The University of Chicago where the theory of human capital was distilled in 1960
The theory of human capital — which provides the intellectual support for student loans and other initiatives that impose the cost of education on students — was developed in Chicago in 1960 to counter Soviet ideology and collectivist political arguments.
That is the case made by Cass Business School professor Peter Fleming in an article published by the Aeon digital website.
Fleming says its principal architects were chairman of Chicago University’s economics department Theodore Schultz and his colleague Milton Friedman, the future winner of the Nobel Prize for Economics.
“Friedman probably agreed with Schultz that human capital theory was the ideational weapon they’d been searching for to counter the Soviet threat on the economic front,” Fleming writes. “The very phrase implied that human beings’ interests naturally coincide with the values of capitalism.”
Schultz and Friedman, though both conventional economists, disagreed about the implications of the new theory. Schultz believed that there were positive externalities to education and training and that, therefore, there was a case for the state to accept at least some of the responsibility for education and training costs.
Friedman, in contrast, argued that the bulk of the benefit was privately accrued. The individual being educated should pay for it.
“Human capital theory shapes education policy in most advanced economies”
Human capital theory was developed by Gary Becker, then a student at Chicago. Its influence has been significant in both theory and practice.
In the UK, the main opposition Labour Party is poised to announce as a manifesto commitment a plan to abolish higher and further education tuition fees. These were introduced by the New Labour government of prime minister Tony Blair in 1998.
This promise – and a similar one was made by the Liberal Party before the 2010 UK general election and subsequently broken when it entered a coalition government with the Conservative Party — flies in the face of conventional theory and the foundations of education policy in most advanced economies.
It is inspired by arguments that tuition fees are unfair to low-income people and economically perverse: they encourage the accumulation of debts at a point in life when many are unable to make a sound decision about the implications of educational choices.
The end of tuition fees is appealing to present and future students and their families. Around 1.8m Britons are in higher and further education in the UK. Their votes could be decisive in its June general election.
Abolishing fees would cost the UK government about £10bn a year. The ruling Conservative Party says this is an example of Labour’s irresponsibility.
Economists find the debate perplexing. Practically all accept the idea that there is such a thing as human capital which exists in the minds of individuals but operates in economies much in the way that physical capital does. It is seen as the most valuable factor of production in advanced economies dominated by service industries like the UK’s.
At the same time, they accept, as Schultz did, that there are positive social externalities to education that will be lost if it is treated as if it were a private good like clothing.
Economics, consequently, is failing to develop decisive insights about the issue. It accepts the case both for privatising educational investment and maintaining state support.
There are a range of public choice options.
This imprecision is the result of the challenge presented to conventional economic thought by the rise of services in advanced economies. The latest ONS data shows 84 per cent of the UK’s total labour force is involved with producing intangibles. Many working in tangible good industries use mental rather than physical energy to create value.
Physical capital required by service industries is relatively modest. Many service workers need very little. Their intellectual and social capacities are far more important than the equipment and other facilities they use.
The problem is this: what happens when demand for physical capital falls to minimal levels as technology steadily allows the productivity of each unit to grow?
In those circumstances, the idea of human capital that can be treated as if it is effectively identical to physical capital maintains the relevance of models that view the economy as a system that combines labour, capital and other physical inputs and technology in a value chain.
But this can only happen if the intellectual capacities of workers are separated conceptually from the bodies of those workers.
For corporations, this has paved the way intellectually for the accumulation of forms of intangible capital that can be counted as assets.
For some major corporations, intangible capital is now dominant in their capital structures.
The acceptance that human capital exists also lays the intellectual foundations for trade. Intellectual capital can be sold and leased for a price. Finance can be raised for investment in human capital both at an individual and collective level.
Fleming says the acceptance by economists, businesses and government of the idea of human capital has had negative consequences.
“Friedman’s decisive encounter with Schultz still reverberates today, and not in a good way,” he writes. “For example, one can trace a red thread from his 1960 victory concerning who’s exactly responsible for human capital investment, and the student debt catastrophe unfolding presently in the US, UK and many other countries that embraced neoliberalism a little too uncritically. Want a university degree and to get ahead in life but can’t afford it? Then here’s a student loan to tide you over, with terms and conditions that will hound you to the grave. The underlying message of human capital theory turns out to be simple, and Friedman cheerfully summed it up in a pithy catchphrase during the 1970s: there is no such thing as a free lunch.”
Fleming is compelling when he considers the unforeseen implications of human capital theory when it is practically applied. But he fails to identify the key issue at the heart of the conundrum.
That is the failure of economics to grasp the theoretical and practical implications of the dominance of intangibles in advanced economies.
This is an incremental process that nevertheless constitutes a radical change in the mode of production from tangible good manufacture to intangible value creation. It’s one that economists can’t address without a matching revision in the intellectual framework that has governed the discipline for more than 100 years.
This approach conceptualised economies as working through the interaction of demand and supply (both for tangible goods and intangible services) where the key vector is price.
That model, although far from perfect, nevertheless allowed economists to distil insights that were useful to business and the state.
In fact, the idea of the market-clearing price — or an analogue that both existed and could be defined — made the 20th century. The trillions of decisions made daily about investment, production, consumption and saving would be impossible if people didn’t believe the price of goods and services bought and sold were essentially technically accurate and socially acceptable.
That’s why most people accept in principle (though they may baulk in practice at the prospect of high student fees) that those benefitting from higher and further education should bear the bulk of its costs.
Within the terms of what is widely accepted as economic theory, this makes sense. It’s almost intuitively obvious.
Economics2030 argues, in contrast, that the rise of services requires a fresh approach that focuses on the way value is created in service economies.
It’s not the by-product of the interaction between supply and demand where price is the key vector.
It’s the result of constructive human interaction where interpersonal relationships – not prices — are decisive.
“In service economies, ideas have no value unless they are shared”
Physical capital supports value creation in services. It’s not central to the value-creation process as it is in tangible good production.
The recognition that, in services, value is created solely as the result of human interaction also destroys the idea that ideas and other human capacities are separable from the body of the person in whose mind they exist.
In service economies, ideas have no value unless they are shared.
That value creation is maximised when ideas are as shared as freely possible.
And the incentive for ideas to be shared as much as possible is that the value created when they are is fairly distributed among all those involved.
The conclusion is that the idea of human capital, which served a purpose in the economics of tangibility, founders once how value is created in service industries is fully understood.
Of course, service industries need infrastructure both in a tangible and intangible form.
But whether this is capital as economists conventionally define it – and their definition of capital (as human capital theory shows) has become so broad it’s already almost meaningless – is an open question.
A five-minute video about the use and abuse of the idea of capital can be found here.