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Keeping land in capital theory: Ricardo, Faustmann, Wicksell and George
American Journal of Economics and Sociology, The, Jan, 2008 by Mason Gaffney
I
Introduction
David Ricardo had a theory of land rent, of course, plus a practical understanding of compound interest and the relationship of capital to labor. He wove these together in his theory of value. He saw how the flow of investing into creating jobs and incomes led to higher employment; he was concerned that excessive conversion of working capital into fixed capital would reduce that vital flow. This concern would resurface with Mill, Jevons, the Austrians, Wicksell, and possibly--indirectly--in Keynes.
Martin Faustmann showed how to convert irregular pulses of cost and revenue, as in forestry, into the level annual equivalent, to define and find the regular flow of site rent. He made this a performance standard to maximize. In the process he showed how to find the optimal time to harvest and replace forests. As an important byproduct, his formula shows that rents vary inversely with interest rates, and this effect tempers the effect of interest rates on financial maturity. An even more important byproduct (quantitatively) is to adapt Faustmann to time the salvaging of sites under old buildings by clearing and renewing the sites.
He showed how to convert the infinite flow of such rents into a present value, or discounted cash flow (DCF). His site value measure combines the DCF of generation 1 with the reuse value of a site, providing a mathematical basis for George's later observations on the damage done by land speculation. There was a flurry of interest in reviving Faustmann from about 1957-1976. Economists now neglect his work again; some industrial foresters may be subverting it for wrong ends.
Bohm-Bawerk and other Austrians revived Ricardo's concept of working capital versus fixed capital, using other terminology while still crediting Ricardo's priority. J. B. Clark and Frank Knight expurgated the Austrian idea of a "period of production" because it would up-end Clark/Knight's conflation of land and capital. Knight's Chicago School dominates academe today, while Austrians survive only in odd corners.
Wicksell improved on Bohm-Bawerk in three ways. He "normalized" the model of tree growth, showing how Austrian capital intensity works as a relation of coexistence (at any moment of time), not just as a relation of sequence. Second, he restated the misunderstood and maligned "wages-fund" theory as a "wages-flow" theory, a basis for reviving Ricardo's concern that converting working capital to fixed capital would disemploy labor. Third, he insisted that the wages-flow employs land as well as labor--a finding implicit in Faustmann, also.
Henry George divided land price into two parts: DCF from the current use, plus the DCF from all future generations of use. He observed that the value derived from the later generations, discounted to the present, often keeps land from its highest and best use today because of speculation. This effect, immanent in all land markets, makes landowners collectively act like a universal cartel, pushing labor and capital to lands of lower quality, depressing wage and interest rates.
The policy implications are that George's proposed policy of focusing taxes on land value, and relieving commerce, industry, labor, and capital from taxation, would enhance human welfare in many ways.
II
How Ricardo's Theory of Value Includes Land and Capital
RICAROO ([1817] 1963) OPENS his Principles by noting that "the value of (some commodities) is determined by their scarcity alone," and exceeds the value of labor embodied in them ([1817] 1963: 5). One example he offers is "grapes grown on a particular soil, of which there is a very limited quantity." That is, a wine's terroir adds to its value. On page 7 he generalizes that the value of a commodity is enhanced by the "additional quantity of labor which the cultivation of inferior land requires." That is, it's the labor required on marginal land that equals value. On better land it takes less labor to produce the same value, so rent enters into value (whether as cause or effect we need not settle here). It is misleading to call that a "labor theory of value," as some do. One need only read Ricardo with reasonable sympathy to see that his value theory is quite sophisticated and comprehensive. He assumes, perhaps too sanguinely, that his readers will see the extended implications of matters he covers only tersely.
As to capital, Sections IV and V of Chapter 1, "On Value," are all about the incorporation of imputed interest into value:
Value ... varies with the unequal durability of capital, and by the unequal rapidity with which it is returned to its employer. ([1817] 1963: 21)
In Chapter 31, "On Machinery," Ricardo picks up these ideas again to show how a reallocation of capital from working capital to fixed capital may disemploy labor. Some later commentators have alleged that Ricardo didn't really mean it, or was aberrant when he wrote it. Yet, it follows from his analysis in Chapter 1, Sections IV and V. Ricardo does not mention Ludd, and he carefully avoids endorsing smashing of machinery.
