Fischer Black: Seeing Capital Everywhere

After Tyler Cowen told me that my macro book needs more on Fischer Black, I ordered the 2010 edition of Exploring General Equilibrium, which includes a posthumous essay. I will probably have a number of posts on the book.

One way I think of Black is that he sees capital everywhere. In an extreme (and Black does not take things this far), think of the economy as nothing but different forms of capital producing utility. Take the concept of human capital really seriously, to the point (again Black does not take things this far) of looking at a human worker as just another machine.

From the point of view of a firm, the human worker-machine has some capabilities. However, in order to make it productive, you have to set it up, tune it, program it, and coordinated it with other machines. It becomes obsolete when the cost of maintaining and using it exceeds the value of what it produces.

When I ate a piece of toast this morning, I was getting utility out of various forms of capital. These included the refrigerator out of which I took the bread and the toaster oven. However, the bread itself resulted from roundabout production. Seeds were planted, grain was harvested, other ingredients were added, loaves were baked, etc. In order to know how to obtain the bread and operate the toaster oven, I had acquired human capital.

In a world where utility is produced almost entirely by capital, most economic decisions are risky. Any decision today represents a bet on how the world will look tomorrow.

Some remarks on this capital-centric point of view.

1. Standard national income accounting assigns a 2/3 weight to labor’s share of output. But perhaps this is highly misleading. The value comes from the capital embodied in the workers, which includes general human capital (skill usable everywhere) and specific human capital (skills usable on a particular job).

2. Standard national income accounting says that consumption is over 2/3 of output. However, very little output is immediately consumed. When I buy a loaf of bread, I do not consume it immediately. Instead, the bread is an input to consumption that takes place over subsequent days. Although Black does not take things this far, you can think of the bread as capital that, when used, depreciates rapidly and proportionately. This is in contrast to the toaster oven, which depreciates slowly and not exactly proportionately to its use.

3. The value of capital changes as events unfold. A desktop computer from 1987 is not worth much today. Houses in Las Vegas were not worth as much in 2009 as they were in 2005. The ability to shoe a horse is not worth much today. Arguably, a plain vanilla college degree was not worth as much in 2013 as it was in 2006.

4. Black points out that because of adverse selection and moral hazard, human capital investments are harder to diversify than physical capital investments. That is, I cannot sell shares in my future earnings without creating adverse-selection and moral-hazard problems, so I have to retain a large interest in my own human capital.

5. One of Black’s central points is that as events play out, some investments earn good returns and some investments earn bad returns. You will not always see equal amounts of good luck and bad luck. A lot of good luck is a boom. A lot of bad luck is a bust.

6. Black says several times that worker compensation consists of training as well as pay and benefits. When a lot investments do not pan out as hoped/expected, compensation for some humans has to fall. Black points out that if the compensation still includes a lot of training, then the firm may not be able to afford much in terms of wages and benefits. It made me think of unpaid internships as a market response to these circumstances. Of course, dropping out of the labor force is another natural response.

7. In thinking about the current situation, ask yourself which sorts of investments are no longer panning out. At the margin, does it no longer pay to take on a manual worker and train that worker? Health insurance costs are rising, and machines are getting smarter and more dexterous. At the margin, does it no longer pay to hire an American worker with a plain vanilla college education? A web site and a call center in India may be more efficient than an American sales force. Maybe financial institutions have had to cancel a lot of plans to hire plain vanilla college graduates to work in what was once thought to be an ever-expanding lending-securitization industry. Maybe when you factor in health care costs and the time it takes for a worker to get up to speed, the present value of investing in a new college-grad worker is no longer positive.

11 thoughts on “Fischer Black: Seeing Capital Everywhere

  1. Re; “From the point of view of a firm, the human worker-machine has some capabilities. However, in order to make it productive, you have to set it up, tune it, program it, and coordinated it with other machines. It becomes obsolete when the cost of maintaining and using it exceeds the value of what it produces.”

    I have been thinking along these lines, and I would modify this to include the idea of expected return on investment in human capital. That is, human capital, like any capital, becomes obsolete when it fails to produce an expected return on investment, a point which usually arrives long before the break even point.

    I think this is important because it correctly places the laborer in society. A laborer is very nearly always paid less than the value of what he or she produces. This is necessary, as no investor will invest in labor that does not produce an expected return (at least, not for long). But it is also true. And because it is true, it is also true that the laborer has already paid a very significant tax on the value that he or she has produced even before the additional taxes he or she must pay on whatever compensation is received. That is, most of the current measurements of the economic incidence of taxation are very wrong.

  2. Here’s one for the future: what is the Net Present Value of the human capital in a new baby? For at least the last few centuries it’s been overwhelmingly positive, and our social and political culture treat that as an axiom, but it’s not a law of nature. There are a wide number of trends that could possibly reduce that value, either by increasing the relative scarcity of other things we trade human capital for (overpopulation, nonrenewable resource depletion) or by creating new ways to substitute other forms of capital for human labor (automation, AI).

    • A new baby comes into being in a social, legal, and economic environment where there are a lot of donors and recipients of various cash flows and benefits, all of which shape his choices. So there isn’t one NPV. Are you the baby’s parents? The baby’s government? Employer or educator? The baby’s future spouse, or future babies?

      Aside from the baby himself each of these people sees a different NPV from the baby’s various income streams.

      So, for example, the government might ask whether the individual pays more lifetime taxes than those which are expended on his account. Maybe that’s the main implicit NPV you’re talking about, and of course it differs greatly between individuals. But that’s merely a subject of the sum of the baby’s economic activities.

  3. Any value stream has a net present value which means it can be treated as capital. Conversely, any capital value has a time value, frequently called rent. You can rent a backhoe but when a plumber comes out to fix your plumbing, you are renting him as a piece of capital equipment. Even the operational costs, such as fuel and maintenance for the backhoe, can be treated either as rent or as capital. Take for example diesel fuel for the backhoe. It can be viewed as renting the petroleum infrastructure, including deposits, for a certain amount of time.

    In this ā€œeconomicā€ sense (excluding of course, ā€œpoliticalā€ economy), humans are just pieces of capital equipment. Like all capital equipment, they have a life-cycle and associated rental costs. ā€œIn placeā€ rental cost simply includes the rental of the relocation infrastructure.

    It is no accident that the field of political economy is dead and has been dead during the 20th century (except, of course, for Marx who by treating all value as labor essentially negates political economy by going to the opposite extreme). When your culture is slave-based, the very idea of political economy is nonsense. So ā€œglobal labor arbitrageā€ is simply ā€œglobal arbitrageā€ whether viewed as capital or as rent.

  4. What is your textbook?

    A quick googling only turned out some online lectures, which I will read, but no textbook. I want to know if I should google some more.

    I find your approach to macroeconomics the most congenial — that is, the approach that focuses on almost microeconomic issues of patterns of capital and trade structure, with a healthy dose of macro-skepticism. That’s not to say that I will agree with you on most macroeconomic issues, but I certainly agree completely with your approach.

    So, I want to know what’s the deal with your textbook.

  5. Objects in an economy have a duality like objects in the natural world.

    Is an object energy or is an object mass?

    Einstein et al revolutionized natural science by answering YES!.

    Light is both a particle (a photon) and energy (a wave).

    Likewise, objects in an economy, a worker, a toaster, a slice of bread are both capital and labor.

    Money is a unit of capital: a dollar is a fraction of a toaster, several slices of bread, a unit of return on a human.

    And money is a unit of labor: a dollar is fraction of the labor that was used to mine, forge, design, assemble, sell, transport the toaster, and a few minutes of human labor.

    One difference between humans and toasters and bread is humans consume bread, and through use, cause nature to consume the toaster faster than entropy would consume an idle toaster. Further, a toaster consumes no bread, and bread neither makes nor buys toasters.

    Thus, the capital view does not explain the flow in an economy which flows by the forces of demand resisted by supply. Labor does explain the flow in an economy. Labor is always from humans, and humans consume using units of labor, but if the demand for labor does not give them work, they have no labor to consume toasters or bread. If machines (made with past labor) double the production of toasters and bread using less labor, then the owner of the machine must consume all the excess, or the pay to labor must double so workers can consume twice as much keeping all workers employed.

    The principle of capitalism is the owner of capital has sacrificed his consumption to build/buy machines to increase the productivity of his labor, and then used only part of the increased production to eliminate the sacrifice, and uses the rest of the production to build/buy more machines to further increase production.

    If the capitalist builds his own machines and produces ever more, then he needs other capitalists building machines producing ever more for each to trade and consume. They MUST consume. If they fail to consume, they MUST produce less, unless the toaster and bread makers are going to fill warehouse after warehouse with toasters, or bread.

    Unless workers have income, they can not consume, and if they can’t consume, then the machines and robots are going to sit idle to bring production down to what the fewer and fewer workers can consume.

    Locke saw the Americas as the escape valve for industrializing England – the idle workers could go to the Americas, stake out a bit of common land and consume what they produced, or even become hunter-gathers who wandered the common land taking what they needed to consume for just their labor. That allowed wages in England to remain low while production soared. The American farmers sent part of the abundant free stuff from America back to England in exchange for overpriced pots and kettles and axes and plows. Until those immigrants said foo, and started mining ore and coal and making the iron stuff here. Triggering British sanctions because Americans weren’t demanding enough overpriced British goods.

  6. Think also about application constraints. When I think about buying machinery, I often pass on low-cost but low-results machines because it’s literally not worth the floor space. In my shop floor space is seriously constrained, and very very expensive to expand.

    So for workers, it’s not just health care and similar costs that get added onto wages. There are also always finite “slots” or “spaces” – some of which are set by revenue streams (the zero marginal production case) but many of which are set by things like available office space, available management bandwidth, available complimentary capital items.

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