The Basics of Capital Formation

Capital formation has to be understood in order to be put into the proper place in a new economic theory. Just as with other concepts in economics, such as debt, there are details which obscure the actual nature of capital formation. These details need to be cut through in order to develop a good new economic theory.

Capital will be defined here as physical capital, including anything needed to increase productivity of labor. It includes a wide range of items, which are not usually lumped into one category. It includes tools for craft work, ranging from a hammer up to a robotic assembly line. It includes transportation items, including vehicles for transporting goods up to cargo aircraft. It includes communication, from post offices to communication satellites.

Many of these items are dual use, meaning they serve consumption uses as well as production uses. This is especially true with transportation and communication. There is not much difference between transporting a 75kg person on vacation and a 75kg person going to work and a 75kg box of commodities. Separating out these uses takes a little diligence, but that is a task for another day.

Besides physical capital, there is knowledge capital, which is the information needed to build the physical capital, to maintain it, and to operate it. It has to be generated and it has to be preserved before being put into use.

Both physical capital and knowledge capital have to be paid for, or “formed”. For a long, long time, the metric used to measure these has been labor. A field plowed in ancient times by humans pulling a plow might look the same as a field plowed by a plow pulled by an ox, but the custom is to say that there was more labor in the first field, and less but more productive labor in the second field. If there was some measure of the value of the plowed field, and the first one took six man-days to do it, old economic theory might say the value of the labor for a day was one-sixth of that of a plowed field, and if the second one took one man-day to do it, that the productivity of that batch of labor was five, induced by the capital of the ox and the associated ox-driven plow, together with the knowledge capital of how to maintain oxed and how to plow fields with them.

The simple example illustrates the ghastly mess that traditional economics finds itself in. There are no good metrics. Because so little can be comparatively measured, the task of measurement becomes a problem for society, and the introduction of money is treated as a solution for this. If there is a large enough community, and plowed fields become a category of exchange, there can be a translation of plowed fields into currency units. Then the value of the plowed field can be defined in economics as whatever someone pays for it. There are multiple obvious flaws with this system of valuation, and they undermine any theory of economics, and any discussion of capital formation. Some sort of market trading everything is a mandatory requirement for setting the value of things, and only certain types of markets will suffice.

The existence of a monopoly or cartel on any type of goods or services destroys the concept of value for necessities, as the holder of the monopoly or the cartel participants can choose a range of prices and have them paid, meaning the value of this good or service is not well defined. For goods and services that are not necessities, there might be said to be a tradeoff between alternate consumption items which fixes the transitional value of an item. If the monopoly controls a whole set of alternate consumption items, such as all foods, we are back to the lack of value situation.

Markets have only existed for certain items in history, typically long-distance trade goods. The distribution of consumption goods was handled in a different way, up to a few hundred years ago in some places, and up to a shorter time in others. Instead, there was a social hierarchy, and the responsibility of the higher levels was to ensure that the lower levels received a share of consumption goods. Let’s call this situation, a pre-market situation.

In a pre-market situation, capital goods had to be provided for out of the share of consumption by those making the divisions. Those making the divisions could simply order the distribution of labor to be such that capital goods were produced by some fraction of the population or by some fraction of the population’s labor time. Alternately, some fraction of produced goods could be saved and given over to a subset of the population for the purpose of supporting their efforts at capital formation.

In the market situation, capital goods were part of a market, and so some consumption goods could be used for the production of more capital goods, by the choice of those who participate in the market. In both the pre-market and market situations, capital formation was subtracted from current consumption. The decision making as to how much of what capital was formed depended on the vision of the decision-makers, who implemented their decisions either through a command hierarchy or through a market choice, or a combination of both. The combination occurs when a leader of a group, call it a company but it could be any group, participates in a market to obtain some precursor materials, brings them into the company, and then commands some of those in the group to produce capital goods out of them instead of producing consumption goods.

Markets are not necessarily better at deciding on value than command decision-makers. Those who participate in markets are limited by the information they possess, by their ability to consider the variability of future events, by their personal preferences, and certainly other factors, just as are command decision-makers. Markets in stable situations might tend to produce some values for items, perhaps optimal in some undefined sense, but in stable situations experienced command decision-makers also do much better. Monopoly effects ruin markets, and a large command hierarchy might avoid this peril, but it has its own perils.

There would seem to be a different source of values, and that would be the preferences of those who make command decisions or who participate in markets. Their vision as to the utility, in the longer-term, of capital formation has an important influence on the growth of capital within some area. A decision-maker who sees some utility in more capital formation can use a market or the command hierarchy to attempt to form this envisaged capital. Having such a vision distorts the market somewhat, and influences the remainder of the command hierarchy.

Thus, capital formation happens, not by some magic in a market, but from a vision of a high-level decision-maker, who does two things mentally. One is to envision the result of diverting current production from current consumption into capital formation and to see that the longer-term result is preferable. The other is to assess alternate uses of diverted current production, for example into inventory to average out production over some future period, and to compare this use with that of capital formation. The decisions are all about long-term benefits versus current consumption. The decision-maker must also assess the needs of the population he takes responsibility for and their desires as well, and make a decision as to how much current consumption can be reduced to pay for either capital formation for enhancing long-term productivity or other expedients for easing potential hardships such as the maintenance of an inventory.

Sometimes the vision of a particular decision-maker might be accurate, sufficiently, to produce some long-term benefit from the diversion of current consumption. Alternately, the result could be desultory and produce little for future consumption. This is often denoted as the risk involved in decision-making.

Decision-makers can make inaccurate decisions, however we might measure inaccuracy. If they have advisors who have more, and more diverse, experience, there could be an improvement in accuracy. One of the advantages of the last century stock market is that investors would seriously investigate a company before buying stock in it, and the stock price then represented information for the decision-makers in the company that they might use. The institution of the board of directions might have been founded for just such a purpose. Of course, stock markets can just become a means of gambling, satisfying whatever emotional needs gamblers have.

For a new economic theory, what has been discussed here is important. It means that the choice of decision-makers and advisors is critical to the success of a society following the new theory. These decision-makers make continual decisions as to the allocation of current production, into a variety of possible capital formation options, as well as many others. How the consumption fraction for this allocation is obtained is less relevant, as it might be from something labelled a tax or a mandatory investment or a mit’a, a mandatory labor allocation used by the Incas, or temporary conscription, or something else. The principal issue is the selection of the decision-maker, their education and experience, and the domain over which they make decisions, and the scope or depth of their decision-making in the hierarchy. Just as debt is only one means of allocating current production, mit’a and other mechanisms are just particular means of forming capital. What matters in an economic theory is not the details of the mechanism, but how the current production is allocated. A good economic theory is one in which the best decision-making for this allocation is ensured.

Centralization and Decentralization

Centralization of decision-making has obvious advantages but also some serious catastrophic failure modes. How can the degree and extent of centralization be managed in a socio-economic system?

In designing a new socio-economic system, hopefully free from some of the built-in catastrophes of previous inventions, one important question relates to the centralization of decision-making. The opposite is decentralization, but there is actually a continuum of alternatives lying between these two extremes. The continuum extends in two dimensions, both in the degree of decentralization, meaning the level in a governmental hierarchy where decisions are made, and the scope of decentralization, meaning the number of different decisions that are being considered for centralization. The oversimplified answers are to centralize everything to the highest level or to decentralize everything to the lowest level, and like all simple solutions to complex problems, they are designed to ensure the built-in catastrophes will happen. To minimize them, something different is needed.

What goes wrong with centralization of decision-making? The same problems exist with any monopolization of control. The person or persons at the top, making the decisions, don’t make them well, and then everyone affected suffers from the choices. The first reason that centralized decisions might be poorly made is uncertainty. If the information necessary to make the best choice is not available to the decision-makers or their subordinates or advisors, then they are forced to make an arbitrary choice. If the decision-making were decentralized, there would be many different choices made, and after a period of time, the results of these different choices would be available for comparison. The best could be evaluated, and more information used for future iterations of the decision-making. This would imply that decentralization might be a good temporary expedient to use until the data was in and the best choice was clearly visible, but the counter to this is that conditions change, and therefore what constitutes best might change, meaning evaluation via decentralization is needed again. The conditions might not be the thing that is changing, but the alternatives might be, as new ones are devised and made available for widespread use. Thus, in a stable, unchanging situation, centralization might be a good decision from the single point of view of efficiency, but not otherwise.

The second problem with centralization of decision-making is the drive to uniformity when uniformity is not the best solution. It is easy for a centralized decision-maker to do some sort of evaluation and make a choice that will be implemented everywhere. However, this is based on the assumption that there is a universal best choice. What is best for one area or for one group or for one time might not be best for another area, group or time. This is referred to as the local conditions situation. For centralization to work well, there would have to be knowledge of how local conditions affect the outcomes of a certain decision, and that local knowledge would have to be available to the centralized decision-makers. Efficiency takes a hit here, as the evaluation of a set of alternatives would have to be done considering the variations in local conditions. Uniformity has a great appeal, as do all simple solutions, but it is often a totally false assumption that uniformity would produce the best results in all conditions. Even what is defined as best may differ when different locations, groups or times are considered, and if the definition of best varies, then uniform solutions cannot hope to achieve this local best except in fortuitous circumstances.

The third problem is actually a set of problems collected under one label, and the label is corruption. It is so much easier to have corruption in a centralized system than in a decentralized one, as a monopoly of control can be exploited by the individual making the decisions at the center of power. Corruption does not simply mean that the decision-maker takes some benefit in order to make a decision favoring a particular party. This is only one of the many facets of corruption, and perhaps the most well-known and appreciated one. However there are more. A centralized decision-maker can have a different agenda that the one appropriate to his position. The centralized decision-maker might have his/her own interests at stake, and therefore seek to have some benefits received for making a particular decision. The ways in which this could happen and even be disguised are manifold. But the agenda the centralized decision-maker has might not be oriented around maximizing his own benefits. After all, benefits are asymptotic in that more and more of something often produces less and less enjoyment and appreciation. They are psychological individuals who feel good about counts of things, but for many individuals, they obtain their enjoyment other ways and tilt their decisions according to these ways.

One is simply the human lust for power. The ability to control aspects of the lives of others provides enjoyment to others, and has for the entire history of humanity. This might explain the desire for the monopolization of decision-making, but it does not portray the whole spectrum of agendas that a centralized decision-maker might have. One is a hidden antipathy to some location or group. Decisions can be made which disfavor the location or locations or group or groups that the antipathy is directed toward. The more subjective the decision, the more that antipathy can be concealed.

The inverse is just as possible. Nepotism toward one’s family or friends might be fairly obvious, but nepotism toward some location or group, the opposite of antipathy, can also be easily concealed.

Furthermore, it does not have to be simply antipathy or nepotism which drives the decisions of a centralized decision-maker, it can be a preference for control of some particular aspect of the lives, of everyone affected or of some subset of the population. Decisions have side-effects, sometimes dramatic ones which in the long-term diminishments overwhelm any short-term benefits. A corrupt decision-maker can promote his preference of opinions by shifting the choices he/she makes. Over the long-term, these effects would be felt.

Self-benefit, antipathy, nepotism, and side-effects are not simply present in top-level decisions in a centralized decision-making arrangement; they can appear at any level. If decisions of a certain category are decentralized to some lower level, the exact same phenomena can appear at that level. It would not have the wide-ranging effect that a single monopolistic decision would, but it would still have a local effect. Preventing this might be seen as one justification for centralizing decisions. Local corruption is overridden by higher-level control. Unfortunately, the higher-level control is just as prone, or possibly more prone, to corruption. There are other means that a newly designed socio-economic system can mitigate corruption.

One is transparency. Transparency is easier to obtain at small local levels, where interpersonal contract is common. Knowing someone as an individual is more likely to reveal their tendency toward corruption than only hearing about a decision via some disseminated ukase. Establishing transparency at high levels of concentrations of decision-making power might be very difficult, and can be countered by having specialists at providing deceptive façades for the justification of all decisions. Investigation of such decision-making by other specialists, perhaps self-appointed ones, can be made difficult by the denial of access or simply by having a unified front of interface people, all of whom are familiar with the façades.

Thus, there are tremendous disadvantages to centralized decision-making, but there is one advantage that is similarly huge: efficiency. If the same decision has to be made thousands of times, as opposed to once, it stands to reason that the same level of attention and scrutiny to the details of the decision cannot be afforded. A centralized decision-maker can have a large staff devoted to a single decision, and even with this, the costs of making the decision once are much smaller than making it at the lowest level of governance. To make a decision properly, in a complex situation, there might be much academic or otherwise collected information and theories to be located and digested. It might be necessary to hire a specialist with a background in some certain area to review this data, and it might even be necessary to have a team appointed to do this. The costs of a decision are not the same at the lowest level and the highest level, as there is considerably more data to analyse when considering a decision that would be implemented on a very wide scale, but the costs do not scale up proportionally with size, perhaps increasing instead only logarithmically. It might well be that at the lowest levels, the cost of an objective decision are simply too high, and some subjective choices would need to be made. Perhaps the solution would be to copy some other location’s decisions, or to keep the prior decision barring some obvious failures, or to simply make a haphazard choice based on incomplete information and inadequate models and interpretations.

There are some clear antidotes to the poison of corruption and the poison of inefficiency. One is to make decisions at the lowest level where the resources would be available to make a thorough decision, perhaps not at the highest or lowest levels, but somewhere in the middle. The other would be to invent methods of ensuring transparency, and of training sufficient specialists that there is no shortage of people able to investigate decisions. Perhaps jocularly, another solution would be to raise everyone up in the society to expect corruption of various types to pop up everywhere, as well as inappropriate subjectivity. People tend to be raised in a trusting environment, without adequate warning and training for the situation that exists in the real world, and countering that some formal way might provide another mitigation for the problems of centralization and decentralization.

In the Valley Between Libertarianism and Communism

It seems that only extreme libertarianism and extreme communism are studied and expounded. This is an error, as there are many alternatives other than these two polar extremes.

Both libertarianism and communism have supporters and detractors, and all of these fine people have reasons for their opinions. But there does not seem to be many who think half and half of these makes a good combination. The two poles attract interest because of their implicit simplicity, and the ease with which they can be explained and justified.

Libertarianism, as we use it here, means there is minimal government interaction and individuals make agreements with one another to enable sharing of work, trade, and everything else. Communism, as we use it here, means there is maximal government interaction, and the government makes rules by which work, trade and everything else is conducted. Furthermore, libertarianism allows inequity in the extreme to exist, and communism does not allow inequity to a great degree.

Decision-making is decentralized in libertarianism, as each individual makes all the decisions involving himself. Decision-making is hierarchical in communism, as rules are made by whoever is doing governance, and then are implemented down the levels of a hierarchy. There are thousands of details in a society and this is no place to make long lists of what those details might be and how the two polar opposite social systems differ in each of them, but instead, something of a big picture needs to be obtained.

Two of the features of a socio-economic system that make a difference in its feasibility are motivation and disparity. Libertarianism tries to maximize motivation, so that each individual is responsible for his/her own future, and goes out trying to be maximally productive, thereby securing the most of society’s benefits for him/herself as possible. Communism tries to minimize disparity, so that those without much capability to fend for themselves, temporarily or permanently, are not deprived of society’s benefits. Strict libertarianism has the less capable being taken care of by the choices of the productive. Strict communism motivates the productive by training people to work hard to support the society as a whole and by exhorting individuals to be as productive as they can.

All societies from the earliest human hunter-gatherers to now have this dichotomy between self-interest and altruism, and somehow have to integrate these two impulses. All successful societies have a solution for this, and it might be a complicated one, as opposed to the simple ones included with the two polar extremes of libertarianism and communism. One solution is to have moral strictures taught to the young, with the expectation that the majority will follow them. The two categories of these moral strictures involve working hard, the motivation category, and taking care of the less capable, the compassion category. Different arrangements of these moral strictures are certainly possible and different ways of teaching them and enforcing them are possible.

One way societies enforce these moral strictures is by shaming and ostracising violators, another is by having specialists for enforcement who seek to locate those violators and pressure them or punish them. The point is not that there is only one way to have these two contrary impulses balanced in a society, but that there are many and choices can be made. There is no best way, only multiple options.

If you think of pure libertarianism and pure communism as unobtainable mountaintops, then in between these two peaks is a huge valley of possible ways of organizing a society, and all of existing and past societies are somewhere in the valley. Extremism in favor of either peak is amusing and entertaining, but doesn’t really work to solve any of a society’s problems. What needs to be done is the development of the means by which these two human impulses of self-interest, and pariochial interest, and altruism, widespread or narrowcast, can be integrated.

There is no best solution to amalgamating the two impulses, as the definition of best depends on personal preference, and that varies with the person and even with the experience of the person and even further with how the questions eliciting a preference are couched. Beyond that, the definition of best depends on what you do with the answers you get. If there is a headman, do you simply ask him/her? If there is an elite, do you simply ask them and average over the responses as much as possible. Do you ask all the adults, and define the adults as those over 30 or 40 or 50? There is simply no single answer.

Those whose thinking revolves around anecdotes can certainly find competing anecdotes to justify almost any point of view. Trying to extract some truth from anecdotes is chancy, as the anecdotes one hears is a tiny subset of possible ones, and the selection is subject to the biases of those who spread them. There is simply no simple solution to the design of a society.

Suppose you try to think of some metric to use. Perhaps persistence is a possible metric, and you want to come up with a social arrangement that will last for decades, or even centuries. You would need to consider the environment that the society lives in. Is it marginal, meaning that life-sustaining substances are in short supply, and you need to maximize the incentives for those who have the capability to obtain or produce them? Is it affluent, meaning that there is abundant life-sustaining substances, and the difficulties that arise come from the monopolization of them by those who figure out how to do that within the social arrangements that exist? You would want to find a choice nearer the peak of libertarianism for the first, marginal society, and one nearer the peak of communism for the second, affluent society. If the society drifts from marginal to affluent and back again, depending on the vicissitudes of weather, international relations, wars, external trade or what-have-you, you might need to make a flexible society.

If the society is extremely marginal, meaning there is much early death and disability due to shortages of critical substances such as food or water or shelter, the interactions of the society would have to be designed to preserve those who can obtain the most of these substances in the worst of the times, and to maintain their capability to obtain these substances both via provisioning them and by maintaining their spirits in a situation of great adversity. If the society is extremely affluent, it would be necessary to design in the moral strictures to prevent too much decadence and dissolution, which would lead to a self-limitation and social collapse. If the fluctuations were extreme, and the time scale of the fluctuations was within a human lifetime or even a fraction of it, the ability to adapt itself would have to be built in.

The design of a social arrangement can not be based in the fantasy of someone as to what they think they would like to live in. People’s specific preferences are largely conditioned by their experiences, or even what stories they were told as little children, or the preferences of those who raised them and taught them. While a person who has developed such a fantasy is not harmful, if they have the ability to influence others through persuasive writing, they could be quite misleading and if extremely persuasive, could cause social change that was not in the best interests, however that might be defined, of the society as a whole. The alternative is a careful, widely based discussion of social arrangements.

Besides persistence, living standards is often used as a metric for societies. One can define it in many ways, and many very different ways. Living standards could be the access to life-sustaining substances and activities of the majority, perhaps 90%, of the population. Living standards as a metric could be some number, denominated somehow, of the median individual or household or other living group. In defining living standards, there is a clear distinction between measuring life-sustaining substances, also known as necessities, and anything else. A society which has a huge amount of trinkets can be compared to one which has a robust inventory of food; which is the most desirable, or ‘best’, one?

Someone who is psychologically prone to altruism might seek to define living standards as the amount of life-sustaining substance received by the lowest 10% of the society, however this percentage might be defined. Someone who is psychologically prone to self-interest might seek to define living standards as the amount of trinkets, plus some measure of services if needed, of the highest 10% of the society. Neither is particularly dominating, and some middle ground can be found, but what?

People who grew up, having been deeply inculcated with some strong moral strictures, can use these moral strictures to help them define what would constitute the best possible social arrangements, and those who grew up to think of everything abstractly can continue to think of metrics and environments in which to evaluate them. This is the condition in the valley between the two extreme points of social arrangements. Once the simplicity of these unobtainable ideals is abandoned, the huge valley of options presents itself, without any clue as to where a definition of best might be found. Perhaps the first thing to do is to recognize this situation, and to realize that the deafening discussions of social arrangements can not lead to any results, as there are none. A huge number of possibilities can be utilized and comparisons are very, very difficult to find bases for.