The most fundamental pillar of the modern-day “text-book economics” is the Law of Equilibrium that tells us that in “normal circumstances” a capitalist economy remains in equilibrium. In other words, the law of equilibrium asserts that whatever is produced in a capitalist economy can get sold/bought in that economy itself. The genesis of this “equilibrium theory” is Say’s Law i.e. “supply creates its own demand”. The Say’s Law assumes that the process of producing commodities creates a purchasing power in the economy which is equivalent to “value” (i.e. the selling price) of the total output of the economy. That is why, according to Say, the capitalist economy remains in equilibrium. The Say’s law is the “classical economics version” of equilibrium theory; there is a “neoclassical economics version” of equilibrium theory as well. According to the neoclassical version, it is the interplay of law of “supply & demand” that keeps the economy in equilibrium through the mechanism of “price-level adjustment”. In other words, the neoclassical economics assumes that even if there is any disbalance between “purchasing power” (i.e. demand) and “value of output” (i.e. supply) the mechanism of price level adjustment restores the “equilibrium” in capitalist economy.
All the major and minor schools of economics i.e. Classical, Neo-classical, Supply side, Austrian, Monetary (Milton Friedman version), Keynesianism and Marxism etc. believe in this “equilibrium" theory. There is a minor difference between Keynesianism & Marxism and other theories. While other theories believe that a capitalist economy necessarily remains in equilibrium, the Keynesian and Marxist theory believes that capitalist economy mostly remains in equilibrium but sometimes, due to some structural imbalances and realignment of various factors, the equilibrium fails.
As we will see later during the course of this article as to how absurd this equilibrium theory is, but despite this we tend to naturally believe it. The primary factor, that makes us believe this so-called equilibrium theory is not any “logic” or “reasoning” but our in-build understanding of an economic system. So, what is our “in-build understanding” of any economic system? When it comes to “economic system” we think that it is basically a process of “production and mutual exchange” of various commodities among the producers. Of course, such a process of “production and mutual exchange of commodities” is bound to be in equilibrium and even if there is any temporary disturbance, sooner or later, it will bounce back to equilibrium.
Although there is absolutely nothing wrong with above hypotheses/assumption as such but what we don’t realize is that this hypotheses/assumption of “equilibrium” holds good only for a pre-industrial era village/cottage economy; it doesn’t apply to modern day capitalistic production system which is a different ball game altogether. In other words, the “law of equilibrium” holds good in a pre (non) industrial village cottage economy only; it fails in modern industrial capitalist system. One can wonder as to why it is so? It is so because capitalism is NOT about production and exchange of various commodities among the producers. So, what capitalism is about? In order to understand it properly we will first try to understand as to what is the fundamental difference between a pre-industrial/non-industrial village economy and a modern-day industrial capitalistic economic system.
1— Pre-industrial era village/cottage economy
To understand the pre-industrial village economy let us first assume a village, comprising many producers of various types of commodities. A pre-industrial “village economy” is basically a set/group of many producers who produce and exchange goods & services among themselves. In such type of economic system, a producer produces a particular commodity; keep a certain portion of it for his own personal consumption and exchange remaining part (i.e. the excess production) with other producers of the village economy. For example, if a weaver produces 100 meters of cloths then he will keep say, 10 meters of it for his own personal use/consumption and will exchange the remaining 90 meters (i.e. the excess production) with other producers of his society. In fact, not only this weaver, every other producer of this economy does the same; keeping a certain portion of his production for his own personal consumption and exchanging the remaining (i.e. the excess production) with other producers of system. This exchange can happen either in barter system or through money. In fact, this type of pre-industrial village based economic system was/is the true open/free market economic system.
Above illustration of market economy is basically that of a “non-industrial village/town economy”. In this economy the production units are basically the families (or individuals) and the “exchange value of their output” is more or less equivalent to their “consumption capacity” (or need). The “exchange value of the output” is the “basket of commodities” that any family/individual end up with after exchanging his excess production with other producers of society. For example, the weaver family produces 100 meters of cloths and after keeping 10 meters for its own personal consumption it exchanges the remaining 90 meters with other producers of society like farmer, potter, cobbler, milkman, carpenter etc. in exchange for food, pots, shoes, milk etc. Therefore the “basket of commodities” that this weaver will end up with is the (1) commodities he will get in exchange for his 90-meter cloths plus (2) 10 meters of cloths that he kept for himself. Similar will be the case with other producers of society.
In other words, the weaver family ended up consuming goods/services worth 100 meters of cloths (i.e. their output) without being left with any “unconsumed surplus” of cloths. The situation is same for each and every production units (i.e. family) of this economic system i.e. every potter, milkman, barber etc. end up consuming goods/services equivalent to exchange value of its output.
For the sake of simplicity, in above example, we have not taken into account the act of “savings” by people. But even if we take that into account and assume that all the people save something in form of money (normally, even in a village economy like this, people save in form of money only because commodities—being perishable in nature—cannot be kept stored for very long; whereas money can be stored for any length of time), the situation will not change. People save money in order to spend it on occasion of any festivity or contingency (like marriages in family, any socio-religious festival etc.) and when that occasion presents itself people spend their accumulated savings. After spending their previously accumulated savings, people start saving again, only to spend the same in future. In other words, in this type of economy hardly anyone is a “perennial saver” or “perennial accumulator of money”. Therefore, what comes out of this analysis is that—over a period of time—whatever is produced in the society is consumed by the society; hence there is no perennial/perpetual accumulation of money by anybody in the economy.
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The basic essence and the objective of this economy is to produce and exchange various goods/services among one another to meet their consumption needs. The most important feature of this economy is that in this system the production units (i.e. families/individuals) end up consuming goods/services equivalent to “exchange value” of their output. Why this is so important a feature of this economy will become clear in following pages. This is also the example of an economy in equilibrium because whatever is produced in the economy gets consumed within the economic system itself; it doesn’t require an “external market”.
Secondly, this economy can function at of any level of money-supply i.e. the level of money-supply is immaterial for this economy because this economy can adjust itself to any level of money supply.
2A. Industrial Capitalism (In Barter System)
We (are made to) think that modern day industrial-capitalism too is very much like the economic system described above whose basic theme is mutual exchange of commodities (goods & services) among the producers. But it is not the case at all, capitalism is NOT about mutual exchange of commodities; let us understand it somewhat deeply.
In the village economic system described above, the workers as well as the owners of production units are the “same set of people” i.e. the family members (or individuals) and they “own” the entire production. But in capitalism the workers and owners are “different set of people” and they share the output of the economy on different principles. In capitalist economy, what workers gets as their share of output is known as the “wages & salaries” and the share of industrialists/capitalists is known as the “surplus production” (which is considered as their profit). Surplus production is that part of the output that remains with industrialists after giving the dues of the workers (in form of wages and salaries). It is this aspect of capitalism that differentiates it from the pre-industrial village economy discussed above. For the sake of simplicity, we will first try to understand the capitalism in barter system and thereafter, in monetary system.
To understand this, let us assume a capitalist economy functioning in barter system. In this case, the wages and salaries to industrial workers are given in form of commodities that their employer firm produces; for example, the workers of a textile mill get their wages & salaries in form of cloths, a crockery producer gives his employees crockery as wages & salaries, a soap cake producers gives soap-cakes as salary/wages and so on. For the sake of simplicity let us assume that wages pay-out ratio is 80% of output uniformly across the economy i.e. 80% of the output of each firm is given as wages & salaries to its employees. The remaining 20% of the output is owned by the owners of the industries i.e. by the capitalists (or industrialists) as their “surplus production”.
Now we can think of this capitalist economy as a “two tier economy”; one comprising of industrial workers who are given 80% of output and other comprising capitalists/industrialists who own the remaining 20% of output. After getting their share of output the industrial workers “exchange” it among one another and end up with a “basket of commodities” that comprise almost all types of commodities produced in that economy. Similarly, the industrialists too exchange their share of output among one another. However, in a capitalist economy, the industrial workers are quite large in absolute numbers and their share of output (i.e. 80% of output) is distributed among very-very high number of people i.e. it is very thinly distributed over a very large number of people. In other words, average per head wages/salaries are not very high.
Therefore, after exchanging his wages with workers of other industries an average industrial worker ends up with a “basket of commodities” that is well within his consumption capacity i.e. he will/can end up consuming the entire basket of commodities he receives as exchange value of his wages/salary. (In this case too we have ignored the savings of individual workers since—like in above case—it will not affect the overall analysis). The crux of the issue is that the portion of output given as wages & salaries to industrial workers gets consumed by them.
But what about the share of industrialists (or capitalists)? Although capitalists/industrialists get only 20% of output as their share but since they are basically the individuals i.e. very few in absolute numbers (in comparison to number of workers); therefore the “per capita profit or surplus production” that an “individual capitalist/industrialist” get as his share of output is thousands of time more than “per capita wages”.
Therefore, the per capita “basket of commodities” that an average industrialist will end up with (after exchanging his goods with fellow industrialists) will also be thousands of times more than that of an average industrial worker. But the important question here is whether an average capitalist (or industrialist) can consume (along with his family) thousands of times more goods/commodities than an average industrial worker can consume? Obviously, it is impossible. Even if capitalists are to live an extremely lavish life, it is impossible for them to consume thousands of times more goods/services than an average industrial worker; it is simply impossible.
In fact, the capitalists will keep accumulating huge volumes of “surplus production” in every production cycle that they cannot consume! Over a period of time, the surplus of commodities accumulated by them will simply get rotten and emaciated without benefitting anyone; there is no point in keep accumulating the commodities ad-infinitum. Now we can clearly see as to why the capitalism is not like the open market village/town economy discussed above. In the open market village economy, no producer was left with any “forced unconsumed surplus” but in capitalist economy every producer (i.e. capitalist) is left with a “forced & extremely huge unconsumed surplus” (in each production cycle) which cannot be consumed by him even if he wishes so. Important thing to note here is that whereas the industrial workers’ share of the output (i.e. wages/salaries) is “fully consumed” by them but the industrialists’ share of the output (i.e. surplus production) is not consumed by them. This “unconsumed surplus” is not voluntary instead it is compulsive because industrialists cannot consume this “surplus” even if they wish so.
So, what the capitalists would do with their “surplus production” if they cannot consume it? What is its utility for them? If it is not of any utility for them why would they continue with the production? Will they not be better off by closing their factories/industries?
Although, our text-books hush-up any further discussion on this issue by considering this “surplus production” as the “profit” of the capitalists but this is an absurd notion of profit. This surplus production becomes the profit of industrialists only when it is converted into money. For capitalists and capitalism, the only thing that matters is monetary profit not the accumulation of surplus production in form of good/services (moreover, you can accumulate the goods; how can you ever accumulate services?). If the surplus production in form of goods/services could be considered as profit then no industry would have ever incurred any loss and every capitalist will make profit even without selling his goods; just by accumulating the stock of finished goods in his inventory (and by exchanging it among one another!)! What is interesting is the fact that our economics text-books stop the analysis of capitalism on this point itself i.e. just by assuming surplus production as profit of industries (as we will see later that it is by design, not by any mistake/omission). Whereas, in reality, the profit of industries is “surplus production converted into money” and understanding the process of conversion of surplus production into money is of “central importance” if one is to understand the functioning of modern capitalist economic system. This, we will do shortly.
If you have got to the gist of the issue then you might have understood as to why capitalism cannot work in barter system even theoretically; because it is the “monetary profit” of the capitalist which is the crux and driving force of capitalism. Not only this, almost all the problems that capitalism has encountered so far have been but the various variants of this issue (i.e. conversion of surplus production into money) only. Therefore, to fully understand the intricacies of capitalist system we will have to analyse it in monetary environment. However, before analyzing the capitalism in monetary environment we can draw some useful conclusion from the above analysis.
· Whereas the ultimate aim of a non-industrial village economy is production and mutual exchange of goods/services, the ultimate aim of capitalist system is conversion of “surplus production” into money.
· Whereas a non-industrial village economy can adjust itself to any level of money supply, the capitalist economy needs ever increasing money supply to sustain itself. It is so because a capitalist economy keeps accumulating the “surplus production” in each production cycle and all of this needs to keep getting converted into money.
The moment the process of conversion of surplus production into money stops the capitalist economy runs into trouble i.e. it starts incurring losses. In fact, the incurring of loss by any industrial firm of a capitalist economy is nothing but the very incident of non-conversion of its surplus production into money. If industrial firms start incurring continuous losses, they will stop further operations and will close down their production units and will lay off their employees.
Now it is apparent that in capitalist system the livelihood of people (i.e. of industrial workers) is contingent upon profit making by industrial firms! In capitalist economies a vast section of population gets their livelihood in form of wages & salaries from industrial firms. Not only this, even those section of population who do not get their livelihood directly from industrial firms (i.e. in form of wages and salaries from industrial firms) are indirectly dependent on wages and salaries from industrial firms only. For example, doctors, lawyers, school teachers, cab-drivers, local plumber & technician, various kind of other domestic utility services providers etc. (whom we loosely call unorganized sector) draw almost their entire income by providing the services to wages and salary earners of industrial organized sector. In other words, the income of unorganized sector is almost entirely dependent on employees of industrial firms. If the livelihood of wages & salary earners from the industries is stopped, so will be the livelihood of these section of people. If the industrial firms keep making profit people keep getting their livelihood but if the firms start incurring continuous losses, they will stop their production and lay-off their workers; thus, the livelihood of people stops because industrial firms are not making profit.
3. How the Capitalist System Makes the Profit
From the above analysis it is clear that in “normal circumstances” a capitalist economy cannot make any profit because all their production cannot be “bought back” by the wages and salaries. Although a complete analysis of capitalism in “monetary environment” has been done later it in this paper but to explain the issue in a better way we are, very briefly though, doing it here. In above example we have assumed that wages payout ratio is 80% i.e. 80% of output is given as wages and salaries to industrial workers. If we translate this assumption into “real-life money wages scenario” it means that industrial firms give only that much of “money wages” to their employees which is sufficient to buy-back 80% of the output of the economy; the remaining 20% of production remains unsold. In other words, the firms seek a 25% profit on their cost of production i.e. if the cost of production of any commodity is Rs.80 they will sell it for Rs.100. Therefore, even in the most ideal condition (i.e. when the people are not saving anything and are spending all their income in buying the goods/services) the industrial firms can achieve, at most, a no-profit/no-loss scenario only i.e. they will end up recovering their “cost of production” only. Under no circumstances whatsoever can the industrial firms (as a whole) make any profit at all. But even the no-profit/no-loss situation is achieved in “most ideal/optimistic conditions” only, in normal real-life scenario industrial firms are bound to be in heavy losses (on account of saving by the people and intermediary stages profits; but these issues will be fully explained when we understand the capitalism in a monetary environment).
To put it in simple words, if the total output of any capitalist economy i.e. the selling price of entire output (of consumer goods & services) of economy put together is Rs.1000 then the total demand (or total purchase of commodities) of the economy will be not be more than Rs.500/600; thus leaving the economy (i.e. its industrial firms) in deep losses and it will be a permanent state of affairs. Therefore, the profit making in capitalism is a theoretical impossibility i.e. capitalism becomes a non-starter from day one. Yet, we see that capitalist economic system is making continuous profit since last 250 years or so! One can wonder as to how a situation of theoretical impossibility is getting defied so contemptuously & derisively? How such a magic is happening in real world? In short, how the capitalist economic system works?
However before going to that we will first try to understand the industrial capitalism is a “real life monetary wages system”.
Industrial Capitalism in Monetary Environment
In our prevailing wisdom we (are made to) think that in “normal circumstances” the capitalist economy too—like the pre-industrial village economy—remains in “equilibrium”. It means that the “income” or the “purchasing power” of a capitalist economy as whole is equal to the “value of the total output” of the economy therefore all the output of the capitalist economy can be bought/sold “within” the economic system itself.
So, we (are made to) assume that “in normal circumstances” capitalist economy remains in equilibrium. Now we will see as to how bogus this “equilibrium” theorem is. In fact, we have already gotten a hint of it while analyzing the capitalism in barter system; but now we will understand the same in monetary system. To understand this point we will take a capitalist economy with following three assumptions; but these assumptions will be relaxed later on for further analysis.
· This capitalist economy consists of only the consumer goods industries and these industries themselves produce & manufacture all the capital goods, raw materials and auxiliary/ancillary goods required by them. In other words, entire production of every industrial firm of the economy is totally in-house and they do not buy anything from “outside”. Therefore, for any/every firm, the only component of the “cost of production” is wages & salaries to its employees.
· It is a 100% corporatized economy with no “unorganized” sector. In other words, all the work force of the economy is in corporate sector only and the only source of “income” or “purchasing power” in this economy is the wages & salaries from industries. Therefore, the maximum/total possible purchasing power of this economy is nothing but the total income of industrial workers put together (since there is no unorganized sector).
· There is no government and hence no taxes.
Now consider a firm M/s ABC in business of producing, say, “soap cakes” and suppose it produces 100000 soap cakes per month and the total “cost of production” is Rs.1000000 i.e. Rs.10 per soap cake. Since the entire production is in-house one therefore the firm ABC itself produces all the raw materials, intermediary goods & services, chemicals, machineries and capital goods (that are needed for producing soap cakes) and do not buy anything from outside. Therefore, the only component of the “cost of production” for the firm is wages & salaries to its workers/employees (since it produces everything in-house). Hence total wages & salaries received by the workers of this firm is Rs.1000000 only. Therefore, it is clear that the total purchasing power (or income) generated by firm M/s ABC in the economy is nothing but its “cost of production” only (i.e. Rs.1000000 in this case). In fact, the same is true for every industrial firm of this economy not only the firm ABC alone i.e. “purchasing power” generated by any industrial firm in this economy is nothing but its own “cost of production” only; irrespective of (1) what product it makes, (2) what is the volume of production, (3) what is the profit margin that it seeks, (4) what technology it uses etc.
In other words, every cloth producing firm, every shoe producing firm, every cement producing firm etc. generates the purchasing power equivalent to its own cost of production only. Therefore, the aggregate purchasing power (or income) of the economy as whole is nothing but the cost of production of aggregate output of the economy as whole. Therefore, it is obvious that the aggregate demand of all the firms of the economy put together is simply the sum of the income of all the employees of all the firms of economy put together which, in turn, is equal to cost of production of aggregate output of the economy.
Therefore, quite obviously, the maximum sales revenue that capitalist economy as whole (i.e. all the firms of the economy put together) can generate is nothing but the cost of production of aggregate output of the economy itself i.e. the break-even (i.e. no-profit/no-loss) situation. Even the no-profit/no-loss (i.e. break-even) situation will be achieved only when the employees do not save anything at all and spend all their wages/salaries in buying the goods/services produced in economy! However, it may well be the case that some firms of economy may end up making some profit but, in that case, the remaining firms of economy will incur equivalent amount of loss. Therefore overall, even in the best-case scenario (i.e. when no one saves anything), the economy will not make any profit. It is re-emphasized that economy will achieve even the no-profit/no-loss situation only when people (i.e. the employees of the firms) do not save anything at all; if they start saving something (that they invariably do) the economy will invariably go in overall loss!
To keep the parity of 80% payout ratio (as was the case in our barter example above) the industries of this economy will have to seek a profit of 25% on the cost of production i.e. if cost of production of any commodity is Rs.100 then its selling price should be Rs.125. In other words, when industries sell their goods at 25% higher than their cost of production then wages-payout ratio of the economy will be 80% i.e. industrial workers will be able to buy 80% of the total output of the economy from their wages/salaries (as in barter system above). Now we can clearly see that industrial workers, even if they don’t save anything, cannot buy more than 80% of the output of this economy and at this level of sales the economy as whole will be in no-profit/no-loss situation. This leaves the economy with 20% of its output (i.e. its surplus production) unsold. So, how can this capitalist economy make any profit?
The only way it can make any profit is by selling its “surplus production” to an external economy i.e. to people other than its own employees (or factor of production). Therefore, it is very clear that as long as a capitalist economy sells its output “within” its own economic system it cannot make any profit, in fact it will invariably remain in loss on account of savings. But our mainstream economic theories assume otherwise; they assume (they never prove) that a capitalist economy can sell all its output within the economic system itself. However, we will come to it later; first we will relax the assumptions.
Relaxing the Assumptions
In the beginning we had made two crucial assumptions (1) the entire production by each firm is in-house i.e. no firm buys anything from outside and the only component of the cost of production is the wages & salaries and (2) no unorganized sector in economy i.e. all the work force of the economy is in corporate sector only and the industrial workers being the only consumers in the economy. Now we will relax both these assumptions one by one and will see that what happens then.
(A) Entire Production Process Being the In-House One
Now we relax the first assumption i.e. the firms do not buy anything from outside and make everything in-house. In this case the firms would be buying/selling many a thing among one another. How will it change the overall situation? Let us understand it in some detail.
In any industrial economy, there are basically two types of industrial firms (1) capital goods & auxiliary/ancillary industries and (2) consumer goods industries. Capital goods & auxiliary industries produce industrial plants & machineries, raw materials, power & fuel; provide various types of auxiliary & consultancy services like transportation, data management, accounting services etc. The consumer goods industries produce the final product of the economy i.e. the consumer goods. One important thing to understand here is that workers of capital & auxiliary goods industries (like the workers of consumer goods industries) buy the consumer goods only; not the capital & auxiliary goods because they have no utility for them. The capital and auxiliary goods are bought by the “industries” only not by the “workers”; the “workers” buy only the consumer goods.
When everything was produced in-house by consumer goods industries itself then entire work-force of economy was employed in consumer goods industries only; but now a portion of the work force will shift from consumer goods industries to capital goods industries. Here, we can safely assume that workers who produced capital & auxiliary goods during their employment in consumer goods industries get shifted to capital & auxiliary goods industries and they shifted at same wages rate (even the change in wages rate makes no difference but this assumption is for the sake of analytical ease only). Since the wages rate is same therefore the cost of production of capital & auxiliary goods in these new industries is the same when these items were produced by the consumer goods industries themselves.
Now, the consumer goods industries buy their raw materials, plants & machineries etc. from newly established capital & auxiliary goods industries. If the capital & auxiliary goods industries sell their output to consumer goods industries without booking any profit, then there is no change in final outcome; everything remains the same. The total purchasing power (or income) generated in economy is exactly the same as it was before since there is no change in wages rate. Similarly, the “cost of production” of the final output of economy (i.e. consumer goods) also remains the same. Therefore, in this case too, the economy, as whole, can generate the maximum sales revenue equivalent to its cost of production i.e. no profit/no-loss situation.
But what will be the situation when capital & auxiliary goods industries book their profit? In that case the cost of production of consumer goods increases by the amount of profit of capital & auxiliary goods industries because the price at which consumer goods industries would buy the capital & auxiliary goods will also include the “profit” of these firms. But the purchasing power of the economy remains the same; because the income of industrial workers remains the same. However, there is one “additional income” in the economy as well—the “profit of capital/auxiliary goods capitalists” (or industrialists) and if we club this profit with the wages/salaries of the industrial workers then, once again, the cost of production of “consumer goods” becomes equivalent to the total income of the economy. But the important point to consider is whether capital/auxiliary goods industrialists spend all their profit in buying the consumer goods? Needless to say, that it is not the case at all; in fact, the industrialists provide for their personal expenditure by drawing salaries & other remunerations from their firm’s accounts by charging the firm’s expenses account. Therefore, the personal expenses of all the industrialists are already covered in cost of production; the profit is hardly, if at all, used for personal consumption of capitalists/industrialists. Let us understand it through an example,
Suppose that total cost of production of “all the consumer goods” of an industrial economy is say, Rs.10000000. Out of this say Rs.5000000 are spent on buying the goods from capital/auxiliary goods industries (plant & machinery, raw materials, power, fuel etc.) and remaining amount of Rs.5000000 are spent on wages/salaries to the workers/employees of the consumer goods. Here, the capital goods industries have earned revenue of Rs.5000000 and this includes the profit of capital/auxiliary good industries and assuming 25% margin on cost of production of capital goods, the revenue of Rs.5000000 will include a profit of Rs.1000000 for the capital goods industries and remaining Rs.4000000 will be the cost of production i.e. wages & salaries of workers of capital goods industries as well as salaries of capitalists of capital goods industries. Therefore, the total income of the workers of the consumer goods industries and capital goods industries (and salaries of capital goods industrialists) put together is Rs.9000000 and the total supply (i.e. output) of consumer goods is Rs.10000000. There is no need to explain that workers of both types of industries buy only the consumer goods as they don’t have any utility for capital/auxiliary goods. Now even if there are no savings by the workers of the economy the consumer goods industries can achieve maximum sales of Rs.9000000 against the cost of production of Rs.10000000.
In fact, even the above scenario doesn’t show the complete picture because we have once again assumed that the production of capital & auxiliary goods, raw materials etc. is totally in-house one. In other words, the inherent assumption here is that the only component of the cost of production of capital & auxiliary goods, raw materials etc. is wages & salaries of the workers. Whereas in reality, even the capital/auxiliary goods & raw material industries too buy a substantial part of their “input” from some other firms and those “other firms” still from some “other firms” and so on. So, the crux of the matter is that most (if not all) of the inputs of the “consumer goods industries”, pass through various stages of processing and usually each “processing” is done by a different firm/industry. The starting point of this chain is usually some “mining & ore extraction” firms or “farm & agriculture” sector. In this chain of production, the “output” of one firm is the “input” of succeeding firm and vice-versa. Now each firm in this chain of production books its own profit before selling its “output” to next firm that uses these outputs as its own “inputs”. Therefore, the final cost of production of a consumer good is simply the wages & salaries to the workers in all the previous stages of processing PLUS the wages & salaries of workers of consumer goods industries PLUS the profit of the capitalists/industrialists at each processing/production stages.
But the “effective” purchasing power of the economy consists of wages & salaries of industrial workers only; the profit of the capitalists is hardly, if at all, ever used for the personal consumption of capitalists/industrialists. Moreover, the consumer goods industries don’t sell their output to the final consumers directly on their own; the final consumer goods pass through various commission agents i.e. stockists, wholesalers & retailers etc. Needless to say, that commission agents too book their own profit before passing on these final consumer goods to final consumers. Even these commission agents too don’t spend their entire profit on buying the final consumer goods; but even if we assume that some (obviously, not all) of the profit of capitalists is utilised for buying the consumer goods, even in that case the “effective” purchasing power of the economy remains well short of the cost of production of consumer goods. Effective demand can be equal to “cost of production” of final consumer goods only in one case—if all the profit during “intermediary stages” of production & sales is utilized in buying the final consumer goods and no industrial worker saves anything (but obviously it can NEVER be the case). Therefore, even in the best-case scenario, what all that the consumer goods industries can achieve is no-profit/no-loss scenario, they cannot make any profit (on the whole) under any case whatsoever.
Therefore, in the ultimate analysis we can safely conclude that although the capital & auxiliary goods industries may make some profit in capitalistic system but it is a perpetual loss-making scenario for “consumer goods industries”. In fact, the “profit” of capital & auxiliary goods industries is at the expense of consumer goods industries. Therefore, the consumer goods industries will be left with no other option but to shut down their operation since no industry would operate in a perpetual loss scenario! Since the market for capital & auxiliary goods industries are the consumer goods industries only therefore, once the consumer goods industries get closed down the capital & auxiliary goods industries too will get closed since there will be no market for them. This brings about the collapse of the capitalist economy; in fact, this makes the capitalistic economy a non-starter from day one!
(B) No Unorganized Sector (Fully Corporatized Economy)
Now let us further relax our assumption that all the work-force of the economy is employed in corporate sector i.e. there is no earning population outside the sphere of industrial economic system. Even in a highly industrialized & corporatized economy there is a substantial “unorganized sector” which is not dependent on salary/wages from industries. Like expenses on education, various domestic service providers (plumber, electrician, carpenter, repair mechanic etc.), various kind of professionals (e.g. doctors, lawyers etc.), some other kind of retail service providers (like cab/taxi/auto drivers) and of course, the food providers i.e. the farmers etc. What about the purchasing power of this section? Can’t the purchasing of consumer goods by this section of economy fill the gap and do the trick of profit making by the consumer goods industries? A closer scrutiny reveals that this too does not change the situation even a bit.
We should begin by enquiring into the source of income of “unorganized sector” of the economy. What is the source of income for this group? Obviously, the income of this group is not dropped from sky. This group earns its income by interacting with the capitalist system itself! The doctors, lawyers, cab drivers & other transporters, farmers, electrician, plumber and a host of other such “unorganized sector” provide their services to the employees/workers of the capitalist system itself and, in turn, earn their income from them only. In other words, this group is indirectly dependent on industries for its income. Therefore, it is clear that the income of the “unorganized sector” doesn’t add any new purchasing power into capitalist economy; it simply shares the existing purchasing power of capitalist system!
So, we can see that even after taking into the account the purchasing power of the “unorganized sector” the problem is still the same—there is no profit for the industries; in fact, they remain in substantial losses. In final analysis it is clear that a capitalist economy is basically a non-starter because industrial firms cannot make any profit.
4.Two Fundamental Issues
This raises two very important and fundamental questions before us.
· From the above analysis it is quite obvious that profit making in a capitalist economy is a theoretical impossibility yet we see that capitalist economic system is making continuous profit since last 250 years or so! One can wonder as to how a situation of theoretical impossibility is getting defied so contemptuously & derisively? How such a magic is happening in real world? In short, how the capitalist economic system works?
· An equally important question that comes to our mind is as to WHY we NEVER come across such type of analysis of capitalist economic system in our text-books and media commentaries on economics? Why no theory of economics—Classical, Neoclassical, Austrian, Monetarist, Supply-side and various other schools of thoughts—takes this approach to explain or understand the economic system? Surprisingly, even the Marxists—supposedly the arch enemies of capitalism—too do not take this approach to expose this fundamental shortcoming of capitalist system. Is there anything fundamentally wrong with this approach?
Now we will take these questions one after another.
How the System Works?
From the above analysis it is very clear that a capitalist system cannot make any profit as long as it sells it output “within” the economic system itself. In order to make any profit, the capitalist economy will have to sell its “surplus production” i.e. the share of industrialists/capitalists (not necessarily the entire output) to some “external economy” i.e. to the people other than their own employees and factors of production. So, whether there is really any “external market” available to capitalistic system and if it is so then one can wonder as to what this “external market” is.
Here, exports seem a plausible answer. But for this to happen all the capitalist economies of the world should be simultaneous “net-exporter” and their entire profit must be drawn from exports only. But, as we see it in modern times, this is not the case with any of the capitalist economy; although some capitalist economies are net-exporters (e.g. Germany, Japan, China etc.) but proportion of their “export-based profit” is only a small fraction of their total corporate profit. Secondly many of the highly developed capitalist economies are “net-importers”, USA the biggest capitalist economy in the world is the biggest net-importer! So, the exports don’t seem to be the solution to the problem—in modern times at least. So, one can wonder, as to what is the answer to this riddle? To understand this issue properly we will have to divide the history of capitalism in two phases (1) pre great depression and (2) post great depression era.
(A) Pre Great Depression Era
In pre-great depression era (i.e. from the onset of capitalism in late 18th century to 1930) the capitalistic system derived its profit primarily by exporting its “surplus production” to colonies. It is a well-known fact of history that all the capitalist nations had a substantial “colonial empires” of their own and colonial empires were basically the markets for their surplus production. The Britain was the first and the only significant capitalist economy till 1830s thereafter France too joined the league and till 1860s Britain and France were the only capitalist economies in the world. Therefore, these were also the countries with any substantial colonial empires of their own. Thereafter in 1860s & 1870s Germany, Japan and Italy too jumped into fray of capitalisms and immediately these nations too indulged to various wars for capturing the colonies. This happened because these countries knew it well that capitalism was not possible without colonization.
So, it is clear as to how the capitalism survived in pre-depression era—by exporting its surplus to colonies. In reality, capitalistic system was like a “money-sucking pump” that sucked the money (i.e. gold/silver) from colonies by exporting (read—by forcibly dumping) its surplus to them. In fact, the very idea behind the emergence of capitalism was precisely this i.e. sucking the money (gold/silver) from colonies and this continued for approximately 150 years or so. Since the advent of capitalism, the industrial base (i.e. the volume of production) of capitalist nations kept on expanding, requiring ever larger markets for their surplus production but on other hand the money stock of colonies kept on dwindling due to continuous sucking of money by western capitalist nations. Therefore, quite obviously, after sometimes the colonies were no longer capable of absorbing the ever-increasing volumes of surplus production of capitalist nations in requisite volume i.e. in the volume that could have kept the capitalist system in profit. The result was obvious—the system collapsed in the form of Great Depression.
(B) Post Great Depression Era
Now we have understood the fact that the basic theme of capitalism is the “conversion of surplus production into money” and as long as that happened the capitalistic system kept running its course. But when it stopped—due to lack of money in the colonial markets—the system collapsed. Therefore, the root-cause of the Great Depression was that there was not enough of “money” in the world-market that could have been exchanged for the surplus production of capitalist system. So, what could have been done in this situation to revive the system?
The only plausible solution was to discover the money (i.e. gold) in substantial volume—from wherever it could have been found—and to distribute the same in masses so they could have bought the consumer goods from that money. If this was done the system could have been revived. How ludicrous an idea; isn’t it? However even if we ignore the ludicrousness of the idea the real issue was that gold could not have been discovered at will; that too in wishful quantities! That is why, in order to overcome the great depression, the first thing that was done was to abandon the gold standard and the era of fiat money begun. Once this was done the banking system got equipped with “unlimited powers” to create the money (in the guise of debt) and thereafter the capitalist system is sustained by monetary/credit expansion (i.e. the money creation in the guise of debt) by the banking system. There are two main tools for the monetary/credit expansion (A) deficit financing by the governments and (B) consumer credit.
(i) Deficit Financing by Governments
Once the gold-standard was gone there was no restriction on further monetary-expansion (i.e. on money creation by the banking system). In order to revive the industrial economy, the governments of industrialised nations undertook heavy expenditure programs, mostly on so-called “infrastructure development” and in so-called “social sector”. The most remarkable thing to note here is that the money that governments spent on these programmes was NOT collected through taxes, rather this money was taken as debt from the banks i.e. this money was created out of thin air by the banks!!
While spending the huge sums of money on so-called “infrastructure development” the governments purchased huge quantities of goods from industries and hired a vast number of people to develop the “infrastructure”. Purchasing the goods from industries for infrastructure development stimulated the sales of industries (mainly of capital goods industries) to a considerable extent and they bounced back into profit. The huge army of people hired by governments for “infrastructure” development also received huge sums of money—as salary/wages—and they spend this on buying the consumer goods. As a result, the consumer goods industries also registered huge jump in their sales. Interesting thing to note here is that this massive “infrastructural development spree” was not for any specific and needful purposes; it was just an excuse to buy huge volume of goods/services from industries to artificially stimulate their sales/revenues!
In addition to hiring the people for “infrastructure” development the governments also employed a huge army of people in other areas (particularly in so-called social sector) as well. Here too, as in case of “infrastructure development”, the job creation in these sectors was not for any needful purpose. These jobs were created just for the sake of creating the jobs so that Governments could have some kind of excuse for giving the newly created money in the hands of people so that they could buy the “consumer goods” from industries! Obviously, all these measures, put together, brought the industrial economic system back to life once again.
(ii) Consumer Credit
Consumer Credit is simply the loan given by banking system to general public for buying various types of consumer goods including house. Needless to say, that all such loans by banking system is nothing but “creation of new money out of thin air” in the guise of debt. Obviously, this goes a long way in creating the additional (& artificial) purchasing power in industrial economic system since the loan taker(s) will spend this amount in addition to their salary income.
(iii) Asset Bubble Creation
Although the primary motive behind the asset bubble creation has been the artificial propping-up of the financial sector NOT the real economy but the sheer volume of the money in this game is so tremendously high that its trickle-feed impact end up creating substantial income for common people and it helps in sustaining the real economy quite substantially.
Under this methodology, the banking sector creates a series of debt—in ever increasing amounts—to financial institutions enabling them to buy some assets (like shares/bonds & mortgage-backed securities) from each other at successively higher prices! This leads to massive boom in these asset prices. For example, between 1980 to 2000 average share prices in USA increased by almost 15 times! The increase in the prices of so-called tech-shares was much more phenomenal; on an average, they jumped 10.81 times only within 10 years i.e. from 1990 (596.28—Nasdaq in October 1990) to 2000 (6447.69—Nasdaq March 2000)! Needless to say, that asset-bubble creation, in true senses of the word, is an absurd, illogical & brainless activity—to say the least. But it is the backbone of entire financial system of the so-called developed world!
Now coming to our basic issue as to how it helps sustaining the real economy. As stated above that most of the “income generation” by this method is pocketed by big financial institutions but a small portion of income is pocketed by common people and this goes a long way in artificially sustaining the capitalist system.
The Summing Up
Now we can easily understand as how the capitalistic economy is “artificially sustained” in post-depression era. It was only after this that capitalism got rid of its chronic problem of recurring depressions because the capitalist system was now able to generate the required purchasing power—in any volume whatsoever—to absorb its surplus production “within” the system itself. That is why it expanded at frenetic pace after word-war II and it was this phenomenon that gave rise to so-called consumer culture because any volume of production could have been made to get absorbed within the capitalist economy itself.
Once the capitalist system got itself sustained in this “artificial manner” it had no further need of colonial markets therefore, soon after the World War-II (i.e. after fully realizing the “magical powers” of fiat money) the colonial era came to an end.
But the wonder of the wonders is that no school of economics explains the modern industrial economics in this way? Why we are not given even a faintest of hint of this in our “text-books” of economics? What is the reason behind this? This we will discuss in next article.
