Monthly articles (English and French) on the theme "Querying economic orthodoxy"

No. 34 - October 2008

Value: an economic puzzle


For over 2,000 years the idea of fair value has generally corresponded to an object's intrinsic worth, not to its market price; only recently have we changed allegiance.
Matthew Edwards, editorial in The Actuary, October 2002

Value indicates the potential capacities of an object or action to satisfy human needs...it is not an attribute or physical property possessed by things themselves.
Friedrich von Hayek, The Fatal Conceit ((Routledge, London, 1988) chap. 6

The doctrines of the Austrian economists - Mises, Hayek and their colleagues - have encouraged our current tendency to allow our lives to be ever more dominated by markets. Austrian theory is, in general terms, a realistic description of how free markets work. But the practical and ethical difficulties linked to this theory demonstrate the limitations of the free-market philosophy.

The conundrum of value

Why does any object, or any quantity of work, have a particular monetary value? Is there a 'true' or 'fair' value for any given article? Is there a 'fair wage' for an hour or a week of work? If so, how can we assess these fair values? For centuries, thinkers have puzzled over these questions.

Those pioneers of modern economics, Adam Smith and David Ricardo, basically held that the value of labour was the level of wages sufficient to keep the workers alive and fit to work, and to support their families, so that the 'working class' could reproduce itself and survive. And the value of any product was essentially the cost of producing it; that is, mainly, the cost of the labour needed for its production. Smith, who published The Wealth of Nations in 1776, wrote before the industrial revolution with its large-scale use of capital equipment. Production in his day was indeed chiefly a matter of human toil. Ricardo came somewhat later - his Principles of Political Economy dates from 1817 - but he retained Smith's traditional outlook on this matter.

The idea of 'fair value', or 'just price', goes back far beyond the age of modern economics. Mediaeval theologians wrote about it. Just prices and wages could not be clearly and precisely defined, but were understood to mean that those who work for their living should earn enough to support them in a manner suitable for their station in life, and that goods should change hands at prices that were equitable to both buyers and sellers. Prices and wages could be, and often were, regulated by princes or magistrates, or by craftsmen's guilds. According to St Thomas Aquinas (1), to sell anything for more than it is worth, or to buy it for less than it is worth, is in itself unjust and unlawful.

Most economists today, I need hardly remind you, regard all that as an archaic curiosity, entirely superseded by the concept of the free-market price.

A fundamental rethink

The change from ancient to modern economic theories about value seems to have begun in the middle of the nineteenth century. The basic change is this: the old method of valuation was objective because the value of any product was the cost of making it, which could be objectively measured. In fact, this still happens in business accounting; a manufacturer's stock-in-trade is normally valued in his accounts at cost of production. By contrast, the newer method is subjective; the value of anything is what a buyer is willing to pay for it. It is a matter of opinion - the buyer's opinion - rather than a matter of fact - the cost of production as recorded in the seller's books.

Though this may seem academic, it is a fundamental change in our way of thinking about economic matters. After a long delay, it is now having big practical consequences, not all of them welcome.

One of the first to write on this topic was Richard Whately, Anglican Archbishop of Dublin in the early 19th century, who tackled economic as well as religious themes. He pointed out (2) that pearls are not highly valued because men dive for them; on the contrary, men dive for them because they are highly valued. But he did not elaborate this theory.

Had the Archbishop been alive today, he might have chosen a different example. Damien Hirst's bullock in formaldehyde (The Golden Calf) was sold on 15th September 2008 at Sotheby's (London) for over £10 million. Clearly, not because Hirst had spent £10 million on creating this 'work of art', even though the bullock is adorned with gold horns and hooves. On the contrary, Hirst created this curious object because he expected, quite rightly as it happens, that someone would pay a very bullish price for it.

A French painter, who works in traditional styles, remarked to me recently that to succeed as an 'artist' today you don't need artistic skills; you need marketing skills.

The theory of the 'marginal price'

Whately's basic idea is very simple: things are worth what buyers are willing to pay for them, not what they cost to produce. The theory based on this idea, however, is more complex, since various buyers may have different subjective opinions as to what something is worth, and their opinions may vary from one day to the next. It was Carl Menger, the Viennese economist about whom I wrote in September, who first refined the theory and explained it in detail. He showed that, in an auction where many identical items are traded, normally they all sell close to the price that suits whichever of the buyers present (among those who actually buy) has the lowest valuation. This is called the marginal price.

The subjective theory of value is a key element in the 'Austrian school' of economic thought. And it presents a problem; for it implies that, in fully liberated markets, it is impossible to define a fair and stable price for anything. Prices can, as we all know, vary erratically according to the whims and sentiments of buyers and sellers. In fact, it is precisely because they accept the Austrian theory that most economists today reject the old notion of just prices and fair wages.

Austrian theory can damage your bank

Subjective (market-based) valuation is one influence behind the current financial crisis. "Value is just subjective opinion" say the Austrians; but opinions can be ignorant, misinformed, confused, erroneous; they can even be wildly out of touch with reality, as happens in markets during extreme booms and busts. The problems of banks and pension funds have been aggravated by the modern practice of revaluing their assets frequently at market prices. If the market is in a tailspin, prices may well be unrealistically low.

A bank's financial condition will then appear to be worse than it really is. This might seem to be a purely cosmetic problem, but it isn't. A misleading appearance can undermine confidence; and banking depends on confidence. The vogue for valuing everything at market prices is part of the modern fashion for transparency. On the catwalk, too much transparency can mean indecency; on Wall Street, it can mean insolvency.

Happily, the Securities and Exchange Commission in America has recently relaxed certain rules that require the assets of financial institutions to be revalued at market prices ("marked to market" as they say in the trade). Even Americans are beginning to accept that the market can be wrong! This is excellent news.

Rates of pay - too low and too high

Austrian theory has some nasty implications for wages. Classical economists held, as we have seen, that the natural and normal remuneration of labour was just enough for survival. Turgot, finance minister to Louis XVI and friend of Adam Smith, wrote (3) that in all kinds of labour it must, and does, happen that the worker's wage is limited to what he needs for his subsistence. That was a harsh view, but at least there was a basic floor for wage rates, what we might call the 'cost of production' of labour.

With Carl Menger, however, this floor collapses under the poor fellows (4): neither the means of subsistence, nor the minimum subsistence level can be the direct cause or the principal determinant of the price of labour. According to Menger, wages in a free labour market behave like any other prices; they tend towards the level conceded by the least-generous employer, whether or not this is sufficient to give the workers a decent livelihood. Menger indeed observes on the very same page that a seamstress in Berlin, even if she works fifteen hours a day, cannot earn enough for her subsistence. Inadequate pay was a widespread problem in the laisser-faire 19th century, and it has become so again as economic and business policymaking, encouraged by Austrian economists, has perversely reverted to 19th century ways.

At the other end of the pay scale, the Austrian theory may be seen to support the practice of paying extraordinary amounts to certain 'star' employees. After all, if the value of a person's work is purely subjective, and if an employer can be persuaded to subjectively value it at $50 million a year, then why not?

The amazing complexity of fares

Another example of Austrianism is the way airline and rail tickets are now sold. In the past, railway companies had a regular fare of so much a mile; some tickets were offered at special prices, but generally fares followed the normal pattern. Today, however, the French railways (SNCF) publicly state that fares are no longer calculated by distance. They are tailored to the demand for journeys between any two given points, and variable according to how far in advance you buy tickets, the popularity of the train you want to take, etc.

If you ask me, what is the single fare from Paris to Nice, I cannot give you a simple answer, and neither can SNCF. It may be as little as 25 euros if you book two months ahead, or as much as 167 euros if you insist on going tomorrow, first class. Between Paris and London, a much shorter journey, you can pay anything between 66 and 338 euros for a one-way trip. Demand for rail tickets from Paris to Nice is rather limited, since you can get there a good deal faster by air; going to London, by train is the quickest and easiest way. The value (or, at least, the price) of a train journey is no longer what the railway reckons it costs to provide it; instead, it is what passengers are willing to pay for it.

Is this complex system an improvement on the old way? There are pros and cons. You can get remarkably good value by booking far in advance; but if you have to travel at short notice, you pay through the nose. The cost of travel has become erratic and unpredictable. The need to book well ahead, unless you can afford the nose job, means that train travel is no longer as flexible as it used to be, when you could buy a ticket from A to B and use it on any train you fancied. This makes rail rather less attractive than it could be, as compared to motoring. However, the new method seems on the whole to succeed in attracting more passengers.

If something is not sellable, is it worthless?

There are further implications. The subjective theory was strikingly described (5) by Ludwig von Mises, one of the leading economists of the 'Austrian school': the value is not intrinsic; it is not in things, it is in us. Mises was a non-religious Jew; but, seen from a religious standpoint, his words seem to tell us that things created by God have no value unless they command a price on some human market. This is clearly not Jewish, or Christian, or Islamic; indeed, it sounds very like blasphemy!

One does not have to be devoutly religious to see that there are serious practical objections to ascribing no value to anything that does not have a market price. We discard as worthless things that are not readily sellable, such as gas flared from oilwells, materials that cannot be reused at a viable cost, machinery that is 'not worth repairing'. My wife once, in a photographic shop in London, asked to have a camera repaired; the puzzled salesman replied with a memorable question: repair, madam, what does that mean? How many millions of tons of materials are junked yearly as a result of this attitude? All this in a world that is consuming many natural resources at unsustainable rates.

In the world of nature, plant and animal species that have no commercial value tend to be crowded out by the activities of us turnover-obsessed humans.

These problems can be tackled. Many rare species are protected by law. In France, a small tax is levied on new electrical goods to finance the obligatory recycling of old equipment. The Russian and Nigerian governments - whose countries are the biggest gas-flarers - are trying to stamp out this wasteful atmosphere-polluting practice. But such solutions entail state interference in the economy, which is in general abhorrent to rigorous followers of the Austrian school.

Should we be dominated by our markets?

It would be absurd to blame all our bad economic habits on a group of deceased Viennese academics. Yet it is fair to say that the doctrine of subjective valuation has encouraged our current tendency to allow our lives to be ever more dominated by markets, these being the places where subjective valuation rules. Austrian theory is, in general terms, a realistic description of how untrammeled free markets work. But it also tries to convince us that markets are always right - or, at least, that they offer in all cases the best available guidance for those making economic decisions.

This notion has brought upon us many troubles. It involves grave practical and ethical difficulties; and these demonstrate the fundamental limitations of the free-market philosophy.

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1 St Thomas Aquinas, Summa Theologica, part II/II, question 77, article 1

2 Richard Whately, Introductory Lectures on Political Economy (1831), lecture ix, para. 9

3 Anne-Robert-JacquesTurgot, Réflexions sur la Formation et la Distribution des Richesses (1769) para. 6

4 Carl Menger, Principles of Economics (Grundsätze der Volkswirtschaftslehre, Wien, 1871), trans. J Dingwall and B F Hoselitz (New York University Press, 1976), chap. 3

5 Ludwig von Mises, Human Action (William Hodge, London, 1949), chap. 4, #2