The Real Economy

Where it all started ...

I initiated the development of the Real Incomes Approach to economics in June, 1975 in Rio de Janeiro when I made use of the resources at the Getulio Vargas Foundation located in Botafogo. This work was undertaken to analyse the macroeconomic and microeconomic implications of the severe impact of significant rises in international petroleum prices on the Brazilian economy. This started out as an enquiry into why Keynesianism, and the then promoted Monetarism, did not possess policy instruments that resolved the slumpflation of the 1970s (recession combined with inflation and rising unemployment). Indeed, the Keynesian and monetarist solutions imposed a significant level of prejudice on the economic and social constituents before economic "growth" was re-established.

After some 40 years of development effort the Real Incomes Approach has emerged to provide a distinct macroeconomic and microeconomic theory and set of business rules and policy propositions applicable to any economy but with an emphasis on the conditions facing the UK economy. This work advanced at the same time as the so-called supply side approach emerged but it remains distinct from this.

The political kaleidoscope

Many economists and even politicians consider that they have a full appreciation of all that is to know in economics and accordingly there is a cynicism concerning the possibility that someone can discover some "new economic theory" and even more cynicism that there might exist "alternative policies" in a world where leaders repeat the mantra, "There is no alternative!". New theories and policies often emerge, not from fundamental changes in the laws of the universe, but rather from changes, often subtle, in the logic applied to the analysis of well established empirical evidence. The reason such alternative logic is often obscured is that politicians have a tendency to only consider options that align with partisan opinions and, at the same time, other options are proactively excluded. Some economists, hoping to remain in the good graces of politicians, put forward those options that align with their known proclivities. The alternative name for the "dismal science" is, after all, political economy.

A particularly muddled characteristic of discussions on economics, within the UK political arena, has been the association of policies with concepts of the left or right of politics and, of late, the concept that somehow being in the middle ground will help resolve the challenges facing the country. As will be explained the fundamental economic theories and policies advocated by the left and right are flawed so discussions on options never attain acceptable levels of objectivity. The prejudice or benefits accruing to different sections of the constituency become the justification for confrontation so as to never find agreement. The Real Incomes Approach is not predisposed to be coloured by such kaleidoscopes as left or right wing or even centre ground. The approach arises from an analysis of the variables that determine our standard of living and it builds around these determinants an explanation of how to manage economic activities so that all may satisfy their needs.

There are fundamental and specific flaws associated with Keynesianism, monetarism and supply side economics. However, these are compounded by the fact that they all operate within commonly accepted administrative frameworks that undermine effective economic management. These relate to primary assumptions on how we think or what we have been told or taught, as to what motivates people within an economy and how all of this is best administered from the standpoint of government. I set out some of these below.

The profit paradox

One unresolved central problem with pervasive negative impacts on the outcomes of conventional macroeconomic policies is the profit paradox (see The profit paradox). Whereas most consider the profit motive to be a driving force in our economy, the poorly defined role of profits has resulted in decision-making creating sub-optimal resource allocations. This is caused by:

the accountancy regulatory framework
government revenue-seeking

The accountancy regulatory framework

The accountancy framework establishes profits as the measure of a corporate performance, as the target for taxation and categorizes wages as a cost to be constrained in order to secure profits. The profit motive therefore operates within a legal framework that creates conflicting objectives for management decision-making. Objectives that should be mutually reinforcing profits, government revenues and wages are set against one other. The result is the conversion of profits into alternative vehicles to avoid or evade taxation, there is less transparency in profit declarations and wages are constrained. As a result wages and government revenues are declining and there is a failure to invest to secure higher productivity.

The logical conclusion , if the aim is to maximize corporate productivity, is that the accountancy and audit frameworks need to be overhauled or the role of profits needs to be redefined so as to avoid the conflicts described.

Government revenue-seeking

During accounts preparation an important decision-making criterion is the minimization of tax levies across a corporate accounting structure. This work is carried out as an ex-post exercise. In other words accountants end up managing the financial outcomes of past decisions and attempt to remould these with a logic to benefit the company. No matter how well resources allocation is planned during the course of the accounting year there are still, sometimes significant, adjustments made in this ex-post basis of operation. This is extremely inefficient and it makes far more sense to remove considerations of taxation from decision analysis on resource allocation optimization and to reduce ex-post adjustments.

The logical conclusion, if one aims to maximize corporate productivity and efficiency during the accounting year, is that it is preferable to eliminate corporate taxation from the equation.

The decline in currency purchasing power

Monetary policy, for some time now, has considered a 2% inflation rate to represent an acceptable "target" for monetary policy. This target is even called "price stability policy" justified as a policy that provides companies with an adequate level of price stability in expectations and demand forecasts and therefore assisting in production planning. However, a 2% inflation rate is equivalent to a currency devaluation of more than 18% each decade and represents a real incomes depreciation treadmill. This is why the purchasing power of today's pound sterling is less Than 5% of it's value in 1945. The paradoxical associated decline in the UK export performance with First Quarter 2015 having the largest-ever export balance of payments deficit is a stark demonstration that the always promised impact of monetary policy on export performance has never worked on a sustained basis. This is because all major economies have been pursuing the same "beggar thy neighbour" policies of devaluation, in the hope of gaining exports, in an undeclared currency war². It was this behaviour that undermined the Gold standard. Because of this constant devaluation the impact of the profit paradox on wage constraint is exacerbated leading to a relative decline in real wages in comparison with profits as a percentage of GDP. The real purchasing power of government revenues has also declined making effective savings more difficult.

Monetarists often react to the accusation that "price stability" policy in fact creates "instability". The reasons are self-evident. When interest rates are raised to stem inflation the impact is raised investment costs and a fall in demand resulting in less investment in productivity enhancing technologies and human resources capabilities. When the interest rates are reduced there is therefore a significant allocative shift of funds away from the low interest rate currencies into assets, commodities and derivatives resulting in a starvation of funds for investment. There is also a significant decline in demand from sections of the constituency who had depended on fixed income investments that rely on interest rates. Therefore although politicians, and some economists, claim low interest rates encourage demand and investment, the asset-based financialization in fact generates a continued production input inflation that is not reflected in standard inflation indices such as CPI or RPI³. This is one cause of instability and there is an associated instability associated with the asset bubbles, that is, too much money entering asset holdings in the hope of gaining margins on resale. When an asset market is flooded there is invariably a point beyond which confidence in prices evaporates because of saturated demand and therefore a likely decline in prices causing a sell-off with many people left with significant losses. In association with the asset driven markets is the fact that much of the activity is based on debt and if interest rates rise in order to stem the rising inflation a significant range of asset purchasers face a state of affairs where they cannot afford to finance the debt leading to panic selling and a bursting of that specific bubble.

The logical conclusion , if the aim is to maximize corporate productivity, is that monetarism or currency management needs to be overhauled so as to sustain an adequate availability of money, either through profits, self-generated equity or loans at all stages of the business cycle of each company. Monetary management also needs to achieve a fine balance between the currency value, or purchasing power, and productivity.

The weakness of Keynesianism

In 1968 Robin Matthews³ published a paper in the Economic Journal on why Britain had full employment since the war. In this he argued that far from injecting demand into the system, governments in the so-called "Golden Age of Keynesianism" had persistently run large current account surpluses, instead of the budget deficits that would have been the expected manifestation of a Keynesian stimulus. From this he inferred that fiscal policy had been not only deflationary, but strongly so in the post-war period, therefore something other than Keynesian fiscal policy must have been responsible. The answer, he felt, lay in demand arising out of wartime destruction and an unusually prolonged private sector investment boom. I would add that this period included a transition in technological structures based on economic unit level decisions contributing to productivity without the help of Keynesian macroeconomic policies. As can be appreciated the augmentation in microeconomic performance had little connection to macroeconomic policies but relied upon the individual decisions taken at the level of the firm. Therefore like the Quantity Theory of Money (QTM), Keynesianism is not supported by convincing empirical data.

Nicholas Kaldor⁴ made important observations concerning Keynesianism and especially in relation to the theory of economic growth and the theory of distribution both of which find no effective reference within the Keynesian model. Early on Kaldor also developed a growth model which introduced technical progress as a key factor along with investment and savings.

Supply side economics

Evidence of the benefits of stopping supply side economics

The results of stopping the supply side approach, following the Reagan period were explained by Bill Clinton in 2014. See the article,

"Some evidence on the failure of supply side economics",

Essentially, supply side economics isn't really supply side at all but is a centrally-imposed variant on fiscal policy. When I reviewed this approach I realized that it was a fiscal approach that relied upon the same aggregate demand model (ADM) as Keynesianism and Monetarism. The theory is that by reducing the marginal rates of taxation to encourage investment in higher productivity processes leading to unit output cost reductions and a growth in purchasing power and economic growth and falling inflation. The main flaw with this policy is that it provides no sustained motivational incentives nor defined mechanisms for businesses to maintain their growth based on increasing productivity through a process that distributes enhanced real incomes. Because of the profit paradox a bias persists in income distribution favouring corporate ownership. Stated more clearly, as in the case of Keynesianism and monetarism, there was no coherence between business rules and policy objectives. Although the approach is known as supply side economics it does not in fact have much to do with the supply side. Convincing evidence of its validity is sparse. Thus when this was applied under President Reagan the resulting distribution of income was the typical generation of winners, losers and those unaffected. The most notable outcome was the large gains in income experienced by higher income groups and lower gains on the part of low income groups. It also generated the largest US government deficit in history paving way for the Clinton years.

Conventional policy outcomes

The faith placed in the so-called Aggregate Demand Model (ADM) and the indirect and ineffective "management" of the economy through attempts to augment or depress aggregate demand has been shown to be a failure. The long term trend has been for real wages to decline and for profits to rise as a percentage of national income. The outcome has been an evolving cost of living crisis that affects an increasing percentage of the social constituency, now eroding the status of middle income families. Fiscal policy, because of the profit paradox, cannot sustain a positive systems consistency⁵. Under these pressures the meaning and role of profits has become perilously ill-defined and abused culminating in repeated disastrous business, macroeconomic policy and financial intermediation failures in so-called free markets within which economic activities continue to be driven by the "profit motive". As a result the role of profits has become so perverted as to take on the role that provided Karl Marx (1818�1883) with the opportunity to refer to profits as "excess production" robbed from the workers.

Inappropriate solutions to debt

Conventional policies are extremely unadaptable to changing circumstances and this has been highlighted by the financial crisis that started in 2007. An anomaly has been that more attention is being paid to sovereign debt as opposed to private debt which is a significant drag on consumption. The conventional solution to debt has become a matter of adjustments in the balance of national accounts. Thus the policy of "austerity" results in public service provisions being reduced as a result of falling real wages and a lower proportion of people being able to pay tax. The removal of people with lower wages from taxation therefore becomes an essential decision simply because benefits would have to increase if this was not undertaken. Politicians will promote such decisions as a sign of their interest in helping people have higher net incomes but in essence it is an admission that the state of the economy and conventional policies are incapable of guiding the economy towards a state of affairs where wages provide sufficient for a decent standard of living including the ability to contribute to the public purse as well as pay off their own private debt. On the other hand those remaining within taxation categories face declining real incomes if any attempt is made to raise taxation complicating repayment of private debt.

Where there is a question of high levels of private or government debt, the static accountancy solution is transformed into one of stripping the assets of debtors and transferring these to creditors. This occurs both within the cases of private as well as government debt. Cyprus and Greece are examples of this form of static analysis leading to destructive outcomes for all concerned. What is missing is a credible policy that is a debt solution founded on real growth in productivity so as to finance the repayment of debt both in the sovereign and private sectors.

The systemic flaw in conventional economic theory and derived policies

If one cares to review the main contributions to theory and policy for Keynesianism, monetarism and supply side it becomes evident that no account is taken of the role of technology, learning, evolution in human technique, tacit knowledge, explicit knowledge and innovation (See: Tacit & explicit knowledge). This is an extraordinary state of affairs when one considers the first industrial revolution took place in the United Kingdom. Some 60% of economic growth is the result of learning and changes in technology, technique or more generally innovation. Indeed, in any particular state of any economy be these high levels of debt and deficit, inflation or deflation, high unemployment or even low unemployment, the evolution in productivity remains an imperative to afford sustained and improving standards of living. The failure to provide useful guidance on how to secure adequate growth in productivity and efficiency is a serious systemic weakness in all conventional theories and their derived policies.

Adam Smith (1723-1790) did express the significance of refinement in technique and innovation depending upon the wit of the individual innovator. In Smith's time the only government revenue based on tax was the windows tax amounting to a range peaking at �50 per annum (in 2015 terms). William Pitt the Younger introduced income tax in 1798, after Smith's death, to support the Napoleonic War and this was equivalent, to a levy of 2% to 10 % according to income. Also the legal accountancy framework taken for granted today did not exist during Smith's time. It is therefore not surprising that the economist most in tune with the impact and importance of innovation would not have been aware of the possibility of the negative impacts of the profit paradox. This became a more significant issue with the growth in formal legally-based accountancy frameworks, corporate and personal taxation and other levies that significantly increased during the 20th Century peaking at around 45% of GDP in the last decade and now being around 40% of GDP. This has resulted in the impact of the profit paradox being of major significance.

Telesis, the required state of the economy

Telesis is the steady progress towards an objective secured through careful planning and the intelligent use of resources. Under all economic circumstances the universal requirement is the maintenance of growth based on a gradual rise in productivity. However, growth needs to be real growth and not nominal growth that is undermined by inflation, taxation or high interest rates. Stated more clearly the basic requirement is growth in real incomes which also means securing a stable currency value.

The Real Incomes Approach to economics places an emphasis on the maintenance or growth in real incomes of corporate ownership, shareholders, managers and employees through policy instruments that ensure that the general purchasing power of the currency is also maintained or increased. Unlike monetary theory, the Real Incomes Approach provides a transparent explanation for the causes of inflation and deflation in terms of corporate motivations and decision-making on prices and provides a rational explanation of how increases in productivity can be expressed directly in prices and therefore in terms of the real incomes of producers and consumers.

Solving the profit paradox

In May, 1983 Peter F. Drucker⁶ published an important article in Forbes Magazine entitled, "Schumpeter & Keynes". In this article Drucker describes Joseph Schumpeter's⁷ view on the role of profits as the foundation or guarantee of future activities and employment. The significance of this view arises from the fact that Schumpeter's role for profits, bears little relationship to their currently perceived role but, in my view, it presents a key to straight thinking; an imperative. By limiting the role of profits to that identified by Schumpeter it is possible to alter the accountancy norms so as to terminate the contention between business success and wages as well as to ensure government revenue rises to realistic levels. At the same time the notion of profits being the Marxian "excess production" robbed from the workers becomes invalid. So it becomes evident that the beneficial solutions lie outside the scope of current application of conventional policies whose muddled practice and outcomes continue to be championed by the British political parties of all colours.

The Real Incomes Approach

The Real Incomes Approach is more directly and practically concerned with supply side management, not at the market level but rather at the level of each economic unit. It is designed to bring decision-making and business rules at the level of the firm into a direct alignment with macroeconomic objectives.

The overall objective of the Real Incomes Approach is the maintenance or increase in the real incomes of corporate ownership, shareholders and all classes of employees. This is achieved by altering the accounting item categories by substituting profit by direct investment in performance enhancing technology and human resources. In terms of corporate returns the profit category is substituted by real incomes of all associated with the company. All government revenue-seeking related to taxation is eliminated from the corporate domain. These two steps eliminate the allocative contentions arising from the profit paradox.

One policy option under the Real Incomes Approach is Price performance Policy (PPP). Here the policy is not concerned with raising government revenue directly from corporate activities. However, a productivity incentive levy (Price Performance Levy (PPL)) is applied to margins. The size of the levy is inversely proportional to the price performance ratio (PPR) achieved by each company. The PPR is the ratio of the change in unit output prices to changes in unit input costs with low values (<1.00) signifying reduction in inflation and higher values (>1.00) signifying augmentation in inflation (see Solving the Price Performance Ratio puzzle). The effect of this levy is to compensate companies that increase productivity expressed in terms of unit prices with the payment of a lower levy. In fact management can allocate resources so as to avoid paying any levy at all if they achieve a genuine enhanced productivity expressed as stable or reduced output unit prices. The reduction in the levy is paid as a bonus to all associated with a company in proportion to their ownership stakes or level of standard career structure wage scales. Companies paying higher bonuses will be those that are achieving stable or reduced unit output prices. The outcome is enhanced real incomes of customers as well as those associated with the more effective company operations. An important associated impact is that the overall purchasing power of the currency rises while inflation is controlled. Unlike conventional policies this is not imposed indirectly through "demand management" but is a direct result of economic unit price controls based on enhanced innovation and productivity arising from management decision-making at the level of each economic unit.

Consumption and "demand"

The Real Incomes Approach does not make use of the Aggregate Demand Model (ADM) that underlies Keynesianism, monetarism and supply side economics but rather applies a supply side Production Accessibility Consumption Model (PACM). In this model competitively priced production that is associated with accessible information, local delivery and prices will gain from increased consumption. The actual growth in consumption will depend upon the price elasticity of consumption (pEc) which will depend upon relative competing prices of equivalent products. Where lower-priced output substitutes higher-priced items growth in consumption will be associated with higher purchasing power of the currency due to lower unit prices. In terms of exports, the pEc will depend upon the exchange rate against the currencies used by the customers. The growth in exports will depend upon unit prices being set at a level that generates growth and income and this can be enhanced by increased productivity. Therefore augmenting income through exports is not primarily dependent upon devaluation but is achieved as a result of a balance between exchange rates and the productivity of economic units involved in exports. The PACM analysis provides a more transparent cause and effect relationship between productivity, unit prices, consumption, real incomes and currency value.

Productivity and growth

The most significant gap in conventional economic theory and practice is the lack of a practical acknowledgement of the major contribution of learning to growth in the economy. The Real Incomes Approach substitutes profits by investment in productivity enhancing technologies and human resources. The price performance ratio can be altered by adding or reducing costs through investment rather than responding only to unit input cost variations. Thus management has a wider range of degrees of freedom to enhance productivity. In this context the role of internally generated performance arising from refinements in human technique as a result of learning (learning curve). The most significant contribution to human technique is the accumulation of tacit knowledge⁸ by each person working in a company. It is often that case that gains in productivity arising from tacit knowledge are not always identified nor acknowledged with companies assuming productivity comes exclusively from investment in hardware. Tacit knowledge is a uniquely individual capability that develops with experience and this is why such efficiency needs to be reflected in terms of the monetary compensation of different individuals according to their contribution to performance. The contribution of tacit knowledge to productivity is significant and there is a gap in management practice with a failure to measure the project unit costs, and therefore feasible output prices, based upon the contribution of this factor. Indeed, much successful innovation is the result of the human resources of a company performing at the leading edge of productivity and there being realizations that methods can be improved by changing internal organization to take full advantage of tacit knowledge as well as explicit knowledge⁶ on technology and systems in increasing general performance.

Resources allocation

By eliminating the profit paradox the full benefits of existing resource allocation methods, including advanced operation research methods, can be applied free from conflicting decision-analysis criteria resulting in the attainment of productivity levels that would not be possible under conventional policies or administrative frameworks.

Accounts

The accounting structure would be changed from the following accounting categories:

Corporate revenue from sales
Income of individuals associated with the company
Current operational costs

Cash
Assets
Profit

The profit category would be re-defined as exclusively investments in technology and people (in the Schumpeterian sense) producing the following accounting categories:

Corporate revenue from sales
Income of individuals associated with the company
Current operational costs

Cash
Assets
Investment in technology
Investment in human resources

Government revenues

On the basis of a more effective constitutional structure all government revenues need to be generated by those of the social constituency in the form of personal income tax. This transformation simply means that the sums previously paid out in the form of various business taxes including corporation tax are embedded in standard career structure salaries paid to employed working owners and employees. Income tax on shareholder incomes would be administered in the same way.

Public services

The Real Incomes Approach advocates the application of the Real Incomes Approach in the form of a Price Performance Policy to all public services with salaries becoming subject to the same performance based payments as the private sector. The outcome would be higher levels of real growth and more efficient use of public revenues resulting from price containment in the provision of public services. The long term impact would be a reduction in the proportion of GNP allocated to public services and or government revenues.

¹ Hector McNeill is director of SEEL-Systems Engineering Economics Lab.
² Rickards, J., "Currency Wars - The making of the next global crisis", Penguin, 2011.
³ RPI - Retail Price Index; CPI - Consumer Price Index.
⁴ Robin Matthews (1927 - 2010) was an Oxford-educated economist who spent most of his academic career as a member of the Cambridge Faculty from the early 1950s onwards. In 1980, he succeeded Brian Reddaway as Professor of Political Economy. He was eager to ensure that undergraduates should be exposed to all schools of thought, even with those with which he disagreed.
⁵ Nicholas Kaldor (1908�1986) - was a Hungarian, Cambridge economist in the post-war period. He was born in Budapest and became professor of economics at Cambridge in 1966. The best reference covering the citations used in this interview article is Isa., Jan, "Nicholas Kaldor - One of the First Critics of Monetarism", BIATEC, Volume XIV, 12/2006 (Narodna Banka Slovenska).
⁶ Peter Drucker (1909�2005) - was an Austrian born American business management consultant.
⁷ Joseph Schumpeter (1883�1950) - was an Austrian born American political economist.
⁸ Explicit Knowledge - is the communication and information used to describe things, data and is easily passed on in the form of instructions. Tacit Knowledge - is a mental and physical capability that is developed on the basis of an accumulation of practice in the application of specific mental and physical tachniques. It is associated with the the development of refined skills in carrying out tasks. Unlike explicit knowledge that can be used to provide instructions and explanations, tacit knowledge cannot be taught but can only be acquired on the basis of learning by doing and each individual has a different capability to benefit from such exposure thgrough experience. The process of acquisition of tacit knowledge is also referred to as the learning curve.

All content on this site is subject to Copyright
All copyright is held by © Hector Wetherell McNeill (1975-2015) unless otherwise indicated