Wanted: A theory of wealth

The question "where does income come from?" was at the core of pre-neoclassical theories of economics. It was phrased differently, as the question of the "theory of value”, but the essence of the question was "what is the source of the physical surplus of goods that are produced each year?”

The issue disappeared in modern neoclassical economics because the word 'value' was reduced simply to a question of relative prices – which is why I titled one chapter in my book Debunking Economics "The Price of Everything and the Value of Nothing”. But the topic is far more than just a question of how relative prices are set. At its heart, this is an existential question: humanity produces not merely enough to stay alive from year to year, but a surplus above needs that (at least for some) results in enormous opulence.

Of course, one simple answer is that there isn’t a surplus – some are driven below subsistence, and their suffering becomes the source of the excessive incomes of the minority. But while there are indeed people who starve to death each year given the current distribution of income, that answer doesn’t survive serious scrutiny as an aggregate explanation – and I won’t waste time examining it further here.

The first coherent answer on how society can generate a surplus – a physical excess of outputs over inputs, so that humanity lives above mere subsistence (though income might be unfairly distributed) – came from the physiocratic school of economics, which originated in France before the publication of Adam Smith’s Wealth of Nations in 1776. They argued that the source of the surplus is the sun. The free energy raining down on the planet was the source of the surplus of outputs over inputs. This free energy was harvested by agriculture, and then distributed through the rest of society by manufacturing, taxation, etc.

They were so adamant that agriculture was the only source of surplus that in Tableau Economique, the model that provided the foundation for physiocratic economics, its author, Francois Quesnay, described farmers as "the productive class” and manufacturers (both workers and capitalists) as "the sterile class”. All manufacturing did, Quesnay asserted, was transform the surplus generated in agriculture into other forms.

Adam Smith, a Scott who went to France to study under the physiocrats, disagreed with them about the source of surplus. Reflecting the industrial nature of British industry at the time, Smith could not accept that labour in manufacturing was "sterile”. He instead proposed that surplus arose from the division of labour that large-scale industrialisation allowed. His famous example of a pin factory is worth citing at length:

"A workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day… But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands… I have seen a small manufactory of this kind where ten men only were employed … make among them … upwards of forty-eight thousand pins in a day."

Manufacturing therefore was productive, Smith asserted – though Wealth of Nations still allowed that agriculture was more productive than manufacturing because:

"No equal capital puts into motion a greater quantity of productive labour than that of the farmer. Not only his labouring servants, but his labouring cattle, are productive labourers.”

That was too much for Marx, who refined Smith focus on labour to say that labour alone was the source of surplus. I’ll have more to say about Marx in future posts, but his initial – not his final – argument was that surplus came from labour and there was a gap between the cost of labour and its productivity. This led to what became known as the "transformation problem”, which locked a century of Marxists into a futile attempt to reconcile Marx’s arguments with linear algebra.

In the 20th century, the ascendant neoclassical theory argued that you couldn’t favour one input over the other: both labour and capital contributed to output, and could be smoothly substituted for each other in what they called a "production function”.

The problem for neoclassicals was that, just as Marx’s argument created a conundrum for Marxists, so did the core neoclassical model – developed by Robert Solow – for neoclassicals. Changes in the amount of labour and capital in Solow’s model accounted for less than 50 per cent of recorded growth: the gap, which became known as "Solow’s Residual”, was attributed to technological change – for which neoclassical economics had no theory.

If this looks like a mess to you, you’re right: economic theory should be able to answer this question, but the best it has managed is to get it less than half right.

The solution, ironically, is to return to the 19th century – though not to its economists but to its physicists, and in particular Ludwig Boltzmann, who developed what is now called the second Law of Thermodynamics. These laws, unlike those of economics which are violated more often than observed (anyone for the Law of One Price, or the Law of Demand?), cannot be broken – and production, which is a physical activity, must therefore obey them.

The four laws of thermodynamics are neatly summarised in a simple ditty:

0th: You must play the game
1st: You can’t win
2nd: You can’t break even
3rd: You can’t leave the game

The zeroth law concerns the dynamic tendency of energy to dissipate: if two connected vessels differ in energy, energy will flow from the high energy vessel to the low one. Hence, "you must play the game”.

The first is the Law of Conservation: new energy and matter cannot be created. Hence, "you can’t win”.

The second is the real catch: the degree of order tends to diminish over time. Connect one vessel full of air to another with a complete vacuum, and over time the pressures will equalise. The equalised arrangement is less structured than the starting point. At the starting point, useful energy can be extracted by putting a fan between the two vessels; at the end, there’s still energy in the system, but no useful work can be extracted. Hence "you can’t break even” – the energy in a system will become less useful over time.

The third law says that you can escape the consequences of the second law if and only if you can dump the waste heat from a working engine into a vessel whose temperature is absolute zero – minus 273 degrees Celsius. Unfortunately, there is no such vessel – hence "You can’t leave the game”.

How does production – and the generation of a physical surplus – fit into this?

Production appears to defy these laws. Each year we start with a given stock of produced outputs, which become inputs to production, and (except during recessions) we end up with a larger stock of more elaborately transformed outputs. Yet the second law can’t be defied, any more than one can defy the law of gravity. So production must cause an aggregate increase in disorder over time.

The only way to reconcile production with the second law is that production involves a localised reduction in disorder in the goods and services we generate, which is more than countered by an increase in disorder via the waste outputs from production. Figure one gives a visual representation of this process – and 'free' energy, energy not produced by humans but nascent in the universe itself – plays a crucial role.

Figure 1: A visual representation of production and entropy


This free energy can take many forms. It can be solar radiation, as indicated in figure one, but it can also be stored energy in fossil fuels, nuclear energy in transuranic elements, even nascent nuclear fusion energy in deuterium and tritium. Without this energy, production – and life itself – would be impossible.

It therefore turns out that the most realistic economic theory of "where does income come from?” was the first: that developed by the physiocrats. Their mistake was to identify the sun as the only source of free energy, and to believe that only agriculture could exploit it free energy. But they were the best: subsequent economic arguments, from Smith through Marx to Solow, took us further away from the proper foundation for a "Theory of Value”.

Econophysicists are taking us back to that foundation now, with the most well thought out work to date being done by Robert Ayres and his colleagues. Their empirically derived model, which treats energy as the key source of production and labour and capital as adjuncts to the exploitation of free energy, adds energy as an additional independent input to production. They call it an "energy-dependent Cobb–Douglas function”:


Whereas Solow’s model (which has labour and capital as independent inputs, but not energy) misses over half the actual growth, Ayres’s model’s fit to the observed growth in economic output in the US from 1960-2999 has an R-squared of 0.999.

Economics has to start from an explanation of where income comes from: a Theory of Value is inevitable. Since we live in a physical universe, this theory must be physical in nature, and the second law is the ultimate physical rule. In my future economic modelling, I’ll be revising my production equations to be consistent with Ayres’s work.

Steve Keen is a professor of economics and finance at the University of Western Sydney and author of Debtwatch and Debunking Economics.

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It's interesting to see economists recognising the laws of thermodynamics (Wanted: A theory of wealth, November 19). Generally physics isn't much help in predicting complex phenomena such as human behaviour, since the basic physical laws are overwhelmed by complexity, which itself can create new kinds of order. Economic value may come from energy, but isn't directly proportional to it, since for example an LED light bulb can produce equivalent economic output (light) as an incandescent with less energy used, and a modern automobile may be constructed with less raw energy input than one of 30 years ago, but in both cases there is a correspondingly greater design complexity (or information entropy?) The progress is coming from better design and process as well as increased raw material usage required by a greater economically active population. Anything that can encourage the sharing of information (e.g., more lenient intellectual property laws) must lead to faster economic progress.
Steve your article is interesting... (Wanted: A theory of wealth, November 19)
I mean with unlimited energy, we can transform any object into any object, there is no opportunity cost, so essentially aggregate wealth/value has a value of infinity or zero, or N/A. (eg. the sun.)
The meaning of this word value affects the way we think about economics and will ultimately affect how evenly technology and the surplus is distrubuted.
If you develop unlimited energy, the value it creates should be 0. That ensures everyone is entitled to it, as the price is therefore 0.
Great read! Yes, a theory is a set of ideas formulated by reasoning (from known facts) to explain something. The facts used for economic theorising always seemed to be moving targets to me. As a scientist I love the idea of econophysicists, linking economics with something solid, and which already explains so much of how our universe operates. (Wanted: A theory of wealth, November 19)
Until Keen deals with Austrian economics, I will not read any more of his work. He seems content with bashing the market orthodoxy, but the Austrians have already beat him to this and the message has been loud and clear. Start debunking Mises and Shumpeter and you will get me interested against Prof Keen (Wanted: A theory of wealth, November 19)
I just love the chart Steve... but should not the labouring figure be holding a shovel or at least a hammer? (Wanted: A theory of wealth, November 19)
Nice work Steve, very enlighening. Next: since we live in a physical universe, how long can economic growth continue? (Wanted: A theory of wealth, November 19.)
Hallelujah and toll the bells! Steve Keen discovers energy as an input into all our daily lives, after the carbon taxers of course (Wanted: A theory of wealth, November 19).
On a note of direct relevance, I would urge both Steve and readers of this excellent article to google and study Nikola Tesla's "The Problem Of Increasing Human Energy: With Special References To Harnessing Of The Sun's Energy", written c. 1900. (Wanted: A theory of wealth, November 19)
Steve makes a fine attempt at atempting to unravel the mysteries of how value is created (Wanted: A theory of wealth, November 19). The missing factor in steves discourse appears to be the "human element that is prone to bouts of irrational behaviour". After all it is humans that put forward the notion of "value" rather than it being some kind of physical law explained by physics. Maslow's hirearchy of needs might provide some clues about what people really value at any given time and hence the devaluation of basic agricultural commodities over recent decades as people in the western world are able to create "wealth" from previously unknown creations some of which arrive via marketing departments! So scarcity or the lack thereof contributes to the relative value of goods at any given time. Just imagine how peoples notions around value will change once the world starts to run seriously low on fresh drinking wter or basic food items. Food for thought.
Brilliant Steve. I am sure over the next century that economics will reform itself based around physical laws.
In the meantime however, economic theory as it currently stands is likely to cause a lot of socioeconomic damage to our economies (Wanted: A theory of wealth, November 19).
Low entropy energy flows in from the sun and an equal amount of high entropy energy is radiated away. Life lives off the difference by creating little islands of low entropy: wealth (Wanted: A theory of wealth, November 19).
Steve facsinating as always, but my problem with economics in general, is that economists more often then not fail to link the theoretical to its practical implications for everyday people, hence creating a disconnect between the end users of economic theory and the economists! Practically, what does the work of Ayres's mean in today's society for the average worker or business owner? (Wanted: A theory of wealth, November 19.)
Wealth generated from labour surplus value according to Marx's production function Y=f(Yo,L); then from multifactor productivity aka technology as per Solow's Cobb-Douglas equation Y=f(Yo,K,L). Now Keen (Wanted: A theory of wealth, November 19) introduces the energy- dependent production function to explain wealth generation: Y=f(Yo,K,L,E), but the famous KLEM model has already introduced energy dependency as well as natural materials dependency of wealth generation as Y=f(Yo,K,L,E,M), and Lucas has extended the energy & materials-dependent KLEM model to incorporate the impact of human capital H in wealth generation as in Y=f(Yo,K,L,E,M,H).
So, Steve Keen's econophysic reasoning on energy in wealth generation has brought economic science backward. Am I right?
Article made me think about value, money, time, energy and transaction costs (Wanted: A theory of wealth, November 19). For example the lowered tranaction cost of internet, increases output per unit time, energy and therefore money and value. Didn't someone win a Nobel Prize for economics regarding a similar view regarding transaction costs? Worth further study...as looks promising for the further refinement of economic theory. Well done Steve.
Lindsay Atkinson (November 19, 12:50 PM) - i don't know who you are - but you must have read my mind!! - It seems quite obvious that given value is an arbitrary assignment by a not necessarily rational herd - there is no possibility of ever having a physics based model of economics. At the end of the day value is dependent upon a persons feelings - the feelings are based on knowledge, past experience etc etc - but no individual purchasing decision at a certain price is ever made by a person who thinks it is not worth it. They may say this, but if they pay the money - they have ultimately determined "it was worth it". Given that the evaluation of whether it was "worth it" is purely personal, based on a multitude of individual and personal past experiences, basic personality, rarity, peer pressure etc etc - there is no way to determine this - as the individual will pay an indeterminable price at any given time for any given thing depending on the circumstances. Aggregating historical figures may give a peek at how this appeared on a bell curve for the particular year/time and place but will never result in a properly predictable model of the economy. There is too much human increasing or decreasing the multipliers involved
Hi - this is a direct question to Steve (Wanted: A theory of wealth, November 19). The universe and physics have no feelings and do what they may. A dead child or a buried city mean nothing to the law of physics and therefore no value is placed by nature on what it does - the application of value is a the process of a living organisms - but value is not ascribed according to these sort of immutable laws - for a human it is essentially a function of human feeling. As a weir example - the community at aggregate level values the life of another human highly - we will happily spend a million dollars or more searching for a missing yachtsmen/adventurer or a sick dying child if the story appeals to our feelings - on the other hand a bogan with a bad debt in Melbourne may accept 20000 to kill someone
Exact opposite valuations - nothing to do with supply or demand. Aggregate statistical analysis may offset the life price between money spent on saving lives vs that taking lives - but that's not the point. Aggregate summation after the event will always be right at any given point in time but so what - the big unknown at any point in time is either the aggregate economic positive or negative multiplier of peoples feelings - and this is not able to be predicted in advance with any model as it depends on a number of unquantifiable variables also largely dependent on human feelings/performance - eg quality of leader, oration skills of leaders, regional specifics etc etc etc
What do you think?
I think for any living organism( particularly intelligent forms) value will be attached to anything that increases the chance of survival. It could be physical matter, usable energy forms, usable matter, traits, information, etc. (Wanted: A theory of wealth, November 21).