Valuing economic activity

On Radio 5 this afternoon (5 Jan), Seb Coe said something like "It is often forgotten that, between now and 2012, the Olympic preparations will make up around 5% of economic activity in the capital".

It is one example of a common refrain in support of any public expenditure: "this project is contributing X (pounds or percent) to the economy, so it must be good/adding something to the economy." In fact, it seems all public works have to be justified in that way nowadays, along with the linked claim that they are creating Y jobs, and will be displacing Z tonnes of carbon.

It is a staple of classical-liberal criticism to point out that the money for this activity had to come from somewhere, and that this is therefore not adding to the economy, but simply moving expenditure from one place to another. The money taken from taxpayers to pay for the Olympics might otherwise have been spent on all sorts of consumer goods, or saved. The producers of those consumer goods, and the producers of the second-order goods that contribute to the production of the consumer goods, etc. will lose as much as the recipients of public funding to build the Olympics will gain. Additional savings would have helped to reduce the structural imbalances that our consumer society developed over the past decade and more.

But this argument, though true, has two weaknesses. It doesn't seem to sum up the full economic inadequacy of the claim. And it is at the same time unpersuasive to those who believe in public expenditure. What additional responses might help to tackle the fallacy?

There is something deeper here, and in my opinion it revolves around the definition of wealth. We may judge if something has value by how much is spent on it. Or we may claim that we can somehow calculate the monetary value of the benefit it brings to people. Or we may assess its value according to what potential purchasers would exchange for it.

The first option is a long-disproven economic fallacy, though our political parties seem not to have realised. If I invest a lot of money to produce a product that not enough people like enough to pay me enough to get a return on my investment, that investment is not worth what I spent on it, but what a rational investor would pay for it in the light of actual and projected costs and demand. In a sense, I have destroyed wealth, because I have turned more into less.

The second option, though beloved of many economists, is a mirage. There is no yardstick by which one can directly compare benefits to individuals (whether the comparative benefits of two goods to one individual, or the comparative benefit of one good to two individuals). Subjective valuation in exchange is the indirect way by which we make that comparison. Markets represent the cumulative sum of those subjective valuations. They cannot be replaced by a man with a spreadsheet or a clipboard.

The third option is the best we have so far. But though it is a keystone of classical-liberal thought, recent history has demonstrated that it is a highly imperfect means of assessment. Did we really get increased utility from our houses as their prices rose in recent times, and are we now getting less utility from them? Had the wealth of the nation increased because the combined valuation of all our properties had increased?

And all three options look only at the thing in question, and not the things that had to be sacrificed so that we could have the chosen thing. If we claim cost as value, we do not count on the negative side of the account the cost of the things that might otherwise have been produced if the money had been spent on them instead. If we try to calculate the monetary value of the benefits, we count only the costs and benefits of the thing in question, and not whether we might have achieved a better balance of cost and benefit had we instead invested in one of the infinite number of other things that might have been done with the time and money. If we see what people would pay for it, we do not look at the consequences of that payment (what other things were not consumed or produced so that we might have the thing in question).

Some would argue that this is the lie of economics and the capitalist system. It should actually be done by human judgment not by economic valuation, by some person or group whose expert judgment will be definitive. These people will have the wisdom and experience to take account of more than monetary values. This argument ignores the fact that this approach was tested to destruction during the twentieth century. There is good reason (set out by many economists, but particularly a succession of adherents to the Austrian school) to think that this approach can never work, and good evidence to support the theory. As Robert Heilbronner admitted, it turns out that Mises was right.

How, then, are we to identify those things that genuinely add to the wealth of the nation? To calculate it is a problem of infinite recursion. To observe it is to be at risk of being suckered by highly imperfect human judgment. And to impose it is to make one person's preference the yardstick of everyone's benefit.

An important test of a valid method of assessing contributions to the wealth of nations is that it would have yielded an accurate indication in recent conditions. As house prices and indebtedness rose, and we spent the money apparently created on disposable items of little value or utility after the brief thrill of taking ownership, a valid method would have identified that we were mostly consuming wealth, not creating it. As we stored up trouble for the future by allowing our infrastructure to run down while we spent our money on knick-knacks as though there were no tomorrow, a valid method would have show our wealth steadily declining. As the public-sector employed ever more equality officers and the like, a valid method would not have counted their costs as adding to the wealth of the nation, but as subtracting from it.

I have only a partial answer. We should place less emphasis on measurement. We should return to the views of the classical economists, who were concerned with structure and policy, not numbers. We could say that we add to the wealth of nations when something earns us more than it cost us, so long as our economy is structured (and policies are implemented and enforced to support the structure) in such a way that the exchange is free (in the Hayekian sense), all material externalities are internalized, neither party is colluding or abusing a monopoly position to distort the other party's choices, the value of money has not been distorted, etc.

And I really think this is the best place to start. But it does nothing to satisfy the empiricist. And not enough people will read books like Mises' Theory and History to understand why scientism is an error. So we still need an easily digestible answer for those who believe that no rules have substance unless they can be tested empirically. And on that, at the moment, I am stumped.