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.

A Note on the Concept of Vulgar Economics

The concept of vulgar economics, developed by Karl Marx, is often cited, but seldom properly used or understood. In the preface to the second German edition to Capital Marx said that:

"[The] period, from 1820 to 1830, was notable in England for scientific activity in the domain of Political Economy. It was the time as well of the vulgarising and extending of Ricardo’s theory, as of the contest of that theory with the old school."

It is important to note that Marx clearly knew that "the theory of Ricardo already serves, in exceptional cases, as a weapon of attack upon bourgeois economy," in particular, because Ricardo was the first to show conclusively the necessary oposition between wages and profits, and the conflictive nature of the capitalist system. The problem with post-Ricardian economics was that it could not claim to be scientific and at the same time argue that the capitalist system was harmonious. For him:

"Men who still claimed some scientific standing and aspired to be something more than mere sophists and sycophants of the ruling classes tried to harmonise the Political Economy of capital with the claims, no longer to be ignored, of the proletariat. Hence a shallow syncretism of which John Stuart Mill is the best representative. It is a declaration of bankruptcy by bourgeois economy."

So vulgar economics was the dominant, or common, view of Political Economy after Ricardo, which was fundamentally apologetic and dismissed the Ricardian conflictive view of capitalist economies.

Also, it is important to note that, although critical of bourgeois economics (Quesnay, Smith, Ricardo), Marx knew his theory built on their analysis. He says:

"As early as 1871, N. Sieber, Professor of Political Economy in the University of Kiev, in his work 'David Ricardo’s Theory of Value and of Capital,' referred to my theory of value, of money and of capital, as in its fundamentals a necessary sequel to the teaching of Smith and Ricardo. That which astonishes the Western European in the reading of this excellent work, is the author’s consistent and firm grasp of the purely theoretical position."

So the excellent work of Professor Sieber correctly grasps Marx's theoretical position, according to Marx, and says that it is "a necessary sequel to the teaching of Smith and Ricardo." I'll leave for another post the discussion of the current state of economics, and in what sense one can talk of a return of vulgar economics.

Scope and flexibility of alternative economic paradigms

Teaching the basics of the surplus approach this week. One important feature of what Garegnani refers to as the core of the surplus approach, shown in the figure below, is the flexibility that it provides for the development of alternative theories.

In the core output, technology and real wages are taken as data of the system. With output and technology one can determine the labor requirements for production. Further, with real wages one can get the necessary consumption needed to reproduce the labor force. Finally, extracting necessary consumption from output one obtains the surplus, and the surplus is what allows for expanded reproduction or accumulation, the main preoccupation of classical political economy authors.

An important thing to emphasize is that the relations within the core do not imply that the theories regarding the data must be similar. For example, while Ricardo accepted Say's Law, Marx clearly rejected it. Hence, the core is compatible with alternative theories of output, and similarly about the determination of real wages and technological change. The core is flexible and capable of encompassing different theories.

Further, nothing precludes the existence of feedback mechanisms and relations between the data of the system in classical analysis. The level of surplus might certainly have a relation to output, and that is central for the theories of accumulation, but those relations lack the generality that is attributed to the core relations. In those, less rigid relations, the role of institutional and historical elements loom large.

In the marginalist approach, in contrast, output and distributive variables (the real wage and profits, which are part of the surplus and, thus, residual for surplus authors) are determined simultaneously by supply and demand. There is no space for alternative views on the determination of output or the real wage. Full employment (a version of Say's Law) is a necessary result with flexible prices (hence, rigidities are necessary to get unemployment).

Suggested Reading:

Garegnani, P. (1984), “Value and Distribution in the Classical Economists and Marx,” Oxford Economic Papers, 36, pp. 291-325. Link here (subscription required).

PS: A complementary post, diagram and suggested reading at Robert Vienneau's Thoughts on Economics.

Giving thanks for David Ricardo

Off to New York, where I'll be interviewed about David Ricardo's contributions to economics, for a documentary on capitalism. So here is a recent post by Robert Paul Wolff, an incredibly wise Marxist philosopher, on Ricardo (his book on Marx is quite Sraffian, by the way). Enjoy the Thanksgivings!

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.

Too many contradictions, not enough cumulation

In 1996, if I'm not wrong, there was a conference at the New School in honor of David Gordon, who had just passed away.  The late Andrew Glynn, gave a very nice talk, but he said something that left me uneasy.  For him, the NAIRU (Non Accelerating Inflation Rate of Unemployment) was our concept, meaning by our radical economics' idea, not mainstream's idea.  The point was that the NAIRU, in contradistinction to Milton Friedman's natural rate, does not imply full employment.

The NAIRU does suggest that output is supply determined, and that expanding demand beyond that level is inflationary, but the fundamental reason is that after that the bargaining power of workers increases and leads to wage-price spirals.  This could happen way before the economy is fully utilizing its productive capacity, and would depend on social factors like the relative strength of the trade unions, for example.

While that is correct, I noted, after the conference, that this still meant that demand had no role, in this view, in expanding the capacity limit of the economy (my students are rolling their eyes, and saying there he goes with Kaldor-Verdoorn again!).  Glynn's reply was a quote from a title of paper by David Gordon.  My views implied too much cumulation and not enough contradictions.  The notion is that if you think that the demand determines long term growth we should live in a paradise with full employment, since demand can be managed.

Of course, in developing countries that is almost never possible. You expand demand, imports increase, current account deficits balloon, and contraction follows.  The external constraint at work.  Well we are finally in an American example of the contradictions that impede demand expansion.  Today, the NYTimes tells us in the editorial that:

"When consumers are constrained, so is hiring, because without customers, employers are hard pressed to retain workers or make new hires."

Yep, the Times got effective demand right (it must be a Krugman thing)!  However, no fiscal package is at hand to solve this simple technical problem.  I'm not going to explain Republicans and American politics (wouldn't dare).  But the political contradictions associated with expanding demand are staggering.  It's a pity that only now I have a good answer for Andrew.

PS: The paper by David cited above is Gordon, D. "Kaldor's Macro System: Too Much Cumulation, Too Few Contradictions." In Nicholas Kaldor and Mainstream Economics, edited by Edward J. Nell and Willy Semmler, pp. 355-83. New York: St. Martin's Press, 1991.

The meaning of heterodox economics, and why it matters

Heterodox economics is often defined as potpourri of of schools, too many to mention. Further, most of these heterodox schools are defined against marginalism (or neoclassical economics, which is also a fragmented school of economic thought).  In this sense, the heterodox camp is defined in a negative (against orthodox) and fragmented (depending on what aspect of orthodoxy is contested) way.  I think that is a counter productive approach, and that heterodoxy should be seen as a set of principles.  A positive (in its own terms) and unified (in the sense of the minimum set of propositions that are universally accepted) definition of heterodoxy is necessary.

Two things are central from my point of view.  First, heterodox economists are concerned with the amplified reproduction of society, and this implies that the production and distribution of the social surplus is central for their theories.  This is part of a tradition that harks back to classical political economy.  The determinantion of the surplus implies that distribution is determined exogenously by social and institutional conditions (be that the real wage as affected by the bargaining position of the labor class, or the rate of profit as determined by the monetary rate of interest influenced by the central bank).  Further, the determination of surplus, for an externally determined distribution, and a given technology, provides an explanation of relative prices (value).

It is important to note that there are several particular theoretical ways of approaching each of these questions associated to the reproduction of the economy.  For example, some Marxists emphasize that relative prices are proportional to the amounts of labor directly and indirectly needed to produce the commodities.  Sraffa provides a different approach, that is compatible with Marx's views of the working of the economy.  Post Keynesian groups that emphasize the determination of prices according to full cost pricing are also compatible with this general preocupation about the determination of the social surplus.  In other words, several schools of thought are heterodox in the acceptance of the necessity of understanding how the surplus is generated and distributed, even if they have different theories (that are not always compatible among them).

The second essential proposition that defines heterodoxy is related to the theory of output and employment determination.  Heterodox economists believe that output is demand determined.  That is, autonomous spending determines the level of activity.  There are a few implications to this simple proposition.  First, the level of autonomous spending will only generate full employment of productive resources by chance, and unemployment is a permanent feature of the economic system.  Second, as the level of income equilibrates savings to investment, the rate of interest must be a monetary (not real phenomenon). Additionally, heterodox economists argue that effective demand is valid in the long run.

In sum, if one believes that prices reflect, for a given technology, the way classes struggle for higher income shares within the process of reproducing the material conditions for survival (including processes in which there is accumulation), and one believes that output and the process of accumulation are driven by the exogenous forces of demand, one may be called heterodox.

Some other issues are often seen as central for defining heterodox economics.  Endogenous money is a typical example.  And it is true that most, if not all, heterodox economists follow some version of endogenous money theory.  However, it is clear that even if money is not endogenous, the rate of interest is still a monetary variable in heterodox economics (e.g. in Keynes' General Theory).  Also, several mainstream economists have endogenous money, from Wicksell to those using the Taylor rule now. The same could be said about true or non-probabilistic uncertainty.  It is important, but neither the determination of prices of production or effective demand are directly affected by uncertainty.  And several Austrians (hardly heterodox according to the criteria above) are very fond of the idea of uncertainty.  The last additional issue that sometimes is used to define heterodoxy is complexity (or non-ergodicity), but is the least relevant.  The main difference between heterodox and orthodox are related to causality issues, and they can be reproduced in simple or complex theoretical frameworks.

The obvious question that anyone may pose is why does it matter to define heterodox economics precisely.  For example, Colander, Holt and Rosser (CHR) suggest that heterodox economists should not consider themselves heterodox but just economists, and try to influence the mainstream working with the best among the orthodox.  The problem is that logic and evidence can support either prices of production or supply and demand, and, by the same token, either Say's Law or Effective Demand must be wrong.  In economic policy compromise might be possible, but in theory principles cannot be compromised.  I replied to their paper here.

PS: My paper is published in the Journal of Post Keynesian Economics, with CHR's reply (subscription required).

Is the American economy profit-led?

In a recent post I showed the evolution of real wages and long-term real rates of interest in the United States from 1950 until now. The figure below shows the real rate of output (GDP) growth for the same period. Between 1950 and 1973 the average (red line) rate of growth was 4.2% and in the subsequent period it was 2.7%. In other words, the change in income distribution dynamics, with a significant slower rate of growth of wages, was accompanied by a significant reduction in the pace of economic growth (we also saw in the previous post that it also went hand in hand with higher real rates of interest).

Many authors (e.g. the late David Gordon), in particular when looking at the evidence post-1970s, argued that the American economy is profit-led. In other words, as profits (some emphasized profit shares while others prioritized profit rates; the profit rate time the level of capacity utilization gives the profit share) expanded, it stimulated investment, and this, in turn, led to output growth. Growth was driven by profits.

The idea is that, even though the reduction in wages has a negative effect on consumption and output growth, this is more than compensated by the increase in investment. However, there are some empirical problems (there are some theoretical issues that I’ll deal with in another post) with this kind of model (often referred to as Kaleckian, even though it seems that their origin should be traced to Joan Robinson’s Accumulation of Capital and the influential formalization by Bob Rowthorn in the early 1980s).

For starters, growth actually fell significantly after real wages stagnated. Also, the output-to-capital ratio (shown from 1960 to 2008 using a OECD measure), as can be seen in the graph below, does not indicate a marked shift in the 1970s. The output-to-capital ratio goes up in the Johnson and Clinton booms, and falls otherwise. The Reagan boom was mild at best. This is consistent with the accelerator. As the economy moves closer to full employment, the output-to-capital ratio, a proxy for capacity utilization, moves close to its maximum. The accelerator would suggest that investment adjusts capacity to output. Investment is not the locomotive of the system, is the rear car (the idea behind the accelerator principle).

Since the 1970s the drivers of accumulation in the United States have been consumption booms driven by debt accumulation. In other words, as Barba and Pivetti have argued, increasing debt has allowed American families to continue to consume, in spite of stagnated wages. This has been mistaken in the empirical literature as a profit-led boom. The suggestion here is that the booms have continued to be driven by consumption (as in more traditional wage-led cases), and that the benefits for capital have been financial and associated to higher interest rates. The last three booms have been more Wall Street debt-led booms, rather than profit-led investment booms. Wall Street, not the Silicon Valley, defines the current American economy. After all, we all remember Gordon Gekko’s “greed is good” (uttered in real life by Ivan Boesky) and nobody remembers an iconic phrase by Bill Gates!