Inflation and The Fallacy of Historic Cost Pricing

Recently, I wrote about the fallacy that inflated asset prices, such as house prices, could repair household balance sheets. It confuses and conflates capital gains with income, just as it confuses and conflates capital losses with a reduction in income. I pointed out, in that post, the similarity that exists, in that respect, with the use of historic cost pricing, as the basis for calculating the rate of profit.

In the case of a household, a paper capital gain, resulting from a nominal rise in house prices, is presented as being equal to an increase in household income, by the amount of the capital gain. The same thing is the implication of historic cost pricing of capital, on the production of profits, with a consequent effect on the calculation of the rate of profit.

If we take a very simple company balance sheet, similar to that presented in relation to a household, we might have the following.

Liabilities		Assets
Owner's Capital	100,000	Fixed Capital	50,000
		Materials	40,000
		Variable Capital	10,000
Total	100,000	Total	100,000

Here, the owner has put up £100,000 of money-capital. The firm owes this money to them, and so is a liability of the firm. The £100,000 is used to buy buildings and equipment, which could be realised, if required to repay the owner, along with circulating capital in the shape of a stock of materials for processing and variable capital, which can be considered in its precise definition as a stock of wage goods to be paid to the workers, or its usual form as a stock of money to be paid as money wages.

If the firm engages in production, its sales may exceed its costs (for the sake of simplicity I am assuming that all of the fixed capital is consumed in the year) by £10,000, which is the amount of surplus value that the workers produce during the year. In other words, the workers create £20,000 of new value during the year, and of this, £10,000 is used to reproduce the variable capital, leaving a surplus value of £10,000.

To avoid the complication of prices of production diverging from values, I am following Marx's example, and assuming that the firm produces with the average organic composition of capital, and that its capital turns over at the average rate of turnover for capital within the economy. In that case, the surplus value it produces is equal to its profit.

In that case, we would have.

Liabilities		Assets
Owner's Capital	100,000	Fixed Capital	50,000
Profit	10,000	Materials	40,000
		Variable Capital	10,000
		Bank	10,000
Total	110,000	Total	110,000

If the firm became a joint stock company, the £10,000 of profit, here, would represent profit of enterprise. The £100,000 of Owner's Capital might be converted into 100,000 £1 shares. In that case, over time, the company could use the profit of enterprise to buy back the shares from the former owner, so that all of the shares are owned by the company itself, and could, therefore, be cancelled, in the same way in which a household can use disposable income to pay off a mortgage, and thereby cancel it, and its obligation to the bank that provided it, and indeed in the same way that the company would pay off, and thereby cancel, any other loan.

If we examine the rate of profit here, it is 10,000/100,000 = 10%.

Suppose that the value of the fixed capital rises by 20% to £60,000. As Marx sets out, in Capital III, Chapter 6, it doesn't really matter here, whether this is due to a real change in value, as a result of a change in productivity, or just a change in market prices. We would then have.

Liabilities		Assets
Owner's Capital	100,000	Fixed Capital	60,000
Profit	20,000	Materials	40,000
		Variable Capital	10,000
		Bank	10,000
Total	120,000	Total	120,000

So, here the value of the firm's output was equal to the value of its constant capital, consumed in production, plus the new value created by labour. The value of the firm's fixed capital, all of which is consumed in production, has risen in value/price compared to its historic price, going from £50,000 to £60,000. To comply with the requirements of the labour theory of value, it is the current value of that constant capital, which is transferred to the output. The total value of output is then £120,000 comprised of £60,000 value of fixed capital, £40,000 value of circulating constant capital, and £20,000 of new value created by labour.

However, if we calculate the firm's profit and rate of profit, using the historic cost method, what we find is that its actual cost of production is £50,000 for fixed capital, £40,000 for materials and £10,000 for wages = £100,000. This gives a profit of £20,000. As we have assumed that this is an average capital, its profit is equal to its surplus value. But that leads us into an irreconcilable conflict with Marx's Labour Theory of Value. The reality, here is that, as before, only £10,000 of surplus value has been produced by labour. The additional £10,000 of profit arises here not from labour, but purely from the appreciation in the value of the fixed capital.

In place of Marx's Labour Theory of Value, what the Historic Cost Method leads us to here is a bourgeois cost of production theory of value. Just as in relation to a household balance sheet, whereby rising house prices create the delusion of increased wealth, and imputed income, so the delusion is created here of a self-expansion of capital, and imputed surplus value. We are led inevitably to the conclusion, on the basis of the logic of historic cost calculations, that it is not just labour that creates new value, and so creates surplus value! Here £10,000 of new value has been created and incorporated into the value of the output out of thin air, thereby creating an additional £10,000 of surplus value.

The profit of the firm appears to be £20,000 and so, on the basis of the advanced capital, at historic cost, of £100,000, the rate of profit appears to be 20%. Yet, its clear, when this money illusion is set aside, that this cannot be the case. Exactly the same fixed capital and materials are utilised in the production process, and set in motion the same labour-power, which produces the same amount of surplus value.

Had the rate of profit really doubled from 10% to 20%, then the consequence one would expect is that the capital could be expanded by 20% in the next cycle, rather than by just 10%. If previously, 500 sq.m. of building space was employed, this would rise to 600 sq. m.; 50 machines would increase to 60; 50 tons of material processed increased to 60 tons; and 500 workers increase to 600.

Is that what actually happens? No. The increase in the price of the fixed capital consumes all of the fictitious profit/surplus value. It now costs £60,000 to use the same 500 sq.m. of building space, and the same 50 machines. The only real profit/surplus value, available for accumulation is that created by labour of £10,000. But, in fact, now it becomes apparent that far from the amount and rate of profit rising, the amount of profit has remained the same, whilst the rate of profit has fallen!

Previously, a 10% rate of profit would have been sufficient to increase the buildings' capacity used from 500 sq.m. To 550 sq.m., and the quantity of machines from 50 to 55; an increase of the fixed capital from £50,000 to £55,000. It would then have made possible an increase in the materials processed from 50 tons to 55 tons (£40,000 to £44,000) and the number of workers employed from 500 to 550 (£10,000 to £11,000). The workers would then have produced £11,000 of surplus value, assuming the rate of surplus value was unchanged.

However, the reality with the higher price of the fixed capital is as follows. £10,000 is available for capital accumulation. The price of fixed capital has risen by 20%. The technical composition of capital has not changed, and so the physical quantity of fixed capital to circulating capital remains unchanged, just as the physical proportion of material to labour-power remains unchanged. Previously, that meant that the capital was divided equally between fixed capital and circulating capital. To employ capital in accordance with its technical composition requirements, means that the £10,000 of surplus value available, has to be divided 60:50, or £5455 to fixed capital, and £4545 to circulating capital.

That means that the building capacity rises to 545.5 sq.m. not 550 sq.m.; the number of machines rises to 54.5, not 55; the materials processed rises to 54.5 tons not 55 tons, and the number of workers employed rises to 545 not 550. As a consequence, the surplus value produced by these 545 workers is only £10,900 not £11,000.

The consequence is that not only has the rise in the price of the fixed capital, relative to its historic cost, not resulted in a rise in profit, and the rate of profit, but the opposite has occurred. The real profit is immediately unchanged, but the higher value of fixed capital means that the rate of profit falls. The further consequence of this is that accumulation is less than it would otherwise have been, so less labour-power is employed than would have been the case. If the rate of surplus value is unchanged, therefore, not only does the rate of profit fall compared to what it would have been, but the mass of profit also falls relative to what it would otherwise have been.

What applies here, in relation to an appreciation of the value of capital compared to its historic cost – and this applies to circulating constant capital as well as fixed capital – applies equally in reverse, where the value of the commodities that comprise constant capital fall. Suppose we had the following.

Liabilities		Assets
Owner's Capital	100,000	Fixed Capital	50,000
Profit	5,000	Materials	35,000
		Variable Capital	10,000
		Bank	10,000
Total	105,000	Total	105,000

Here the value of the circulating constant capital has fallen (the same would be true with a fall in the fixed capital value), relative to its historic cost. The value of the firm's output is then £50,000 fixed capital, £35,000 materials, £20,000 new value created by labour = £105,000 in total. But, its cost of production on an historic cost basis is £50,000 fixed capital, £40,000 materials, £10,000 wages = £100,000. The profit/surplus value is then only £5,000.

Yet again, this conflicts with Marx’s Labour Theory of Value, because there has been no change in the rate of surplus value. The workers themselves still produced £20,000 of new value, and their wages were still only £10,000, giving a surplus value of £10,000, and not the £5,000 that the historic cost method derives. It means here that the rate of profit would be calculated, on an historic cost method, of being just 5%. But, what is the reality?

In fact, because the value of raw materials have fallen, any given quantity of profit will accumulate more of them, releasing capital to be accumulated. So now we would have a situation where, in order to comply with the requirements of the technical composition of capital, the actual £10,000 of surplus value is apportioned in the ratio of 50:45. That means that £5,263 goes to fixed capital, and £4,737 goes to circulating capital.

The amount of building capacity rises to 552.6 sq.m., the number of machines rises to 55.26. Meanwhile, because the value of materials has fallen relative to labour-power the quantity of materials rises to 55.26 tons, and the number of workers employed rises to 552.6. This larger number of employed workers now produces more surplus value, assuming the same rate of surplus value. Instead of the £11,000 of surplus value that would have been produced by 550 workers, this 552.6 workers produce £11,052 of surplus value. Once again, therefore, this change in the price of constant capital has consequences not just for the current rate of profit, but also for the future mass of profit, and rate of profit and accumulation in future periods.

Where the value of commodities that comprise constant capital – either fixed or circulating – rise this not only reduces the current rate of profit, but it also acts to tie up capital, and thereby reduces capital accumulation, which reduces the future potential growth in the mass of profit itself. Where the value of commodities that comprise constant capital falls, the opposite is the case. The historic cost method not only results in an unavoidable conflict with Marx’s Labour Theory of Value, but it also obscures this underlying reality of the process of social reproduction, because it confuses and conflates capital gain with the production of surplus value, and similarly confuses and conflates capital losses with the production of a negative value, or reduction in surplus value.

In periods of high inflation, such as the 1970's and early 1980's, an historic cost model will then tend to overstate profits, and the rate of profit, whereas for periods of low inflation or deflation, such as the period from the late 1980's onwards, the historic cost model will tend to understate the actual level and rate of profit, for the same reason.