Human Capital is Labour (and Labour makes Capital)

Branko Milanovic has an interesting post where he attacks the obfuscation of the term ‘human capital’  – backing up Piketty.

it obfuscates the crucial difference between labor and capital by terminologically conflating the two. Labor now seems to be just a subspecies of capital. Second and more important, it leads to a perception — and sometimes to the argument used by insufficiently careful economists — that all individuals, whether owners of real capital or not, are basically capitalists.

Nick Rowe replies

Branko Milanovic (HT Mark Thoma) misses the point about the usefulness of the concept “human capital”. To explain the point, let me talk about “land capital” instead….Raw land, in it’s natural state, often isn’t very productive. Before you can grow wheat on it, you usually need to clear it, or drain it, or fertilise it. There’s an up-front investment, which is costly in the “opportunity cost” sense, because it uses resources that could have been used elsewhere to produce something else. What we call “land” is as much capital as land. The rents on “land” are as much a return to capital as they are a return to raw land.

Setting aside Nicks confusion between extensive (margin of fertility or other windfall such as access to market), intensive (addition of capital) and absolute (oligipoly rent where there is a shortage of land for a use) rent (Marx used a confusing terminology for the same thing so his terminology is rarely used today) and that Rowe’s argument only applies to intensive rent, Rowe has a point.  You can have an up front investment to labour to increase a value stream. But is this labour, what is the relationship between this and rent?

The terminology ‘human capital’ is confusing.  To unpick this we have to go back to value fundamentals.

Straight out of high school a young adult has to make a decision, go to college/university, at some cost and possibly foregone wages, or not.  It is possible to express this in terms of an equation for a profitable investment. Things are simple here – we have no fixed capital that depreciates.  So how do we calculate the value of the ‘factor x’ whatever we call it that increases earning power through sacrifice of time?  In effect we a pure labour economy plus factor x.

In a pure labour economy without consideration of time/discount rates you can apply the labour theory of value.  It works here if labour all has the same disutility, then the equilibrium price is exactly proportional to labour because if labour time reduces in one firm in that branch of production due to an innovation then labour (and capital) will switch to that branch, until investment and disinvestment across firms and branches ‘equalises’ (more a process than a conclusion) the rate of profit. The classical economists explanation of the price process.

This approach seemed to break down if you had ‘different capitals’ (in terms of turnover and or size) – as then the rate of return has to be equal ‘in the long run’ to the capital advanced.  Torrens (and Malthus) used this as his main criticism of Ricardo – it troubled Ricardo to his death.  James Mill thought he had come up with a solution – he thought you could consider capital as letting out value stored over time – like a barrel of wine, how is not fixed capital different than a barrel of wine.  This argument dominated discussions of the Political Economy Club early in 1823 and fractured its radical vigour.   Ricardo considered the argument had logical flaws – how did you measure the labour input – you are measuring it with an output price?  That isn’t the labour theory of value.  Also no new value could be created without new labour.  Ricardo famous concluded as a result that there was no absolute measure of value. It would seem that was where the argument ended, if you read any book on the history of economics. But just after (1823) Ricardo died there was a startling (and now completely forgotten) development.  But to explain how this development can be applied here lets get back to our student example.

We can extend this pure labour economy to consider discounting through time and the impact of ‘factor x’ – the solution is the same.   The optimisation the pupil must solve is what cost in terms of cost/unit time of studying (and price of that study through a loan – rational leverage) is optimal given any discount rate and assumed uplift path of earnings after the study compared to expected path of earnings through time without the study.  Now the issue is what is the difference between the present values of these future earnings and whether the NPV is greater than the cost of the loan and opportunity cost of lost earnings.  what method then do we use to calculate this ‘factor x’ the economic worth of invested time?

The solution is to calculate the price of an annuity with the same time stream of value outputs  as the addition to wages at any given interest rate.  In a competitive economy it must be priced the same otherwise we get the same process of investment/disinvesntment of factors of production.  Using this you discount the future value of labour by the discount rate to find the present value of labour.

Just after Ricardo s death (1823) the same realisation came to James Mill, and it appeared in the 2nd edition of his book in 1825 and in McCulloch’s book in 1825 also (more obliquely and with the old James Mill barrel of wine example which confuses everybody).  More confusion seems to have been caused by Marx perhaps only having read the 1821 version of Mills back, not the 1825 version, as their is no mention in Marx’s extensive notes to new theories in the 1825 edition.

Mill had cracked it.  There was no circular logic as there was no reliance on price if you discount labour – no circular logic.  And Ricardo’s other objection was dealt with too, there was no new labour, simply release of value created by old labour.  Lets be clear labour is not stored like in a battery, rather labour creates ‘factor x’ and factor x (ceritus paribus and assuming no shifts in demand) releases its value over time.  It is the same as Crusoe on a island building a fishing new argument, is this ‘factor x’ then capital, as the Austrians would claim.  Mill and McCulloch argued it was – and that as a result capital and labour were  transferrable – labour could be used to create capital and labourers could at any point become self employed and become capitalists.  Marx criticised this as obscuring relations of ownership.  Marx though criticsed the use of the term ‘capital’ when it suited him and used it when it did not.

Consider the issue of fixed capital.  James Mill (using a hint from Torrens and also then applied by Malthus) realised that the same annuity approach could be used in terms of valuation of fixed capital.  The trick was to use joint production.  The fixed capital produces outputs but also itself, a new fixed capital of greater age which depreciates.   JS Mill and Torrens  realised in correspondence in 1843 that these arguments, together with advances in capital theory made by Longfield, solved all of the objections to the labour theory – though it was now a very different labour theory.  Which it did,  and if they has published it, and mathematised it rather than treating it as a trivial  historical question long solved, then we might never had had the marginal revolution and neoclassical economics.

Marx held to Torrens approach.  Marx’s real criticism then was regarding ownership, workers cant just up sticks and become capitalists.  They don’t have the savings.  Indeed the true test of whether some one is a worker or a capitalist is whether they employ not whether they are self employed (witness zero hour contracts).

Indeed terminologically I think it would be clearer if we referred to ‘factor x’ not as capital but as a value resource, and confined capital to the monetary value before, during and after production.  This is contrasted with physical resources (land, water, mines etc.) which earn land rent.  Similar to the word ‘saving’ which also should be expelled from economics for meaning two different things.

Think then a worker as a store of value resources, which increase through time through experience but which also experiences physical decline (depreciation) we can therefore model this value resource in the same way and price their labour outputs. This labour output is combined  with other value resources and physical resources to produce commodities for consumption.(Note there is never a ‘capital residue’that does not resolve to labour or rent).

One possible objection is we have not explained the discount rate, and that we have snuck in prices (price of money) through the back door.  No the price of money can be explained through rent theory and no more disrupts value theory than rent does, it is an extraction from total value added.  Credit after all is nothing more than a claim on future production enforced with the threat of violence, and that threat and the requirement to undertake labour to pay taxes having been used to force money into circulation.

Where does ‘surplus value’ fit into this?  If price =  discounted labour value then the only source of surplus value is where the capitalist can charge a monopoly (Schumpetarian) rent.  But as in perfect competition there are no such rents then surplus value is solely due to the uneven distribution of resources and education in the economy.  Its not ‘job creators’ its labour which creates the value – in all cases, which is then extracted as a rent through titles of ownership.




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