The Unraveling of Economics

Cross posted on
Economics Unmasked on

The goal of this essay is radical: build a new theory of economics to make sense of the historical success of protectionism. If you're a supporter of free trade, I strongly welcome your critique, because I believe economics can only be fixed with a very healthy national debate. A national debate is needed, for several reasons. First, this is not a task for a single individual, since the literature is immense and the essence of each school of economics is open to interpretation. Secondly, the political body needs to become aware of the fact that economics does not consist of a single school. In fact it is a 'science' of warring factions. I would go so far as to suggest, that Congress needs national hearings on the various schools so as to cast some doubt on our present direction towards the economic abyss. The new model is based on nearly six years of research and 200 plus textbooks of economic theory and history. In a nutshell, it argues the core error lies in an incomplete economic definition of money. Note. Slight modifications to this essay have been made from the original on

Let's get started.

Is it conceivable that flawed economic theory could ultimately be the invisible force behind America's economic decline? Is it also conceivable that the GOP is completely oblivious to its own party's and Constitution's economic heritage? I suggest the answer is yes. To begin to understand why this might be possible, let's first frame the discussion in a very puzzling historical perspective. Consider Daniel Webster who said the main reason we have our Constitution is to stop free trade. In keeping with this nation-building tradition, Lincoln and GOP were protectionists until 1960. Karl Marx interestingly echoed this spirit when he suggested that free trade would accelerate capitalism's destruction. Fast forward a hundred and fifty years and recognize that China adopts Lincoln's logic and we Marx.

Given this picture, it is not difficult to imagine that these men would have predicted a boom for China and a bust for America. Yet, a modern economist would very likely argue that free trade, not protectionism is the road to prosperity. To make sense of this contradiction, I begin with a very daring proposition: there has never been a sound theory of economics. The key intellectual error of all schools of economics is the incomplete economic definition of money: 1) medium of exchange, 2) store of value, and 3) unit of account. Note this definition completely ignores money's link to wages so that labor content maybe tracked in industrial goods in order to measure productivity gains. Tracking productivity gains is absolutely critical to worker mobility from one sector to another as short term unemployment results from such gains. The cost savings are passed on to the consumer in a price reduction, which in turn is spent in a new sector providing new employment opportunities. More importantly, a correct definition of money is not only needed for a labor theory of value (abandoned by mainstream economics), but that it is ultimately a domestic phenomenon.

Three critical components give money its domestic basis and its rigidity. The first aspect results from the establishment of a national minimum wage. Thus as James Steuart writing prior to Adam Smith in the 1700s understood, money is nothing more than an "arbitrary scale" which arises out of an infinite and worthless paper money supply or credit system. Thus a minimum wage definition provides the point of gravitation from which a national wage structure is established via supply and demand for skill sets. The second component is wage negotiation process itself. As Keynes observed it is a relative comparison process (an American steelworker compares his wage to another American steelworker, not a foreign steel worker). A necessarily rigid wage system is established so that labor content of industrial goods can be rationally tracked for measuring productivity gains. The properly handling of productivity gains, and the short term resulting unemployment, requires a common language component, a critical theoretical oversight which in my view will prove to be the Euro's undoing. In other words, a French worker will be hard pressed to move should the superior competitor (greatest industrial productivity) happen to be in Germany for example. Thus Steuart's phrase more accurately would be described as "a domestic arbitrary scale that can only be maintained in a closed economy."

In terms of economic theory this means the 200 year old Quantity Theory of Money (QTM) is flawed, something the long forgotten James Steuart, as noted above, understood at a basis level. He recognized England's industrial might rested on an advanced system of credit, not gold. The anti-QTM sentiment also had brief a revival with Thomas Tooke, but would be eventually cast aside by a mainstream interpretations of economic thought. If QTM is flawed, so then is modern micro, macro, and international economics (free trade theory). Unfortunately for Steuart, at home in a world super power, he could not quite close the thinking regarding the domestic implications for the subsistence wages of the English workers (something Marx exploited).

QTM itself was packaged in two different forms: 1) Fisher's equation of exchange ( a model without savings), and 2) the Cambridge form (money's store of value is emphasized). In spite of various tug-of-wars over money theory, the fundamental flaw remains: the erroneous causality leading from the quantity of money to price level as these two models suggest. The end product which has risen out of generations of QTM-based chalkboard scribbling is a modern economic model which is built on stone-age barter, with money as an afterthought (general equilibrium/Walras model). In this astonishingly bizarre interpretation of reality, an invisible auctioneer is introduced to negotiate prices and wages in the blink of an eye across a nation (supply and demand in the form of simultaneous equations). In short, modern economic theory amounts to an auction house model which establishes relative barter prices (e.g.. two eggs for one chicken). Money, in any form you can imagine, is then sprinkled on top in order to establish a price level. The more money (i.e. eggs) in an economy the higher the price level. The roots of this mind set go back to the 1700s where we find David Hume's gold-like-the wind speculations. From such an intellectual fantasy of money mechanics, germinated the first forms of free trade theory courtesy of David Ricardo.

The first critical error in such a barter-based approach is its assumption that the quantity of goods on the market are given before relative barter prices are established. In other words, this is a near equivalent of manna falling from heaven. Each agent is "endowed" with a given quantity of goods against which he will negotiate a relative exchange price for another good. This is the complete reversal of reality in which the cost of production of a good ultimately drives the level of demand, and in turn drives the final sector size (quantity of goods on the market). In other words, in the real world price comes before quantity, not quantity before price. The price of the wage in turn is established by the foundation of a minimum domestic wage (by decree).

In addition, the negotiation of barter prices in Walras' model suffers from a much more subtle problem. Markets clear (all goods are exchanged and no one is unemployed) by instant and infinitely flexible price and wage adjustments in such model. This again is the complete reversal of reality where domestic wage rigidity is required to force short term unemployment due to productivity gains. In other words, in models built on barter productivity gains can not be properly tracked since prices magically adjust to prevent unemployment. The rigidity serves a critical secondary purposes: Inferior domestic competitors cannot reduce wages under the pressure of a superior competitor to gain an artificial advantage. In other words, rigid wages serve to identify the superior competitor with the lost cost of production in a domestic economy.

To fully appreciate this mind set, one only needs to consider Menger, from the Austrian school (i.e. the intellectual home of many modern libertarians), who claimed it makes no difference for the price of diamond if you find it by luck or have to dig it out of the earth. Tell that to mine operator who just bought a million dollar earth moving machine. One of Menger's followers, Boehm-Bawerk takes this to heart with his horse auction example, where buyers outnumber sellers. Some buyers obviously are forced out of the process and the price of a horse converges to a happy-price which clears the market in this Austrian world of barter economics. Unfortunately, this is almost the same error of the classical school which mistakenly believes price theory is microeconomics, instead of macroeconomics. To see the mistake in Boehm-Bawerk's logic, one needs to understand the implication of the excessive number of buyers. These buyers have chosen not to spend their money in other industry sectors, resulting ultimately in unemployment. These unemployed can now migrate to the horse sector to breed more horses to meet demand at the cost-of-production, and not at auction-house prices. Even more troubling in this horse model is the fact that the final horse prices ultimately sets (imputes) the wages of the horse breeders. Tell that to the factory accountant when he prices out the final cost of an assemble automobile consisting of 14,000 parts.

This sort of intellectual confusion is also reflected in the Austrian School's love for a gold standard. Ask your self the following question. Did China's rise rest on gold or on the power of industrial credit for a growing industrial base? Consider the possibly that in country A it takes 10 hours to extract 1 oz of gold, while in country B a 100 hours. Thus gold was nothing more than an arbitrary domestic scale. The minimum wage definition has effectively replace the role that gold played. Gold did not prevent free trade economic chaos under the Articles of Confederation.

The intellectual skirmishes over QTM have spawned various schools of economics (e.g. Keynesianism, Monetarism), with painfully complex and irrelevant debates over the money supply, money demand, savings, investment, and interest rates. Irrelevant, because as any observer of China can see, its prosperity is not linked to any of these variables, but the simple principle of building and protecting an industrial base.

Though the early schools of economics were built on a labor theory of value (not barter pricing), they were not immune from errors regarding money. To make the case, consider that the classical school's founders Smith (father of free markets) and Ricardo (father of free trade) failed to recognize free trade as the source of England's subsistence wages upon which a flawed labor theory of price was constructed. The intellectual irony that results is nicely illustrated by Smith the father of free markets and capitalism, and the father of anti-capitalism Marx who both built their theories on the very same flawed wage/money model. American protectionists of the 1700 and 1800s were much subtler in their thinking than Smith and recognized that a critical distinction had to be made between free domestic markets and free international mkts. Why? Gut instinct and the school of hard knocks. American protectionist as far as I've been able to determine never make the theoretical connection to money and its domestic implications in terms of economic growth, thus making them vulnerable to flawed free trade theory.

Keynesians, with only one foot still in the neoclassical world, end up praying that stimulus will save the business community. Divide $6 trillion in fed, state, and local annual spending by 115 million full time workers and you get about $52K per worker of "stimulus". Not enough? Well, perhaps the Keynesian multipiler as it miraculously goes to infinity if you don't save will do the trick. Even more troubling, from an engineer's perspective, is Keynes' new interpretation of the classical school's belief of a relationship between investment and saving. Investment as a percentage of GDP, is simply due to the state of technology. It is not as Keynes suggests a function of interest rates and the marginal efficiency of capital. In addition, investment is not the source of instability in an economy as Keynes argue, it is consumption (following wealth destruction). Nor can investment lead an economy out of recession, because business owner investment follows the behavior of the consumer. And finally, if all this was not enough to cause confusion, Keynes failed to understand the implications of investment patterns which follow (trail) 115 million unique consumption patterns. Where do you suggest we invest in such an economic kaleidoscope and how do you distinguish between a business that is slowing down because it is an inferior competitor verses one whose business is slowing down due to a recession? Which of the two should invest? The answer: neither.

Post Keynesians though having made some progress grasping endogenous money (demand drives the level of credit--a form of anti-QTM) and understanding profit as a mark up on costs of production, seem unable to let go of the notion of capitalism as inherently unstable (no guarantee of full employment). Turn this position on its head by arguing that is it precisely domestic money's critical role in a closed economy which gives protectionist capitalism's its stability (speculative busts in real estate aside--this is a problem with human nature, not industrial economy). The stability comes through cost of production and domestic money's role in this process. Only speculative goods such as stocks and real estate bring instability because their pricing is not based on a labor theory of value and can collapse overnight. This is no different if a society decides tomorrow to blow their life savings on a new fad. The mistake is not to separate the two. One is the foundation of economics, the other the noise of an economic system.

So if economics is a science, which science are we talking about? The Marxists, the New Keynesians, the Post-Keynesian, the neo-Keynesians, the Austrians, the neoclassicals, the Monetarists, the New Classical, The Real Business, the classical school, ...well you get the idea. A bit like having 10 different laws of gravity.

What then do we offer as the new law of economic "physics"? The answer: A theory which provides the missing theoretical basis to protectionism (Lincolnomics). A new model of money means simply that protectionism is the only sound theory of economics. The proposition is thus the complete reversal and rejection of QTM, and 200 years of economic thought. The subtle implication of the argument is the belief that a closed nation will drive an economy to full employment in the long run with minimum labor content per industrial good (i.e. its the highest standard of living a nation can achieve given the ingenuity and work ethic of its people). As a result, those who produce the wealth will fully consume the wealth of a nation. The notion of exporting a surplus does not exist in the model (sectors would simply adjust in size instead). Nor is this an attempt to say nation "A" will have a higher standard of living than nation "B" due to the wealth measuring problem. Instead, the model argues a closed economy is the best you can do, because free trade ultimately results in long term unemployment (for the inferior cost competitor), or results in wealth exportation (as the superior nation competitor--e.g. subsistence wages of 1700/1800s Britian).

Super powers grow rich by protecting their industries. Superpowers by definition are industrial power houses. In other words, factories ARE the economy because their long-run productivity gains free up labor for new sector growth. All sectors ultimately depend on the industrial base for their existence (otherwise we'd still be an agricultural society). Destroying the blue collar worker will ultimately destroy the rich because the health of the finance system ultimately relies on wealth production, not vice versa.

Unless we learn the very hard lessons of economic chaos our founding father's had to learn under The Articles of Confederation due to low cost imports from Britain, I suspect more and more businesses will find it very difficult to succeed. Niche markets will remain, but as a whole the outlook will be one of increasing economic dysfunction.

If the Chinese understand the economic wisdom of our founding fathers, maybe it is time we do to.

Additional reads by this author:

Van Geldstone



No kidding, it is almost too late

China has captured so much of U.S. manufacturing one has to wonder if it is even possible to come back. Great article and very glad you shared it with us. So few realize the founding fathers and America itself used tariffs and various measures to gain a trade advantage, which in turn built up America.

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Thank you


Thank you for giving me a chance to post. I think your site is exactly what America needs. This is no longer about theoretical musings, but national survival in my opinion. Nor is it any longer about Left and Right, who both ironically share free trade as a philosophical foundation. In short, fixing America will require us to pull together and recognize my neighbor's prosperity in turn is my own. Several years ago a national reporter took interest in my interpretation of another field of science which sent shock waves through the industry after the story broke (hoping to revive this story again in a much broader scope). Without him, my analysis would have amounted to nothing. So in a like wise manner, without your site, I would not be able to move forward with this discussion. Thank you

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the great come back economy


I can appreciate your pessimism on this matter. But the good news is that that history of American tariffs shows we can come back. We went through repeated cycles of high and low tariffs in 200 years. We came back from the Civil War which some argue was a war over tariffs. Coming back from our present mess is a piece of cake; we can recover fully in 5 years, with a gradual increase in tariffs (want to avoid shock therapy). Don't give up! :) Your site can become the catalyst. All it will take is one national reporter to break a story and grab national attention.

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Perhaps of interest:

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free trade

You covered a lot of territory, any one paragraph is easily worth its own blog. :-)

I have some thoughts on free trade but haven't had time to organize them. Certainly as a practical matter free trade has done the American middle class no favors. Here are a few random thoughts on free trade:

-- agree with MMT that it is foolish to export scarce natural resources in return for little pieces of paper. Better to be an importer of scarce natural resources than an exporter.

-- but -- and here I am in disagreement with MMT -- I see no harm in exporting knowledge products. When you export a knowledge product, you don't lose any knowledge. To the contrary, the more knowledge product you make, the more knowledge you gain. Better to be an exporter of knowledge products than an importer.

-- if you outsource the production of knowledge products, you lose knowledge and the other country gains knowledge.

-- free trade creates a "race to the bottom" where any business that can relocate, has an incentive to relocate to 3rd world countries with cheap labor and few regulations. Effectively, we surrender our national power to regulate commerce.

-- free trade has pretty much killed unions except for public sector and service sector unions that don't have to compete with 3rd world countries.

-- in the long run, market forces may indeed tend to resolve trade imbalances, but in the long run we're all dead. In the short run people get laid off and it's difficult for older workers especially to find new careers.

-- in general, I think trade should be evaluated on a case by case basis, based on whether importing a particular item is in our best interest. I'm inclined to protect our knowledge industries. I wouldn't mind a tariff on manufactured goods. But if some other country wants to give us their scare natural resources in return for our little pieces of paper, I'm probably OK with that.

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free trade


Thank you for the feedback. My argument is really a broad generalization, so your point about case by case issues is well taken. Historically, the rule of thumb was to allow geographically-limited and luxury goods into the country. Of course, there is no obvious theoretical basis for this. My general thinking on "exceptions" at this point remains a work in progress, but the rule of thumb I've set myself is to allow anything which increases the productivity of the industrial sector (e.g. energy products), along with geographically based goods (I don't importing coffee will ruins us). This is based on the idea that the real measure of wealth is in the diversity of industries you have, because the greater the productivity gains (the cheaper the output) the more sectors are generated. So as the number of sectors grow, the richer the country will be (measuring wealth is something Ricardo said was not possible; I agree with him). For example, if it wasn't for the prod gains of the industrial revolution we'd still all be subsistence farmers so to speak (that's one sector instead of 1000s).

I have no objection to exporting knowledge, because protectionism would protect you from any negative wage consequences. For example, if say a cellphone company wants to build a factory in every nation, then all the nation's workers gain from the company's knowledge, while at the same time earning enough to purchase the phones they produce. The only exception that immediately comes to mind are those for national security.

As for market forces resolving trade imbalances, I would argue that it only leads to pointless destruction. An example I have used in my previous writing is a very simple one. Say there are two identical nations side by side, with the exact same national output (standard of living). They are identical in every respect (culture, taste, production). The only difference is the quantity of gold each country posses. Thus they have different price levels, say 10 to 1. If they open to free trade, one nation will be decimated by imports, and the other exports its wealth (cannot fully consume what it produced) resulting in nothing more than inflation. Chaos ensues. The result is destructive for both. Notice gold, like under the Articles of the Confederation, did not prevent ruin, because no one recognizes that gold, like paper money can be nothing more than an "arbitrary scale." Instead, the classical economists made the mistake of treating gold, not as domestic measure, but as supply and demand good (QTM). Economics never recovered from this error in my view.

By MMT, did you mean Modern Monetary Theory?

best regards

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