't have any say in whether or not the transaction takes place, then the transaction will be mispriced - this is what I see as the real role of government in a neoliberal economy, is internalizing the externalities so that transactions that cost third parties (like pollution) are discouraged and ones that benefit third parties (like education) are encouraged.
spoonless
Mar. 1st, 2012 05:34 am (UTC)

Of course, one thing that makes the entire concept of "fairness" in economic transactions extremely questionable is the fact that most interactions are not zero sum (which of course is related to the fact about the subjectivity of value that you started with). If we trade, and you end up gaining more value than I do through the trade, there's some sense in which the transaction was unfair to me, but if I still gain a lot of value, then there's another sense in which it wasn't unfair, especially if I gain more value than I would have in doing a similar transaction with other people.

Which reminds me, I feel like I was a bit negligent in saying up front that I was going to explore how profit could be seen as unfair even from a subjectivist viewpoint, and then not really mentioning anything more about it and if anything, sort of implicitly assuming more of an objectivist viewpoint through most of it.

I think this may deserve a whole nother post, if I get around to it.

Great point about the transactions being zero-sum, and it not being clear how to define fairness. When I was a bit younger, my viewpoint was that as long as they are making the exchange voluntarily, you know that they are each getting something they consider equally or more valuable in return for what they're giving up in the exchange... and therefore all you could say was that the transaction was surely a net "good" in the world, but that you couldn't say anything for sure about who benefited the most because that was just trying to compare two inherently incomparable quantities.

My viewpoint nowadays is different in that, while I still don't think we will ever have a calculus for determining who is deriving more benefit from a transaction... there are certain things you can say with reasonable certainty. And if it's clear that one person is obtaining a better deal simply because of their position of power, then it does seem relatively straightforward that there's something "not right" or "not fair" going on. Although it's hard for me to quantify that.

I admit that some of the shift in my viewpoint seems like a shift from a radical subjectivist POV more towards a moderate point of view. And I also must admit that, even though they shouldn't be confused as precisely the same issue, I feel a bit more receptive now to the points you were making earlier about value being (at least somewhat) objective. Part of it just comes down to language, but as I've thought about it more I realize how it makes sense in a lot of practical situations to deal with value as if it's objective, even if at its roots it isn't. Probably still have at least a couple more entries to write on that at some point.

Regarding the unfairness of a transaction where both parties benefit, one thought experiment that I keep going back to in my mind is something we learned in a Game Theory class I took a long time ago. We learned that if a millionaire and a beggar collaborate in a game where the payoff is 1 dollar, then because of their different utility curves... and essentially because the millionaire doesn't give a shit whether he makes the dollar or not while the beggar cares a lot... you can prove that the "rational" division of the payoff is 99+ cents to the millionaire and a fraction of a cent to the beggar, even if they put in equal amounts of effort. I think this demonstrates the possibility for unfairness even in Pareto-optimal exchanges about as clearly as possible.

The basic issue is that the rewards people get are not proportional to their contributions or expended amount of effort. I guess that's the way of stating it that I feel doesn't depend on assumptions of value objectivity.
spoonless
Mar. 1st, 2012 05:43 am (UTC)
Regarding externalities, I think I agree that it's an important part of capitalism that needs to be corrected for and is often ignored by the hard right. But on the other hand, it seems logically like something kind of separate from what I was interested in.

For example... what if we punish or tax the behavior (like polluting) but we don't connect that to a transaction? In other words... isn't it just as much a harm to society that needs to be punished... if one person by themself decides to pollute (say, a farmer who wants to burn a pile of his garbage) versus if one person pays another person to do some task which ends up involving pollution somehow in that task? I guess what I'm saying is that, things like pollution are great examples that tie libertarians heads in knots because they tend to think too much about whether one individual is doing harm to another and not enough about whether one is doing harm to society as a whole. But it doesn't seem like a central problem with capitalism itself.
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