Not entirely debauched by economics

The quote of the week (I should instate it as a policy) comes from a letter from Piero Sraffa to Joan Robinson:

"If one measures labour and land by heads or acres the result has a definite meaning, subject to a margin of error: the margin is wide, but it is a question of degree. On the other hand if you measure capital in tons the result is purely and simply nonsense. How many tons is, e.g., a railway tunnel? If you are not convinced, try it on someone who has not been entirely debauched by economics. Tell your gardener that a farmer has 200 acres or employs 10 men – will he not have a pretty accurate idea of the quantities of land & labour? Now tell him that he employs 500 tons of capital, & he will think you are dotty – (not more so, however, than Sidgwick or Marshall)."

That was in 1936. The reference comes from this paper by Velupillai on Krishna Bharadwaj’s contributions to economics.

Not so Keen on Krugman

I have been critical of the theoretical positions held by Krugman for a while now, even if he and DeLong, and even Summers, have been useful for policy reasons. Now a lengthy debate between Krugman and Steve Keen, a very pragmatic and reasonable post-Keynesian (and I guess part of MMT tradition) that understands endogenous money has developed [a good summary with all the links here].

First, and foremost endogenous money implies that the rate of interest is exogenous and determined by monetary authorities. That per se is not necessarily in contradiction with a neoclassical/marginalist view according to which the rate of interest equilibrates investment to full employments savings, as Krugman clearly believes. Wicksell [see here] certainly did not think so either.

For Wicksell in a giro system, in which all transactions were recorded as debit/credit relations, credit could expand indefinitely, but in the real world, bank reserves would vanish and lending would eventually collapse if the bank rate remained below the natural rate for a long period. That is fundamentally the reason why Krugman does not understand the notion that banks can create reserves, and that loans cause deposits. In other words, what regulates the bank rate is, ultimately the natural rate of interest.

Further, the natural rate of interest is NOT a banking phenomenon in marginalist analysis, and, as a result, cannot be exogenous to the system. It results from the marginal productivity of capital and the intertemporal decisions of consumers. Krugman is in fact very clear that he supports the loanable funds theory of interest.

Hence, Peter Cooper is correct to point out that ultimately the debate with Keen must revolve around a notion of a long term normal rate of interest that is institutionally determined by the central bank independent of the marginalist notion of the natural rate. That can only be obtained with the proper critique of the neoclassical notion of capital.

More on the capital debates: Eatwell on Garegnani

Follow up on my previous post. Here is the link to the lecture given by John Eatwell in honor of Piero Garegnani (hat tip Revista Circus). It goes beyond the question of showing why and how mainstream (aggregative or intertemporal models) are flawed. It shows that the classical-Keynesian approach is rooted in a historical-institutional which makes it directly relevant for policy analysis. As he says:

"Economics is meant to be useful. Not only is it supposed to give a greater understanding of how a market economy works, but also it should be a guide to economic policy.

... classical value theory and Keynesian theory share a common structure that both are dependent upon empirical data from outside the theoretical core. Classical theory is dependent upon market structure, the composition of output and the distribution of income (or, to be more accurate, one of the distributive variables, the wage or the rate of profit). These data can be derived from the historical position of the economy, the stage of evolution in the history of technical progress, the structure of international trade, the structure of corporate enterprise, the financial and monetary system, the policies of the state, and so on, all of which are arrayed outside the core, but are vital to its specification. Similarly Keynesian theory is inconceivable without a clear specification of the structure of finance. The principle of effective demand is dependent upon the existence of a relatively sophisticated financial sector, and developments in the financial sector will in turn have an impact upon the determination of investment and the process of accumulation. It is one of the obvious failures of neoclassical theory that financial variables play no role in the determination of prices and outputs. It is an abiding strength of classical and Keynesian analysis that not only can financial variables be readily accommodated, some of the analysis will not work without them."

Read the rest here.

The capital debates: A brief introduction

Teaching on the capital debates this and last week. So here are some thoughts, based on my class notes and the required readings (see below). The capital debates remain a puzzling chapter in the history of economic ideas. Nearly everyone accepts that the British (as opposed to the Massachusetts) Cambridge won the debate, something Paul Samuelson acknowledged early on.[1] Yet, no one seems to grasp the full implications and relevance of the debate itself. Typically it is assumed that the capital debates relate simply to problems of aggregation, and that the use of aggregate production functions and aggregative measures of capital are still justifiable, for simplicity’s sake. However, contrary to this viewpoint the capital debates did not rest upon the possibility of building aggregate measures.

The capital debates are associated with the very notion of capital. Classical political economy authors, from William Petty to Karl Marx, including Quesnay, Smith and Ricardo, treated the process of production as a circular one. In this context, capital is a produced means of production,[2] rather than a factor of production used in the process of obtaining final goods. The most important result of the capital debates is that, once capital is defined as produced means of production, there is no direct relation between the relative abundance or scarcity of the means of production and its remuneration. Distribution, in other words, is not governed by supply and demand.

Since the Marginalist Revolution, and the rise of the so-called neoclassical school, the notion that relative prices are determined by supply and demand, and that these reflect the relative abundance or scarcity of all goods and services – including factors of production – became consensual. As a result, the supply and demand for capital became the determination for the remuneration of capital. The more abundant is capital, the lower its remuneration, and vice versa if it is scarce. Conflict has no role to play in the determination of distribution, and social classes vanished entirely from analysis.

Additionally, substitution leads to the full utilization of resources and their optimal allocation. If capital is scarce and expensive, and labor abundant and cheap, economic agents substitute labor for capital and fully utilize labor. Thus, despite the abundance of labor, its relative cheapness, through the principle of substitution, leads to full employment. Indeed, unhampered markets do lead to the veritable best of all possible worlds.

It is the logic of the principle of substitution, based on relative scarcities that the capital debates shattered. Contrary to the neoclassical parable, the capital debates showed that it is not generally possible to obtain a univocal relation between remuneration and relative scarcity. For example, assume that we have two commodities produced with capital and labor, and that one can be said to be univocally more capital abundant than the other. In this case, as capital becomes more abundant the profit-to-real-wage ratio will fall, more capital will be used, and more of the capital-intensive good will be produced. However, it is possible that one good would be more capital intensive at high levels of the profit-to-real-wage ratio, and that the other becomes the capital intensive good at lower levels of the same ratio. That is, we would have factor intensity reversal. In the instance of factor intensity reversals, the conventional relation between factor scarcity and relative prices breaks down.

In this situation, it would be possible that as the profit-to-real-wage ratio falls, more labor will be used, and more of the labor-intensive good will be produced. In other words, there would be reverse capital deepening and a lower rate of profit associated with a reduction in the use of capital. Substitution moves in the wrong direction, so to speak, and more of the scarce factor is demanded. A simple algebraic exercise may help understand the point.

Let’s assume that there are two methods of production, associated to the manufacture of capital (iron) and consumption (corn) goods respectively. The prices are determined by:

(1) pc=wlc+rpkkc
(2) pk=wlk+rpkkk

where the subscripts refer to consumption and capital, l and k are the technical coefficients of production, and w and r are the real wage and rate of profit. Using pc as a numeraire and solving for pk we obtain:

(3) pk=(1-wlc)/rkc

From (3) into (2) we get:

(4) [(1-wlc)/rkc]=wlk+rkk[(1-wlc)/rkc]

Simplifying, and solving for w we find:

(5) w=(1-rkk)/[lc+(lkkc-lckk)r]

If the expression in the small parenthesis in the denominator is equalized to zero we obtain a wage-profit frontier that is linear. This assumption is what Samuelson (1962, p. 225, n. 7) refers to as the equi-proportional assumption. Figure 1 shows the choice of technique under this assumption.

Figure 1

The firm chooses the highest rate of profit for a given real wage, which implies that as the rate of profit falls the firm must choose the more capital intensive (b in this case). In this case, the neoclassical parable works; there is an inverse relation between factor intensity and its remuneration.

Once, the assumption of equi-proportional capital to labor ratios in the machine and consumption sectors (which would mean in Marxist terminology the same organic composition of capital in both sectors) is dropped the wage-profit frontier is not linear anymore. If we assume that the capital goods sector is more capital intensive than the consumption sector then the wage-profit frontier will be concave (as shown in Figure 2).

Figure 2

In this case, we have two switches; at high levels of the rate of profit the firm choose technique a, which is more labor-intensive, and as the rate of profits falls it switches to b the capital-intensive one as prescribed by neoclassical economics. However, at even lower levels of the rate of profit, the firm switches back to the more labor intensive technique. Reswitching and reverse capital deepening, hence, result from the dismissal of the equi-proportionality assumption, which is what one would expect in a world with several goods.

The implications for neoclassical theory cannot be overstated. First and foremost, there is no relation between relative scarcity and the remuneration of factors of production, and, as a result, distribution is not simply the product of market forces. Further, there is no guarantee that all resources will be fully utilized.[3]

It must be noted that, even though the capital debates are fundamentally about the logical coherence of the neoclassical approach, the results of the capital debates have important empirical implications. Neoclassical theory makes strong predictions vis-à-vis substitution effects and the relation between relative scarcity and remuneration. Yet the capital debates suggest that some of those predictions might not be consistent, and, as a result, the absence of those relations might be expected in the real world.

The most obvious prediction is the inverse relation between investment (capital intensity) and the rate of interest (its remuneration). As it is well known, there is little evidence that investment is sensitive to variations in the real rate of interest. In a rare survey of the empirical literature on the determinants of investment Robert Chirinko (1993, p. 1906) argues, “[T]he response of investment to price variables tends to be small and unimportant relative to quantity variables.” In other words, interest rates have little effect on gross capital formation, and the substitution effects that imply that agents use the cheaper factor of production are not operative. Further, the empirical evidence suggests that investment reacts to quantity variables, meaning the level of activity. This suggests that the income effects tend to be larger tahn substitution effects and that a firm facing less demand will not buy capital goods, even if the interest rate is low. These results underscore the empirical relevance of the capital debates.[4]

Similarly, the capital debates highlighted the futility of using the aggregate production function to measure the growth and productivity performance of real economies. The theoretical problems with the aggregate production function, associated to the notion of capital as a scarce resource, are compounded by the impossibility of disentangling it from the identity of income with the structure of the functional distribution of income (Felipe and Fisher, 2003). In other words, if one runs a regression of income on capital and labor, as is often done by those using a production function, it necessarily follows that income grows because capital and labor grow. Furthermore, changes in income distribution also affect income growth, as total income (net of taxes) is by definition the wage multiplied by labor utilized in production plus capital multiplied by its remuneration.

In this way, the capital debates demolished the theoretical foundations of neoclassical economics, and provided significant empirical evidence that those neoclassical models and their resultant policy prescriptions should be viewed with a healthy measure of skepticism.

Faced with the impossibility of using both the notion of aggregate capital and the principle of substitution, neoclassical economics opted to apply the principle of substitution to each kind of capital good taken as a distinct factor of production, by using the Arrow-Debreu model of intertemporal general equilibrium (Garegnani, 1976; Milgate, 1979). Even though the idea of intertemporal equilibrium, in which capital is treated as a vector of heterogeneous capital goods, was first developed by Eric Lindahl and then popularized by John R. Hicks in the 1930s, and used by Arrow and Debreu in the 1950s, it was only after the capital debates that it came to be dominant within the mainstream.

The problem with the use of heterogeneous capital goods is that it implies a change in the traditional method of economics. Normal equilibrium positions are associated to a uniform rate of profit; however, when dealing with heterogeneous capital goods that are not substitutable between each other, it becomes necessary to discard the notion of long run equilibrium. In Arrow-Debreu models all prices are short run prices, associated to differential rentals for each capital good, and any change in the data of the system – preferences, technology, and information for given initial endowments – affects the direction to which the economy adjusts (Petri, 2003).

In other words, the forces of competition that lead capitalists to those sectors with higher remuneration and establish a uniform rate of profit do not operate in the Walrasian world.[5] Hence, the Walrasian models are incapable of ascertaining tendencies in real economies, a defect that is not mitigated with the introduction of imperfections (Stiglitz, 1993, p. 109), which Stiglitz calls the post-Walrasian and post-Marxist paradigm. Far from increasing the realism of the model, the casting about of such lifelines only complicates the results of an exceptionally unrealistic one.

Information imperfections, and other related imperfections like price rigidities or lack of rationality, once introduced leave the Arrow-Debreu model unable to produce Pareto efficient solutions, or even market equilibrium, since some markets may not exist. Additionally, the introduction of imperfections renders the aggregative model prone to suboptimal outcomes. Suboptimal results in the presence of imperfections suggest that in their absence markets would still produce optimal outcomes.[6]

Some authors tend to confuse the imperfectionist arguments, and the implicit support that they provide for policy intervention, as a break with orthodoxy. While it is clear that they provide space for flexibility in policy advice, they remain firmly based on orthodox grounds.[7] The capital debates, in contrast, showed that unhindered markets, free of imperfections of any type, do not lead to market efficiency in general.

Faced with the logical problems that neoclassical aggregative models are riddled with on the one hand, and the irrelevance of general equilibrium models on the other, neoclassical economists did what any rational agent would do: disregard the critiques and in so doing, their deleterious results, and proceed as if nothing had happened. However, an innovative, if not peculiar, development generated a curious division of labor within neoclassical economics. Aggregative models were deployed for the purposes of teaching and policymaking, while the Arrow-Debreu model became the retreat of neoclassical authors when questioned about the logical consistency of their models. In this response, a harsh tradeoff between logical consistency and relevance was cultivated in the very core of mainstream economics.

The degree of fragmentation – as Roncaglia (2005, p. 468) so aptly expresses it – and confusion in the mainstream today is the result of such inconsistency at the core of economics, and not uniquely, as is frequently asserted, because of the demise of the Keynesian consensus. The collapse of the certainties provided by the old aggregative neoclassical model has brought about an often cynical defense of market-oriented policies for their own sake. The return of Vulgar Economics, which “sticks to appearances … [and] believes that ‘ignorance is a sufficient reason’” (Marx, 1867, p. 307) is complete.

Notes:
[1] See Samuelson (1966). A typical position is that of Robert Lucas (1988, p. 36) who notes the victory of the British argument, and yet remains oblivious to the problems of using the aggregate production function in the same paper.

[2] For Marx (1867, p. 189) capital also involved a social relation between the owners of the means of production and those forced to sell their labor power. For him, capital “can spring to life, only when the owner of the means of production and subsistence meets in the market with the free laborer selling his labor-power.”

[3] Both results are important, for example, for the Keynesian possibility of unemployment equilibrium. Keynes’ (1936, p. 243) emphasis on the unimportance of the natural rate of interest not only implies that the supply and demand for capital (loanable funds) do not determine the equilibrium rate of interest, but also that the conventional rate of interest may be set at such a level that brings about persistent unemployment.

[4] In the same way, the empirical evidence seems to contradict the notion that higher wages would lead to substitution of cheaper factors of production for labor. The exemplary case is the well-know study of the fast food industry in New Jersey, which found a positive correlation between the minimum wage and employment (Card and Krueger, 1995).

[5] That GE models do not support the notion that the abundance of a factor of production will be associated with lower remuneration has been pointed out by a survey of those models (Bliss, 1975).

[6] The same is valid for Bowles and Gintis’ (1993, p. 84) notion that market exchanges are usually contested and endogenous enforcement costs are not zero, and, as a result, there are conflicts of interest among exchanging parties. Therefore, if enforcement costs were nonexistent the Arrow-Debreu results would prevail. It must be noted that all the literature on post-Walrasian economics presumes continuity between the classical political economy authors and the post-marginalist revolution economics, which would mean that there are no significant distinctions between Smith, Marx, Walras and Arrow.

[7] Colander et al. (2004), for example, seems to suggest that several of the post-Walrasian developments can be seen as breaking up with orthodoxy. For a critique see Vernengo (2010).

Additional Readings:

Bliss, Christopher (1975), Capital Theory and the Distribution of Income, Amsterdam and New York: Elsevier North-Holland.

Bowles, Samuel and Herbert Gintis (1993), ‘The revenge of homo economicus: Contested exchange and the revival of political economy’ The Journal of Economic Perspectives, 7(1), 83-102.

Card, David and Krueger, Alan (1995), Myth and Measurement: The New Economics of the Minimum Wage, Princeton: Princeton University Press.

Chirinko, Robert (1993), ‘Business fixed investment spending: Modeling strategies, empirical results, and policy implications’, Journal of Economic Literature, 31(4), 1875-1911.

Colander, David, Rick Holt, and J. Barkley Rosser Jr. (2004), “The changing face of mainstream economics,” Review of Political Economy, 16, pp. 485-99.

Felipe, Jesus and Franklin Fisher (2003), ‘Aggregation in production functions: what applied economists should know’, Metroeconomica, 54(2-3), 208-262.

Garegnani, Pierangelo (1976), ‘On a change in the notion of equilibrium in recent work on value: a comment on Samuelson’, in M. Brown, K. Sato and P. Zarembka (eds), Essays in Modern Capital Theory, Amsterdam: North-Holland.

Heim, John J. (2009), ‘Which Interest Rate Seems Most Related to Business Investment?’, American Society of Business and Behavioral Sciences E-Journal, 5(1), February.

Keynes, John M. (1936), The General Theory of Employment, Interest and Money, New York: Harcourt Brace.

Lucas, Robert (1988), 'On the Mechanics of Economic Development,' Journal of Monetary Economics 22 (1), pp. 3–42.

Marx, Karl (1867), Capital, NY: International Publishers.Capital, NY: International Publishers.

Milgate, Murray (1979), 'On the origin of the notion of ‘intertemporal equilibrium’,' Economica, 46(181), 1-10.Economica, 46(181), 1-10.

Petri, Fabio (2003), ‘A ‘Sraffian’ critique of general equilibrium theory, and the classical Keynesian alternative’, in F. Petri and F. Hahn (eds), General Equilbrium: Problems and Prospects, London and New York: Routledge, pp. 387-421.

Samuelson, Paul (1962), “Parable and Realism in Capital Theory: The Surrogate Production Function,” Review of Economic Studies, 29(3), pp. 193-206.

Samuelson, Paul (1966), ‘A summing up,’ Quarterly Journal of Economics, 80(4), 568-583.Quarterly Journal of Economics, 80(4), 568-583.

Vernengo, M. (2010), 'Conversation or Monologue? On Advising Heterodox Economists,' Journal of Post Keynesian Economics, 32(3), pp. 389-96.

Too many things wrong (Sargent and Field edition)



And not enough time to blog about all of them. Two that seem to be really important and worth noticing in recent debates around the blogosphere among the chattering classes are the idea  (subscription required) that State Defaults after the Jacksonian economic crisis were good to establish US credibility, and the notion that Total Factor Productivity (TFP) was essential for the US recovering from the Great Depression.

Very briefly I’ll discuss why these two propositions are just wrong. Sargent argues that by guaranteeing State debts the Hamiltonian system created moral hazard, and that the States defaults of the 1840s, which resulted from this arrangement, were instrumental in creating a credible fiscal commitment to sound finance. In his words: “in refusing to bail out the states in the early 1840s … the federal government reset its reputation vis-à-vis the states, telling them in effect not to expect it to underwrite their profligacy.” The lesson for Europe is let the periphery default, and, by the way, that would lead them to fiscal consolidation by even more austerity (yep he never heard of multipliers). At any rate, this account of the United States experience is pure fiction.

First of all the collapse had nothing to do with profligacy, and all to do with prices of cotton falling, and States defaulting on foreign debt, not domestic debt. In Europe the countries do print the money in which their debt is denominated, the problem is that the ECB is not willing to do it. The crisis is self-made, and if the ECB monetized a bit of debt there would be no danger of inflation, since the economies are really (really) far from full employment.

Further, the US national government at that point had no public debt (Jackson paid it down and caused a financial crash; he also required payments of public lands in specie, that is the crisis was worsened by austerity and sound money), and no national bank or monetary authority. Hence, it could not bail the States out. Only after the Civil War, with greenbacks, a more centralized management of debt and money were created in the US. So there is no possibility that the reputation of something that did not exist until the 1860s was built in the 1840s.

Sargent's anal fixation with austerity in order to pay debts, even those in domestic currency, and his lack of understanding of basic events in the history of the United States are appalling. And this guy got a Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (yep, it’s not a real Nobel!).

Field is an interesting case. The mistake in his book is not of his making, in all fairness, but the result of the profession's lack of understanding of basic economic principles. His point, well explained by Mark Thoma, is that part of the recovery in the 1930s was caused by rapid growth in productivity (TFP). Nothing against the argument, which might be (and probably is) true, to some extent. Note also that productivity is not only pro-cyclical but also structural and demand-led, which means that some of the increase in productivity was actually caused by the recovery. But the problem is that TFP is not a measure of productivity.

Note that TFP is based on the notion that there is a production function in which output (Y) is a function of labor (N) and capital (K), and forget for a second the problems of using the notion of a quantity of capital. In addition, we know that income (Y) is equal to the payments to labor (N) and capital (K). So we have a theoretical construct and an identity:

Y=f(N, K) and Y=wN+rK

Obviously if you derive Y with respect to time, you must obtain from either equation that the growth of Y over time is a function of growth in labor and capital, and either some additional part, which depends on the technology f(…) in the theoretical construct, and the weighted average of the growth of wages (w) and profits (r) in the identity. And yes the second is an identity and by definition (constructed in the national accounts) true. So TFP is a residual that says something about income distribution. Let’s please use labor productivity, when discussing productivity. For more on that see, for example, Felipe and McCombie (2001; subscription required).

More on "free" trade

In a recent post I promised to develop the critique of the dominant trade model, the so-called Heckscher-Ohlin-Samuelson (HOS) theory. While the Ricardian concept of comparative advantage is based on the labor theory of value (and is compatible with modern versions of that theory, as developed by Sraffa), and its results hold if the assumptions are realistic (limited capital mobility, and a fixed level of employment, the latter could result from domestic demand policies), the HOS is an application of the marginalist theory of value and distribution and it suffers from that theory's inconsistencies.

The HOS theory says that a country exports the goods that are intensive in the use of the factor of production that is abundant in the country. A country with lots of workers, and according to theory cheap labor, would produce goods that are labor intensive and export them, while importing capital intensive goods. The graph below illustrates the argument.

If there are two goods (a and b), and one (a) is always more capital intensive (bigger capital-labor ratio) than the other (b), and in both goods we have that as capital intensity increases (larger K/L ratio) the rate of interest falls, then as the rate of interest falls the relative price of the capital intensive good with respect to the labor intensive one falls too. In other words, in a capital abundant country, capital intensive goods would be cheap, and specialization would be guided by the relative prices.

The capital controversy showed that there is no reason, in a world with multiple capital goods, to have a monotonic decreasing relation between capital intensity and the remuneration of capital. One way in which that effect could be represented would be with a capital intensity reversal in the production of goods a and b, as shown below.

In that case, as the intensity of capital increases (K/L goes up) at first, as before, a is the capital intensive good, but now there is a switch and b becomes the capital intensive good at lower rates of interest. The consequence is that for a part of the process as the capital-labor ratio increases the price of a with respect to b increases, but after the switch, the other part of the process, it decreases. The relative abundance of capital and labor is not a guide for relative prices anymore, and as a result, neither can it determine patterns of specialization.

 

As a result it is not generally true that trade depends on comparative advantage based on relative scarcities of factors of production. This suggests (as the critique of the Ricardian version of the model) that absolute advantage, lower costs, might be more important than conventional wisdom suggests. Also, it implies that history and institutions are central to understand patterns of trade specialization.

The seminal work in this area was done by Ian Steedman, extending the ideas of Sraffa to foreign trade. The classic papers have been collected in Steedman's edited book Fundamental Issues in Trade Theory.

Garegnani and the revival of the surplus approach

(1930-2011)

Last weekend Pierangelo Garegnani passed away in Rome. He was the main disciple of Piero Sraffa, and one of the most important heterodox critics of the mainstream marginalist (neoclassical) approach. A full account of his contributions to economics is well beyond what I can offer in this space, but here are a few highlights.

As early as 1961, while spending an academic year at MIT, he suggested during a presentation by Paul Samuelson that his results depended on the assumption that all sectors use the same capital-labor ratio. The final results of his critique were presented in Garegnani's paper "Heterogeneous Capital, the Production Function and the Theory of Distribution." His paper shows conclusively that the marginalist theory of value and distribution based on an aggregate production function is untenable. This of course builds on Sraffa's work in the Production of Commodities (PC). By 1966, in the famous Quarterly Journal of Economics (QJE) Symposium, Samuelson had admitted that the neoclassical parable was not defensible.

In his 1976 paper "On a Change in the Notion of Equilibrium in Recent Work on Value and Distribution" Garegnani argued that to avoid the problems associated with the aggregative marginalist model, the mainstream had switched to Arrow-Debreu (AD) General Equilibrium models, which did not use aggregative capital, but also did not assume a tendency to a uniform rate of profit, which implies that it can only be seen as a short run equilibrium. Further, Garegnani later argued that, beyond the problem of being stuck with a short run theory, the AD model was still open to the capital critique, since a notion of aggregate capital was still needed for the equilibration of savings and investment (see his 2003 paper "Savings, Investment and Capital in a System of General Intertemporal Equilibrium").

Garegnani was also the central author arguing that the recovery of the classical theory of value and distribution (and hence Marx) was not incompatible with the Principle of Effective Demand (PED), as developed by Keynes and Kalecki. His two papers in the Cambridge Journal of Economics show that a rejection of the marginalist notion that labor and capital markets tend to full employment depends on the rejection of the mainstream theory of value and distribution, and that Keynes' PED is fully consistent with the old and forgotten classical or surplus approach. He also actively contributed to the extension of the PED to the long run until the end of his life (e.g. his paper with Trezzini).

There are several other contributions, in particular his work on the interpretation of Ricardo and his debates with orthodox Marxists, which again follow in the steps of his teacher. His work is essential for those interested in the understanding of the functioning of capitalist economies, and the incapacity of the mainstream to provide a useful tool to analyze reality.

Lucas in context, Keynes out of context

Krugman decided to try his hand at history of macroeconomic thought in one of his last posts. That's great, since history of thought is essential to understand how we got here. It's also bad, since Krugman is still very much a mainstream author, and misses the point of Keynes' contributions, and the limitations of neoclassical (or more properly, marginalist) approach. He suggests correctly that the New Classical (NC)/Real Business Cycle (RBC) project was a failure, but both the reasons for that and his interpretation of the Keynesian project are misguided.

The first proposition in Krugman's reassessment of the recent history of macroeconomics, is that Keynesian models were ad hoc, and assumed wage and price rigidity. The whole of chapter 19 of the General Theory (GT) is about the effects of price and wage flexibility, and how it does not produce full employment. It was with Franco Modigliani's PhD dissertation, done at the New School for Social Research under Jacob Marschak, that the sticky wage version of Keynesian theory that would dominate the neoclassical synthesis was concocted.

Keynes is actually quite explicit about the negative effects of wage reductions. He says (GT, ch.19-link above):

"A reduction of money-wages will somewhat reduce prices. It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.

What will be the effect of this redistribution on the propensity to consume for the community as a whole? The transfer from wage-earners to other factors is likely to diminish the propensity to consume. The effect of the transfer from entrepreneurs to rentiers is more open to doubt. But if rentiers represent on the whole the richer section of the community and those whose standard of life is least flexible, then the effect of this also will be unfavourable. What the net result will be on a balance of considerations, we can only guess. Probably it is more likely to be adverse than favourable."

Hence, the fix-wage version of Keynes' thought is the result of misconception, that suggests that if markets worked well, without imperfections, they would move to full employment. Unemployment is a disequilibrium, by definition a short run situation resulting from a rigidity.

The whole point of the neoclassical synthesis was to suggest that one could continue to teach that markets are efficient, and that supply determined the price and quantity of equilibrium in all markets including those of "factors of production" (i.e. the labor and capital markets), and as a result unemployment could only result  from rigidities in the labor market. Nothing revolutionary there, and in that case, as Keynes foresaw, people would think he was quite wrong or said nothing new.

By the way Krugman does not believe that rigid wages are behind our current lack of full employment (in his view it is the downward rigidity of the rate of interest; Keynes also did not believe in the liquidity trap as the cause of depressions), which makes it more difficult to understand why he defines Keynesians (Old and New) as pragmatic rigid price and wage modelers. You cannot blame then Laurence Kotlikoff for his confusion (here and Krugman's reply and here; Jamie Galbraith, also implicated, gives a better answer since he never said that Keynes is about wage rigidity; scroll down for Jamie's and Kotlikoff's back and forth).

Krugman's second point is that Friedman and Phelps in the 1960s were trying to provide microfoundations to wage and price rigidity. Actually, the microfoundations agenda had more to do with the theoretical development of theories for consumption (Modigliani, Friedman), investment (Eisner, Tobin) and money demand (Baumol, Tobin) behavior. The Phillips Curve (PC) debate and the Friedman-Phelps notion of a natural rate of unemployment is associated to the idea that there is a supply side constraint to the economy, and stimulating demand would ultimately have only effects on prices and not on quantities. The economy naturally moves to full employment, unless there are restrictions, and what is needed is to eliminate the restrictions not stimulate demand.

In other words, the monetarist approach of Friedman accepts the neoclassical synthesis notion that it is the rigidities that cause unemployment. It just proposes a different policy solution. By pointing out the existence of a natural rate of unemployment analogous to Wicksell's natural rate of interest (which Keynes' criticizes in the GT) Friedman was just emphasizing that if one believes in the neoclassical theory of value and there are no restrictions the system moves to full employment. In fact, Friedman's (1970) theoretical framework, an ISLM cum PC and natural rate model, is remarkably close to the neoclassical synthesis models.

In that sense, the Lucas Revolution and the subsequent move, after Kydland and Prescott's work, of most New Classicals , including Lucas, to the Real Business Cycles camp is a not a break with Friedman, and the New Keynesians (NK) that accept everything (including the natural rate) are part of the same tradition. The difference is that some emphasize the long run neoclassical principles and others the short run rigidities that demand policy action.

The fundamental problem of the neoclassical/marginalist approach, and the importance of Keynes analysis, can ONLY be properly understood in light of the 1960s capital debates (for a good reference go here). The point, for the purposes of our discussion here, is that if there is unemployment and real wages fall, neoclassical theory tells you that according to the principle of substitution, more labor is demanded (the cheap thing that is in excess supply) and less machines (capital) are used, since they are relatively more expensive. However, since labor (which is cheaper) is used in the machine sector too their price should fall too, and is not generally true that there is a tendency for the full utilization of "factors of production" according to their relative scarcities. Further, even if the substitution effects go in the right direction, and more labor is used, the income effect of lower real wages tends to be large and have a negative effect on demand (put simply, workers cannot buy stuff), which implies that less of all "factors of production" are used. In other words, there is no natural tendency to full utilization of labor or capital, and both the natural rate of unemployment and its evil twin the natural rate of interest do NOT exist.

So it is peculiar that Krugman thinks that "NK economics [is] useful, if only as a way to check my logic, although it’s not really clear if it’s any better than old-fashioned Keynesianism." What logic? New Keynesian models assume a natural rate, and that the economy (without rigidities) moves to full employment! The problem with the NC/RBC/Lucas' type of theory is not that it failed to predict the 1980s recession or that they think that most crises are caused by real shocks (although both propositions are obviously wrong), as Krugman seems to believe, but that they do maintain the fiction of an efficient market that clears (in their case too fast for Krugman's taste) and that produces a natural rate. If he wants to move in the right direction Krugman should follow Galbraith and announce that it is time to ditch the natural rate hypothesis.

PS: That means that progress in economics is not linear, and that one can and should learn from old and forgotten traditions (classical political economy did not assume full utilization of resources).

Macro vs. Micro

A debate on the relation between micro and macroeconomics has been raging in the mailing list of the Societies for the History of Economics (SHOE; yep that's the acronym they went for!).  The main question being discussed is whether micro-foundations are necessary for coherent macroeconomic theory. I have argued in a previous post that, in fact, this is the other way round, macro-foundations for microeconomics are essential.

From a history of thought point of view, it is important to note that the distinction is a relatively modern one, starting in the 1930s.  The term macroeconomics was first used, most likely, by Ragnar Frisch in his lectures notes in 1933-34, and first used in print by Jan Tinbergen and Eric Lindahl in 1936 and 1939, respectively (for a full discussion see Vela Velupillai, 2009; subscription required).  Keynes did not use the term in his General Theory, even though the book is considered the foundational book of macroeconomics. To a great extent the work of John Hicks -- both his ISLM paper and his Value and Capital -- is central to understand the direction in which the profession developed.

Yet, Keynes book was central in the eventual split of macroeconomics and microeconomics.  In particular, because Keynes defied the conventional wisdom, associated with marginalism, that the rational maximizing behavior of firms and individuals would lead to the optimal (meaning full) utilization of resources, including obviously labor resources.  Full employment was not the normal equilibrium position of the economy.  In that sense, Gary Mongiovi provided the most enlightened note to the SHOE debate.  He tells us:

"the macro/micro distinction actually arose after Keynes's theory took root, and students had to be taught two distinct and apparently incompatible stories about how market economies work: (1) a neoclassical distribution theory in which the real wage adjusts to bring the S & D for labor into line with one another; and (2) a Keynesian story about how the economy could settle into an equilibrium in which the labor market doesn't clear."

That incompatibility and incoherence is still with us.  Students are taught that markets are efficient in their micro text, and some imperfectionist story is told in order to provide a foundation for the Keynesian macro story (at least in salt-water departments).  Of course an alternative would be to discard the marginalist approach altogether, since it does have insurmountable problems as admitted by Paul Samuelson during the capital debates in the 1960s.  But that's another story for a different post.

Dr. Krugman and the natural rate of interest



So I have said a few times here that, while Krugman has been extremely useful for Keynesians in recent policy debates, as a New Keynesian (neo-Wicksellian would be a better term for this school of thought), he is not properly a real Keynesian.  In a recent post he shows exactly my point.  He says:

"There is still a sufficiently low real interest rate that would produce recovery, but it’s a rate that’s hard to achieve."

In other words, there is a rate of interest that would increase investment and bring about the full employment level of savings.  In this post he surprisingly seems to say that liquidity traps or lower zero bound limits (rigidities) for nominal rates do not matter.

The reason seems to be connected to the fact that creditors must have a positive effect on their net wealth in a deflationary balance sheet recession, and their spending should go up.  Hence, creditors should spend more with a slightly lower interest rate.  Wealth effects have been the traditional neoclassical argument for a self-equilibrating economy since Pigou.  If this were true no fiscal policy would be actually necessary.

It's hard to believe that Wall Street bankers would spend sufficiently more for a recovery to follow.  And I doubt that Krugman believes that this effect is sufficiently strong in the real world.  But he does believe in some sort of natural rate, like Wicksell did, which is compatible with Friedman's natural rate of unemployment.

Keynes, on the other hand, thought that the very concept of a natural rate should be discarded.  In chapter 17 of the General Theory Keynes states that:

"In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level. ... I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.
I am now no longer of the opinion that the concept of a “natural” rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis."

So, in fact, there might be the case that NO long term rate of interest, a highly conventional one according to Keynes, would be compatible with full employment.  The socialization of investment, in Keynes' terms, then would be necessary.  In other words, effective demand matters in the long run, not just the short run, because there is no tendency for self-adjustment.

Since Friedman's infamous Presidential address to the American Economic Association the neo-Wicksellian approach has dominated macroeconomics.  In this view, the central bank pins the short run policy rate to the long run natural rate, and the economy (save for rigidities and imperfections) moves automatically to full employment.  No fiscal policy is necessary, again with the exception of short run imperfections.  That's why long term considerations about deficits and debt are important. 

My question is: should we be surprised that with this theoretical model as the dominant one, we are in a situation in which the administration is unable to understand and unwilling to promote the fiscal expansion necessary to get us to full employment (or at least lower levels of unemployment)?

PS: Keynes developed the ideas in chapter 17 on the basis of Sraff'a's critique of Hayek's theory of capital in 1932 (here; subscription required).  Note that while Keynes understood that the idea of a natural rate of interest that equalized investment to full employment savings had to be discarded, he did not get that his negatively sloped marginal efficiency of capital actually provided the basis for such a rate.