Value extraction keeps economies moving from bubble to bubble

Talk of a fairer capitalism is just hot air unless we rehabilitate and reward the idea of value creation instead of favoring private equity firms’ wealth creation

By Mariana Mazzucato  /  The Guardian

Sat, Jan 19, 2013 - Page 9

At the end of the 19th century, Big Bill Haywood, one of the founders of the US’ first industrial union, made a succinct point about the paradoxes of the labor market: “The barbarous gold barons do not find the gold, they do not mine the gold, they do not mill the gold, but by some weird alchemy all the gold belongs to them.” More than a hundred years on, the modern equivalent of the gold barons are still getting away with it.

In order to boost share prices — and the stock-based pay of executives and other major shareholders — Fortune 500 companies have spent US$3 trillion in the last decade on buying back their stock. Such value extraction has funneled money away from areas that can increase long-term growth — for example research and staff development — to areas that only increase the inequality between the 1 percent whose rewards are linked to stock price movements and the 99 percent whose rewards are linked to investments in the productive economy. Value extraction is rewarded over value creation.

“Financial innovations” based on trading existing assets — largely responsible for the financial crisis — are also on the rise. A New York Times report showed that hedge funds — one of the “innovations” that helped produce the crisis — are making record profits from Greek debt, speculating on the difference between the debt’s price and value, so reducing the government’s ability to invest in areas that help the recovery.

Private equity firms continue to justify their profits, calling their value-stripping exercises “wealth creation.” Last year the failure of solar power company Solyndra saw US$535 million in state guarantees go down the drain when venture capital prematurely pulled out, yet the private equity vultures who immediately flew in made massive profits.

What can politicians do? There is much talk about making capitalism more “moral,” “fair” or “responsible.” However, restraining the power of value extraction requires a theory of value — an area once hotly discussed in economics, but no longer. This is because a century ago the notion that labor creates value — central to the work of “classical” economists like David Ricardo and Karl Marx, and measured by objective factors like productivity — was replaced by the “neoclassical,” subjective notion that satisfaction and “preferences” create value. What is important here is not to defend any one theory, but to understand the implications of going from one that emphasizes production (value creation) to one that emphasizes consumption (value extraction).

The neoclassical theory has served ideological ends, more concerned with justifying capitalism than analyzing it. It became mainstream with Paul Samuelson’s famous economics textbook in 1948, which portrays the supply of labor and wages as primarily dependent on companies maximizing their profits, and workers their preference for working versus leisure, in free markets.

It is a theory that disregards what was happening in the economy at the time, and what is happening today: In the 1930s US unemployment never fell below 15 percent, reaching 25 percent in 1933; then World War II pulled the US out of depression, and later government spending for the Cold War and the welfare state kept the US from plunging back into depression. The most productive and best-paying jobs in this period were in large corporations, many highly dependent on government spending. A theory of wages as functions of preferences and profit maximization was out of touch then, and still is.

This is where today’s politicians on both left and right should begin the debate. There is a need for a theory that identifies those factors that contribute to value creation versus those that are focused on value extraction. Or put another way, is it really possible to pursue a “pre-distribution” strategy, or a “fairer” capitalism, without first questioning the underlying model of what determines wages? Indeed, the battle against “rent-seeking” behavior will remain lost without a theory able to clearly distinguish when profits move from being a result of value creation, to “rents” — a result of value extraction.

Value creation is about reinvesting profits into areas that create new goods and services, and allow existing goods to be produced with higher quality and lower cost. Investments in human capital, skills, infrastructure, and research and development create value. If we do not get this right we will go from one bubble to the next, talking about “morality” and “responsibility” while challenging little that threatens value extraction and the inequality it generates.

Mariana Mazzucato is an economist and RM Phillips professor in science and technology policy at the University of Sussex.