(This item originally appeared at Forbes.com on January 5, 2017.)
An underappreciated idea in economics is what I call the capital/labor ratio. This ratio is not really some kind of numerical statistic, but rather, a way of thinking about problems and solutions. It can be used to illustrate some of the difficulties of free trade, and also, what we should do about them.
From the beginnings of industrialization, around 1780, people wondered if machines would replace human labor, and thus lead to mass unemployment and disenfranchisement. If one person with a steam-powered spinning machine could replace 100 people using old-fashioned spinning wheels, what would happen to those 100 people?
If there was only one spinning machine, then 99 people might be destitute, or be reduced to low-value menial work, like sweeping the factory floor or raking the factory-owner’s yard. They are underemployed. The economy would actually grow. It would have not only the output of the spinning machine, equivalent to the previous output of all 100 people, but it would also have the output of whatever those 99 people ended up doing. Although the one person operating the spinning machine would be very productive, their wages would not be very high, because they could be replaced at any time with one of the 99 low-paid underemployed people. The average productivity of all 100 people would still not be very high.
This is a situation where there is just a little capital – one spinning machine – and a lot of underemployed labor.
However, if there were 100 spinning machines, then all 100 people could be very productive. The output of the economy would be much higher – a hundred times higher than when everyone used old-fashioned spinning wheels. Wages would be high, because you could not get the output of the machines without the employees to run it. Capital would compete for limited labor with higher wages. Any new investment would have to bid away labor from the textiles business, by offering a higher wage; consequently, to be profitable, that labor would have to be used in a manner even more productive than in the textile business. The toilets would still have to be cleaned, and the factory owner would still pay to have the leaves raked from his yard, but he would have to pay a high wage for it.
This is a situation where there is a lot of capital – 100 spinning machines – and no underemployed labor.
“Job destruction” is a normal part of economic expansion, wealth creation, increasing productivity and higher wages. It takes fewer and fewer people for more and more output. But this must be matched by “job creation” – and not just low-paid/low productivity jobs, which consume a lot of labor to create a product or service that can’t be sold for very much, but high-paid jobs which themselves represent the investment of large amounts of capital, to create high productivity.
Factors such as the end of centrally-planned communism in both China and the former Soviet sphere, or cheap telecommunications which have enabled people from India to make use of their English skills, have radically increased the amount of underemployed labor available in the increasingly globalized world economy. It turns out that a lot of manufacturing is not all that hard. Who would have thought that the miracle of the two-terabyte hard drive could be created by Malaysians, or the iPhone 7 by Chinese? The developed economies, such as Germany, Japan and the United States, have been driven toward manufacturing of capital goods rather than consumer goods, and also, a few industries (like chemical production) where so few employees are needed that labor costs are a minor factor.
Free trade can be a little like the spinning machine. It now takes one person with container ship to create what used to take 100 employees to do.
Our retail stores are filled with a profusion of goods from China, Mexico or Malaysia. We don’t see the complicated capital goods, which are mostly purchased by big corporations. These are things like telecommunications equipment, electric power generation and distribution equipment, the defense industry, the barcode and conveyor-belt systems used in the warehouses of Amazon.com or UPS, equipment for the medical industry like MRI scanners or laboratory test equipment, hardware for the oil and gas or mining industry, the huge industrial plants that make yogurt and beer, or the commercial software that helps it all to function. These kinds of high-value products are the likely future of American manufacturing.
What American labor – the middle class, and the below-middle class – needs today, most of all, is capital investment. This is best accomplished by making the U.S. a great place to do business. It should include tax reform, such as the 15% corporate tax rate that president-elect Donald Trump has proposed. Eventually, this should be extended to everyone, a flat income tax with a rate also around 15%. It also means a rollback of regulatory burdens, which is especially choking off the smaller companies that have always accounted for most job creation. Ideally, it also means a stable dollar – in U.S. history, this means a dollar linked to gold – which does not confuse the capitalist system of prices and returns on capital with monetary distortion, manipulated interest rates, and wild exchange-rate swings. We need real investment in the real, nonfinancial economy, not weird asset bubbles, financial chicanery, and all the other elements of “malinvestment” that arise from unstable money.
This will create a situation where there is a lot of capital investment, relative to available underemployed labor – a situation similar to the 1950s and 1960s.
Where will that capital investment go? It will go, of course, to wherever the return on capital is the highest. This might mean the kind of high-value manufacturing I’ve described. But, we might find that we have enough stuff. People would rather spend their next dollar on something interesting to do. Much of the new investment might be in a variety of services. These would be high-value services. These could be in healthcare and education, for example. But, they could also be in things like restaurants and hospitality. A high-end hotel resort, or a high-end restaurant, takes just as much labor as the low-end versions. The difference is capital – a Four Seasons costs a lot more to build than a Motel 6. Instead of a spinning machine that radically increases the production of cotton cloth, our increasing productivity might express itself as a profusion of high-end restaurant and travel options – if that is what provided the highest return on capital.
Related to all of this is the raw increase of capital itself. The earliest economic writers understood that it was the steady increase of capital invested that made societies wealthier. They always focused on capital accumulation. More spinning machines. This capital investment is the flip side of savings–more savings means more investment. Decades of Keynesian promotion of “consumption” has led to a diminution of savings, and thus, domestic capital creation. This capital deficiency is remedied somewhat by imported capital – a “current account deficit” – but that is problematic on many levels. For one thing, a lot of small business creation arises from personal capital (personal savings), and also friends and family. The local accountant, chiropractor, marriage counselor, construction contractor or rental-apartment investor might never become listed on the NYSE, but these kinds of high-value service businesses, multiplied by the hundreds of thousands, can form the foundation of middle-class prosperity. They are largely locked out other sources of capital, including their local banks, until they reach sufficient size and stability. None of this happens if everyone, and their friends and family, are deep in credit card, automobile and student loan debt; or if oppressive regulatory burdens make it impossible for small businesses to form.
Much more capital investment requires much more capital to invest. This will have to be the foundation of any economic revival in the U.S., whatever trade or tariff policy may be. Without it, nothing much will be accomplished.