The officials quoted from Robert Margo’s paper on labour and capital in the South after the Civil War:

Although wages fell in the South, interest rates rose, resulting in a sharp decline in the cost of labour compared to the cost of capital. Simple economic theory predicts that the capital intensity should have decreased in the South in response to this change in relative factor prices. (Historical perspectives on racial economic differences: summary of recent research. NBER Reporter Winter 2004)

In a free market changes in “relative factor prices” alter factor combinations but never the size of the capital stock. The length of the capital structure is determined by the quantity of savings expressed through the rate of interest which is determined by the social rate of time preference. Rather than a rise in the rate of interest reducing the cost of labour in the South, I would suggest that it had more to do with the war-time destruction of massive amounts of capital, just as happened to war-time Japan and Germany. I therefore suggest that the rise in interest rates was a consequence of the war as was the destruction of capital. The case of falling real wages in the South, like that of Japan and Germany, therefore underlines the relationship between the level of real wage rates and the capital structure. This argument leads to the ineluctable conclusion that wage rates do not determine the size of the capital stock.

Let us not forget that at the end of WW II German and Japanese labour were a lot cheaper than American or British labour. Nevertheless, and in defiance of the Treasury paper conclusion, not to mention Davidson’s lamentations about New Zealand wages, these defeated nations went on to quickly accumulate capital and dramatically raise their living standards. Why? Because capital goods raise the marginal productivity of labour. That’s why we invest in tractors, bulldozers, cranes, computers, container ships, forklift trucks, drilling equipment, etc.

Because labour and capital goods are complementary factors this means that if the supply of capital goods increases relative to labour then their prices will fall while labour incomes rise. The reverse is equally true. The treasury paper focused on this process which is illustrated by the following table. It was taken from Samuelson’s Economics (10th, edition 1976, pp. 731-33). I have made several changes. Whereas Samuelson used land as his fixed input I have used capital. In this case production is consists of a single stage at the point of consumption. Capital is homogeneous and consists of 1,000 units equalling 1,000 capitalists. Labour is also treated as homogeneous.

Relation of output to labour and Capital
	1 units of capital	2 man-days of labour	3 output of consumer goods	4 wage in consumer goods per day	5 labour's share of GNP (%)	6 rent in consumer goods per unit of capital
A	1000	500 501	4000   4008	8	100	0
A'	1000	1000 1001	8000   8008	8	100	0
B	1000	3000 3001	20,000 20,005	5	75	5
E	1000	6000 6001	33,600    33,604.2	4.2	75	8.4
Z	1000	8,000 8,001	39,000 39,000	0	0	39

It is clear from the table that the height of real wage rates is determined by the capital-labour ratio. The higher the ratio of capital to labour the higher the real wage rate,¹ and vice versa. As we can see, beyond a certain point the return to labour falls but starts increasing for capital. In other words, the increase in the supply of labour against a given capital structure lowers wage rates relative to the price of capital goods.

In the light of this how can our Treasury officials seriously suggest that a lowering of real wages shortens the capital structure? It’s as if they are treating wage rates as being determined by some yet unidentified force. Their inconsistent treatment of wages reminds me of how Sir Dennis Robertson wittily characterised Keynes’ interest theory:

Thus the rate of interest is what it is because it is expected to become other than it is; if it is not expected to become other than it is, there is nothing left to tell us why it is what it is. The organ which secretes it has become amputated. And yet it somehow still exists — a grin without a cat. (Mr. Keynes and the Rate of Interest in Essays in Monetary Theory, London: P. S. King & Son, 1940).

These treasury officials argue that labour costs have fallen relative to the price of capital goods. I am assuming that they are using an index. The problem with this approach is that it is misleading. Capital cannot be measured. As Professor Ludwig M. Lachman put it:

The root of the trouble is well known: capital resources are heterogeneous. Capital, as distinct from labour and land, lacks a ‘natural’ unit of measurement. While we may add head to head (even woman’s head to man’s head) and acre to acre (possibly weighted by an index of fertility) we cannot add beer barrels to blast furnaces nor trucks to yards of telephone wire. (Ludwig M. Lachman, Capital and Its Structure, Sheed Andrews and McMeel Inc 1978, p.2. There is also Capital Expectations and the Market Process, Sheed Andrews and McMeel Inc, 1977; (Friedrich von Hayek, The Pure Theory of Capital, The University of Chicago Press, 1975; Israel M. Kirzner, An Essay on Capital, Augustus M. Kelley Publisher, 1966)

By heterogeneous Lachman made it clear that he meant heterogeneity in use as well as in the physical sense. So this paper’s figures on capital goods and the capital stock are a statistical fiction. If real wages in New Zealand have been falling then, according to economic theory, investment per head of the working force has declined or the labour force has grown faster then per capita investment. In either case, wages are the factor that is determined, not capital accumulation. To suggest otherwise is to sneak in the Ricardo effect which has it that when real wages rise capitalists substitute machinery for labour, and when real wages fall they substitute labour for machinery.

Note that the Ricardo effect says nothing about what determines height of real wages. Moreover, it ignores the vitally important fact that capital goods must come out of savings. Professor von Mises called the Ricardo effect “one of the worst economic fallacies” and went on to say:

The confusion starts with the misinterpretation of the statement that machinery is “substituted” for labour. What happens is that labour is rendered more efficient by the aid of machinery. The same input of labour leads to a greater quantity or a better quality of products. The employment of machinery itself does not directly result in a reduction of the number of hands employed in the production of the article A concerned. …

The employment of more and better tools is feasible only to the extent that the capital required is available. Saving — that is, a surplus of production over consumption — is the indispensable condition of every further step toward technological improvement. (Ludwig von Mises, Human Action, Henry Regnery Company 1966, p. 774)

Meaning there can be no increase in capital goods without an increase in savings. If a union forces wage rates up and firms try to compensate for these increased labour costs by substituting capital goods for labour, they can only do this by bidding them away from other firms.

So where does this leave the New Zealand situation? More than 30 years ago I developed the idea of what I called the “relative rates of return thesis”. It was my contention that under certain conditions loose monetary policy could lead to excessive expenditure on consumer goods relative to capital goods. This would raise the annual rate of return in the lower stages of production at the expense of the higher stages, eventually resulting in more labour intensive techniques being employed to meet the additional demand for consumer goods and services.

Shortly after considering this possibility I came upon Hayek’s The Ricardo Effect (Profits, Interest and Investment, Augustus M. Kelley Publishers 1975, pp. 8-71). Friends have argued with me that the difference between our approaches is only apparent and amount to a distinction without a difference. But my fundamental disagreement with Hayek rests on the belief that labour would not be substituted for capital, bearing in mind that capital goods make labour more efficient, so long as the necessary savings remained available, irrespective of how high the price of the product was with the respect to the marginal cost of labour.

What might happen is that as labour became more abundant at the lower stages its costs would fall relative the price of its products, thus encouraging an expansion of labour intensive activities without leading to a decline in the demand for capital goods, as suggested by the Ricardo Effect. In this respect my views are much closer to Hayek’s 1929 article The “Paradox” of saving. I think the housing boom could very well be a vivid example of what I am driving at. On 16 June The Economist reported that “Over two-fifths of all private-sector jobs created since 2001 have been in housing-related sectors such as construction, real estate, and mortgage banking”. The housing sector, as any economist should know, is at the consumption stage of production².

Although all my suggestion is highly speculative it ought to direct attention to the role that expansionary monetary policies play in changing the shape of the capital structure. Even those who defend New Zealand’s labour market reforms still remain ignorant of the nature of capital and the fact that money is not neutral. This renders them incapable of effectively dealing with the consequences of monetary disturbances that make themselves felt through the capital structure. Let me briefly return to the ‘economics’ of the anti-market Ken Davidson who kindly informed his readers that

Employers, particularly those with small workforces, have almost as much to fear from the Australian legislation as employees. If bosses have to negotiate wages, instead of accepting the one price standard provided by awards, failure to reach the lowest wage means they could be put out of business by nastier competitors. (The Age, The IR facts behind the PM’s ‘truth’, 14 July 2005)

That brilliant piece of economic analysis was followed by this equally brilliant insight:

And small businesses are price takers rather than setters. They have more to fear from big business than from unions.

The first thing to note is that the statements contradict each other. If small businesses are the price takers he claims them to be then the price of labour will be given to them by market conditions and they will have to pay it or go without. The truth, however, is that firms are not price takers at all. It is true that from the point of view of the single employer factor prices appear to be given. But to accept this as fact is to fall victim to the fallacy of composition. Factor prices, including labour, are in fact determined by the total entrepreneurial demand for factors of production. Furthermore, his assertion that “failure to reach the lowest wage means they could be put out of business by nastier competitors” is pure hogwash and amounts to claiming that marginal productivity theory is fallacious and the laws of supply and demand do not apply to labour. Firms will always bid wages up to the full value of the labourer’s marginal product and no further. No employer needs a unioncrat or a politician or a market-hating journalist to tell him that. As Phillip Henry Wicksteed wrote:

In like manner the individual entrepreneur, if he contemplates taking on or discharging a workman, will ask himself whether that workman will be worth his wage or not, i.e., whether he will increase the product, other factors remaining constant, at least to the extent of his wage; and he will take on more men as long as the last one earns at least as much as his wage, but no longer. The man, on his side, can insist on having as much as the marginal significance of his work, i.e., as much as the difference to the product which the withdrawal of his work would make. (Phillip Henry Wicksteed, Essay on the Co-ordingation of the Laws of Distribution, Macmillan & Co., 1894, p. 9).

So much for Mr. Davidson’s grasp of economic theory and the history of economic thought. As for small businesses having “more to fear from big business than from unions”, try telling that fairy tale to a building contractor who was just made an offer he couldn’t refuse by some union heavies. Then there is Kemalex in Dandenong that recently had its premises ruthlessly picketed for 65 days by the leftwing AUW. No intimidation or thuggish behaviour there, was there Ken? But I guess we should not be too hard on poor old Ken. After all, Labor’s industrial relations spokesman Stephen Smith is saying the same thing. So much for the Labor Party’s understanding of economics.

The annoying thing is that this anti-market nonsense is not being challenged. No wonder some people in the Liberal Party have started pointing fingers. And I for one do not blame them.

1. Many neoclassical economists have assumed that the continuous accumulation of capital eventually results in diminishing returns. This was Paul Krugman’s view on Asian growth, in which he took the process of capital widening, the multiplication of existing capital goods, as given. But as Professor Lachman explained in Capital and Its Structure:

As capital accumulates there takes place a ‘division of capital’, a specialisation of capital items, which enables us to resist the law of diminishing returns. (p. 79).

The upshot of Lachman’s observation is that capital widening is impossible.

2. Even eminent economists have confused durability with capital. First and foremost, capital goods are future goods. This means they are intermediate that goods that are eventually transformed into consumer goods. Put another way, the services of consumer goods are directly consumed while the services of capital goods serve consumers indirectly. According to this definition durability does not define capital goods but the position in the capital structure does.

What is more, the good must be reproducible, i.e., land is not capital. Oddly enough Hayek considers houses to be capital goods “so far as they are non-permanent”. Additionally, “we have to replace them by something if we want to keep our income stream at a given level…” (The Pure Theory of Capital, The University of Chicago Press, 1975, pp. 77-78).

But the same thing can be said of cars, televisions, books, furniture. In fact, just about any household appliance. Huerta De Soto adapts the same approach as Hayek with respect to durability as a definition of a capital good:

Fourth, durable consumer goods satisfy human needs over a very prolonged period of time. Therefore they simultaneously form a part of several stages at once: the final stage of consumption and various preceding stages, according to their duration. (Money, Banking and Credit Cycles, Ludwig von Mises Institute 2002, p. 300)

Gerard Jackson is Brookes’ economics editor

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