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PART FOUR: PROBLEMS IN MACROECONOMIC AND CAPITAL THEORY - Ludwig M. Lachmann, Capital, Expectations, and the Market Process 
Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy, ed. with an Introduction by Walter E. Grinder (Kansas City: Sheed Andrews and McMeel, 1977).
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PROBLEMS IN MACROECONOMIC AND CAPITAL THEORY
Complementarity and Substitution in the Theory of Capital
Complementarity, introduced into economic dynamics by Professor Hicks in 1939,1 has since given rise to a host of bewildering and intricate problems. Soon Dr. Lange, in defending the Hicksian view of complementarity against overt criticism by Professor Machlup,2 had to warn us against confusing the effects of complementarity with those of a “sympathetic shift in demand.”3 But a few years later the same Dr. Lange relegated complementarity to a scornful footnote.4 For this he was promptly taken to task by Mr. Harrod, who told us that “in the context of the enquiry, in which we are interested in changes of the prices not of highly specific factors, but of widely employed factors or categories of factors ... the co-operant attribute predominates.”5 Mr. Harrod also expressed the view that “factors may be co-operant or alternative to one another. The latter attribute belongs to factors that are very specific. Thus if tool B becomes cheaper it may lead entrepreneurs to have no further use for tool A (which does roughly the same job).”6 This view plainly contradicts Professor Hicks's statement that “there is a tendency for factors jointly employed in the same firm to be complementary.”7 There is thus good reason to believe that this is a field in which the wise walk warily.
We may start by recognising with Professor Hicks that goods subject to “sympathetic shifts in demand” will probably be also complementary goods, that “companiable commodities will very usually be complements.”8 Where the cause of a dynamic change lies on the demand side, the effects of complementarity and companiableness may therefore be almost impossible to disentangle. It follows that if it is our aim to study the effects of complementarity on dynamic change, it will be better to choose as our standard model a case in which the change originates on the supply side. This method we shall adopt in the latter part of this paper.
Reprinted from Economica 14 (May 1947).
Next, we have to realise that the traditional treatment of factor complementarity in economic theory has been quite unduly narrow. The standard case discussed is here, of course, the labour-land-capital relationship in the distribution of incomes, Mr. Harrod's “widely employed categories of factors.” But what precisely is our criterion of classification of these categories? And why cannot complementarity exist within each category? In this paper we shall endeavour to show that it is in the theory of capital that the concept of complementarity proves a most powerful lamp to throw light into some notoriously dark corners.
To reduce that heterogeneous assortment of buses, blast furnaces, telephone kiosks and hotel-room carpets that we call Capital to an intelligible order, to exhibit the design of the pattern into which all of these have to fit, is the chief task of the theory of capital. This is usually done by representing capital as a “stock” or “fund” the component parts of which are units of money value. our heterogeneous assortment is thus converted into a homogeneous aggregate by using Money value as a common denominator. As Professor Hayek has shown, this becomes impossible under conditions of dynamic change likely to cause relative value changes.
In a homogeneous aggregate each unit is a perfect substitute for every other unit, as drops of water are in a lake. Once we abandon the notion of capital as homogeneous, we should therefore be prepared to find less substitutability and more complementarity. There now emerges, at the opposite pole, a conception of capital as a structure, in which each capital good has a definite function and in which all such goods are complements. It goes without saying that these two concepts of capital, one as a homogeneous fund, each unit being a perfect substitute for every other unit, the other as a complex structure, in which each unit is a complement to every other unit, are to be regarded as ideal types, pure equilibrium concepts neither of which can be found in actual experience.
In reality we should expect individual capital instruments to be substitutes for some, and complements to some other instruments. Each locomotive, we may surmise, is complementary to a number of wagons, but at the same time a more or less perfect substitute for every other locomotive. If this is so, the next question we have to ask is whether, over the field of capital as a whole, complementarity or substitutability is the dominant relationship; or, more precisely, under what conditions we may expect one or the other to predominate. Mr. Harrod believes that among capital instruments substitutability prevails. But we should require further evidence. Enthusiasts of econometrics may well have a dreamy vision of new playgrounds to conquer and new toys to hug, for is this not precisely the kind of situation in which the harassed theorist has to “appeal to the facts”? But a little further reflection shows that here, as so often, “the facts” refuse to give a simple answer to our question.
The view that factor complementarity and substitutability are alternative modes of the relationship between factors in the same situation rests on a fallacy. There are too many instances of change, of which labour-saving invention is the most familiar, where complements are suddenly turned into substitutes; or, even more intriguingly, in which capital (our supposedly homogeneous stock!) is split into two parts one of which becomes a substitute for, while the other remains a complement to, labour. There are also cases where both relations appear to exist side by side. If a firm has four delivery vans, each delivering goods in a quarter of the town, are they complements or substitutes? According to Professor Hicks they are the former, as “factors jointly employed in the same firm”; according to Mr. Harrod they are bound to be the latter (“doing roughly the same job”). But are they not really both? Furthermore, while locomotives may be substitutes, and locomotives and wagons complements, from the point of view of the time table, the production plan for the railway system as a whole, all trains are complements. But if trains are complements, how can locomotives be substitutes?
These examples go to show that factor complementarity and substitutability are not exclusive alternatives. Factor complementarity and substitution are phenomena belonging to different provinces of the realm of action. Complementarity is a property of means employed for the same end, or a group of consistent ends. All the means jointly employed for the same end, or such ends, are necessarily complements. Factor complementarity presupposes a plan within the framework of which each factor has a function. It is therefore only with respect to a given plan that we can meaningfully speak of factor complementarity. Factors are complements insofar as they fit into a production plan and participate in a productive process.
Substitution, on the other hand, is a phenomenon of change the need for which arises whenever something has gone wrong with a prior plan. Substitutability indicates the ease with which a factor can be turned into an element of an existing plan.9 A change in plan is possible without a change of end. The importance of substitutability lies in that it is usually possible to pursue the same end (output) with a different combination of factors. The importance of complementarity lies in that “technical rigidity” (invariability of the mode of complementarity) may often make it necessary to change the end rather than the means; an existing combination of factors is used to produce a different output.
The change in question must be possible but not predictable. If it were predictable there would be no need for substitution. We should take it into account in drawing up our plan. Here, as elsewhere in the theory of action, predictable change is indistinguishable from any other known element of the situation. The designer of a motor-car is as unlikely to forget the lamps as the mudguard.
A production plan involving a large number of factors and with a complex complementarity pattern is particularly vulnerable in case any of them breaks down. We safeguard ourselves against such occurrences by keeping a reserve stock of perfect substitutes for the operating factors (spare parts). We diminish its necessary size by devices calculated to increase substitutability, like the standardisation of equipment. Where the complementarity pattern of the plan is complex, a high degree of substitutability between operating factors and factors held in reserve may be required to keep it going. We have to provide for many minor changes in order to prevent a major one.
We now understand why the locomotives in our example gave us so much trouble. In saying that each locomotive is complementary to so and so many wagons we think of a given production plan (time table). In saying that each is a more or less perfect substitute for every other we are, as it were, turning our mind to an entirely different situation, one in which our original production plan with its allocation of locomotives to trains has been modified. In the first case we think of a given situation, in the second of a change in the situation.
This is not to say, of course, that every change will turn all complements into substitutes. Most factor complementarities, to be sure, can stand up to a number of changes, some of them, like the one mentioned, may outlast almost any change. Our point is merely that every major change is bound to upset some plans and disrupt some complementarities. On the other hand, it is impossible to speak of substitutable factors without defining the kind of change we wish to provide for. One cannot help feeling that the plant bred in the rarefied atmosphere of a static world with a given system of wants, does not stand up very well to the rough climate of a dynamic world which we cannot but study in terms of plans, but in which failure and revision of plans is an every-day occurrence.
It is now clear why factors jointly employed in the same firm tend to be complementary: they are all means to the same end, elements of the same plan. Unity of management here ensures consistency of action.
We shall now extend the scope of our analysis from the individual enterprise and its production plan to the economic system as a whole. Shall we now find factor complementarity throughout the system? At first sight one might think that here, where factors are employed, not in one production plan but in many, there can be little or no complementarity. But further reflection shows that this need not be so. A firm, carrying out a plan extending over a period of time, is during that period in equilibrium, as equilibrium means essentially consistency of a number of acts by different individuals, or the same individual. We may now imagine an economic system in equilibrium in the sense that the acts of all individuals, producers and consumers, are consistent with each other, hence so are all production plans. The stationary state is the simplest type of such a system, but generally foreseen change will not affect the essence of the matter. In such an economic system in equilibrium, complementarity will exist between all factors in the system in precisely the same way as in each firm. For where the production plans of all firms fit into a coherent whole, they may, of course, be regarded as elements of one large plan constituted by this whole.
Let us now assume that an unforeseen change throws our system into disequilibrium. Substitution of factors ensues. It is important to realise that while factor substitution destroys one set of complementary relations, another will be created, though possibly of a different mode. If the factor substituted is a perfect substitute for the factor displaced, nothing further need be done. We fit the spare part into the machine, and it continues to run as before. But if the factor substituted is not a perfect substitute, there may have to be an adjustment of other factors. In the former case the new factor merely joins an existing combination, in the latter the coefficients of production,10 the proportions in which the various factors are combined, will have to be altered. A change in the coefficients of production in one firm will, of course, have repercussions throughout the economic system and entail further acts of substitution in other firms. A sequence of changes will permeate the system, affecting prices, output and coefficients of production. But however many subsequent acts of substitution our first act may entail, as long as factors are used together in productive processes there will always be factor complementarity.
What we have said so far about complementarity and substitution applies to factors in general. Now, capital resources are more sensitive to unforeseen change than are either labour or permanent resources, and this marks them out for special treatment. Capital goods are products of the human mind, artefacts, produced in accordance with a plan. Capital gains and losses as effective tests of such plans will therefore affect decisions concerning capital production in a sense in which wage fluctuations, in general, do not affect the birth-rate.
Every capital instrument is designed for a purpose. Where it is highly specific, this purpose is identical with a certain kind of (anticipated) use. Where it is “versatile,”11 it may cover a wide range of uses. But in any case it is planned for some kind of use, and failure to succeed in any of them as reflected in loss of earning power will result in revision of plan. At the moment at which a new machine is installed in a factory, one production plan impinges upon another. If the second plan, in which our machine is in use, fails, there will be repercussions on the first kind of plan: fewer such machines will be produced.
We have seen that if capital is to be regarded as a homogeneous aggregate, all its constituent elements have to be perfect substitutes. But the complementarity of capital resources (plant, equipment, working capital) is a fact of experience. Hence, if we are to take account of it, we have to give up the “aggregative” conception of capital in favour of a structural conception. But if capital is to be regarded as a structure, what determines its shape? We have to allow for the heterogeneity of different capital resources which now have different functions. But what determines the character of these functions?
The shape of the capital structure is determined by the network of production plans. Each production plan utilises a given combination of factors. The proportions in which factors enter a combination, the coefficients of production, express the mode of factor complementarity in it. More particularly, the proportions in which the various capital resources enter it express the mode of capital complementarity in it, what we shall call the capital coefficients. The capital coefficients in each combination are thus the ultimate determinants of the capital structure, at least in equilibrium. In disequilibrium the degree of consistency between plans is a modifying factor.
Strictly speaking, of course, a capital structure in our sense can only exist in equilibrium, where all plans are consistent with each other, and the network of plans displays the firm outline of a clear and distinguishable pattern. But in dynamic reality this structure is in a state of continuous transformation. As production plans prove inconsistent and fail, the outline of our pattern becomes inevitably blurred. Plans have to be revised, new combinations formed, old combinations disintegrate, even those which persist have to undergo an often drastic modification of their factoral composition.12 In reality the coefficients of production are ever changing. Every day the network of production plans is torn, every day it is mended anew. Under these circumstances we shall find some, at least temporarily, unutilised capital resources while others are scarce. In any case, in the world of our daily experience all unexpected change entails more or less extensive capital regrouping.13
The theory of capital has therefore every reason to occupy itself with the network of production plans. It is readily seen how failure of plans affects investment decisions and how, broadly speaking, complementarity serves as an amplifier of internal capital change. These phenomena of internal capital change the theory of capital neglects at its peril. Unfortunately, scant attention is paid to them in most of the economic thought of our time,14 which, as regards capital change, seems almost exclusively preoccupied with problems of investment, i.e., problems of external capital change. Interrelations between internal and external changes are almost completely ignored.15
We now must pause for a moment and contemplate our results against the background of traditional capital theory. We have tried to show that a theory of capital based on a notion of homogeneity is bound to miss our problem entirely. It is to a structural conception of capital that we have to look for encouragement and inspiration. But in the sphere of human action Structure implies Function, and Function, where a number of factors is involved, implies co-ordination and complementarity.
Such a structural conception of capital is to be found in the system of Böhm-Bawerk. Contrary to what appears to be a widely held view, Böhm-Bawerk's chief contribution to the theory of capital was not the introduction of time, but of complementarity over time. Here, to be sure, the “stock of real capital” becomes a flow, but not a homogeneous flow. Its elements, the individual capital goods, are not, like drops of water, perfect substitutes, but each has its place in the flow. If it is true that Böhm-Bawerk's “stock of intermediate products” is essentially a wage fund in motion, we must remember that its different elements move at different speeds.
Hides, leather, and shoes in wholesale stocks, are not just physically similar goods at different points of time, but products at different stages of processing. And “processing” requires the existence of a production plan in which complementary factors come into operation in accordance with a time schedule. Time is relevant here as the dimension of processing, the medium of complementarity. Thus, what really matters is not time, but complementarity over time. On the other hand, under the stationary conditions characteristic of Böhm-Bawerk's system all capital instruments in existence at the same point of time are necessarily complements. Thus, whatever their position in time, all capital instruments are linked together by complementarity.16
We may say that within the realm of capital complementarity is an all-pervasive fact, at least as long as equilibrium is maintained.
If we regard capital as a complex structure the pattern of which is determined by the proportions in which the various capital resources co-operate in productive processes, it follows that all capital change, including new investment, is bound to modify the structure. Under these circumstances it is difficult to see how there could be “widening,” or even “deepening” of capital. As Professor Hayek has shown, “widening,” i.e., the multiplication of existing equipment, is, for the whole economic system, impossible in the absence of unused resources, while it is possible in some industries at the expense of other industries. “For the economic system as a whole the first of these alternatives is possible only if there is a labour reserve available. But in any particular industry the required additional labour may be attracted from another industry.”17
Now, as we shall see in the next section, the existence of unemployed labour and unutilised resources is very important for the dynamics of capital, because they provide potential complements for the new productive combinations. But in their absence there can be no capital change which leaves coefficients of production unaffected. “Widening” of capital in some industries must be accompanied by disintegration of existing factor combinations elsewhere. The contrary impression is evidently due to the habit of confining our attention in matters of capital to what happens in a few expanding industries. The notion of capital “widening” is apparently an empirical generalisation of the well-known fact that the accumulation of capital as a rule takes the form of successive growth of new industries, and that at each moment a few expanding industries appear to bear the brunt of it. We may accept this empirical generalisation, but the impression that we may safely neglect what happens elsewhere, is nevertheless mistaken. Furthermore, even capital “deepening” is bound to modify not only the coefficients of production as far as labour and capital are concerned, but the capital coefficients. It is hard to imagine cases in which the proportion of capital assets to other factors increases while relative proportions of plant, machinery, tools, raw materials, etc., remain constant.
In other words, there can be no major change which leaves the existing structure and composition of capital intact. All such change tends to create situations in which there is too much of some capital assets and too little of others. In this fact lies the ultimate reason for that instability of the “capitalistic” economy which so many deplore and so few understand.
We shall now test the efficiency of the analytical tools we have forged by applying them to a problem which in recent years has become a focus of economic controversy, viz., the effect of the accumulation of capital on profits and the inducement to invest. According to a powerful school of thought this effect is bound to be depressing. As more and more capital is accumulated, investment opportunities gradually become exhausted and the rate of profit declines. “Other things being equal, the marginal efficiency of capital will be lower the greater the amount of capital goods already possessed.” (Author's italics.)18 We shall endeavour to show that the accumulation of capital gives rise to processes which make it impossible for “other things” to remain equal. On the other hand, Professor Hayek has pointed out that there are cases in which investment actually raises the demand for capital.19 An obvious example would be a copper mine in Central Africa in which we could not even begin to sink capital without having first built a railway from the coast.
It is clear that the issue hinges on complementarity and substitution. The “depressionists” evidently regard capital as a homogeneous aggregate; each unit of capital is a perfect substitute for every other unit, and accumulation means essentially an addition of further units to a pre-existing homogeneous stock. It is equally evident that Professor Hayek's view is based on complementarity. The “investment that raises the demand for capital” is investment in capital goods complementary to those to be constructed later.
The question now confronting us is, which of the two rival influences, the stimulating influence of complementarity or the depressing effect of substitutability, will on balance prevail within the economic system. At first sight it might be thought that, as complementarity is all-pervasive while substitution will probably be confined to a few expanding industries in which new capital goods are installed, the former influence will prevail. But this would be a premature conclusion based on an unwarranted use of ceteris paribus assumptions. For the effect of new capital assets on the capital structure is not confined to those sectors in which they are installed and their immediate neighbourhood. By its effect on the coefficients of production, the breaking-up of existing combinations, and the formation of new ones, the accumulation of capital affects the whole economic system. But its modus operandi is gradual, depends in each case on the composition of the factor combinations affected, and is certainly very different from that usually assumed in capital theories based on the notion of homogeneity. We shall illustrate it by an example.
Let us assume that there is an increase of capital in the film20 industry. More cameras, studio equipment, etc., are produced and installed. The greater number of films produced makes it necessary to have more cinemas21 (complements). As film rentals fall cinema earnings rise. To the extent to which there is unemployed labour and unutilised resources new cinemas will be built. But this may be possible only within fairly narrow limits. The typical location of cinemas is in the central sector of urban areas where as a rule there are no empty spaces. Any considerable rise in cinema earnings, together probably with some decline in the demand for other forms of entertainment,22will thus cause existing capital equipment to be turned over to new uses. Theaters, ice rinks, dance halls, will be converted into cinemas. Existing factor combinations, house-cum-theatre, house-cum-ice rink, etc., will disintegrate. But while rents earned on such buildings will increase, considerable capital losses will be suffered on theatrical settings and costumes, freezing equipment, and musical instruments. In fact, unless these can be sold to somebody able to fit them into a new combination, they may altogether lose their capital character and become scrap. On the other hand, owners of “free” capital instruments complementary to them are now able to get them at “bargain prices” permitting large capital gains.
The accumulation of capital will therefore have what we may term a “chain reaction” effect. The initial change entails a sequence of subsequent changes as the final result of which the structure of capital becomes modified. The new capital instruments cause the disintegration of existing combinations, increase the earning power of elements complementary to them, and set free those for which they are substitutes. The latter will either lose their capital character or have to seek out other complements, new partners with whom to enter into new combinations. For this they depend on the existence of, at least temporarily, “free,” i.e., unutilised capital goods, or on the breaking-up of other existing combinations. But the disintegration of the latter, by setting free some elements, would again create the same problem. The process will continue until all discarded factors have either found their way to the scrap-heap, or found “free” partners, or found owners willing to wait and hold them until a complement turns up.
This conclusion incidentally throws new light on the vexed problem of “excess capacity.” We now realise that in a world of dynamic change unused resources have two functions. Firstly, they act as shock-absorbers when combinations disintegrate. Secondly, their existence provides an inducement to invest in those capital goods which are complementary to them.
We may therefore conclude that the production of new capital instruments will have different effects on the earnings of different existing capital resources. Those to which they are complements will earn more, those for which they are substitutes will earn less and often nothing at all. To ask what is the effect of the accumulation of capital on “the” rate of profit is to ask a meaningless question, since one of its main effects is to make rates of profit diverge. If in equilibrium it is possible to speak of “a” rate of profit, the accumulation of capital will destroy such equilibrium.
We may now briefly survey the chief results of our enquiry.
Our first result, and the most general, is the inadequacy of static equilibrium methods in the theory of capital which clearly emerges as an eminently dynamic discipline. The concept of complementarity, which originated in a static three-commodity world, with a given system of wants, does not stand up well to its transplantation into the sphere of dynamics, and is not very well suited to the kind of plan analysis appropriate in this sphere.23 At any rate, factor complementarity and product complementarity cannot be treated on the same level.
Secondly, it is useless to treat capital change as quantitative change in one factor under ceteris paribus conditions, when it is plain that at least some cetera will not remain paria. What is really needed is a new type of sequence analysis which enables us to follow up, sector by sector, the chain of changes set in motion by the impact of the original change. We may add that this applies at least as much to technical progress as to the accumulation of capital.
Thirdly, internal capital change, the regrouping of existing capital resources in response to unforeseen change, emerges as by far the most important topic of capital theory, although in present-day economic thought it is almost completely ignored. Undue preoccupation with mere external capital change, like investment, preferably in quantifiable money value terms, in the discussion of which internal repercussions are neglected, is seen to lead us nowhere. Furthermore, the question of the effect of the accumulation of capital on “the” rate of profit and the inducement to invest now appears as a meaningless question. Some profits will rise, some will fall. Unforeseen change always engenders capital gains and losses. It remains a question of some interest, to what extent the expectation of such gains and losses influences the inducement to invest. But in any case the installing of new capital instruments cannot meaningfully be regarded as “growth” of anything concrete or measurable. For it is bound to entail the, at least partial, destruction of some existing capital values.
Finally, if all this is important for the theory of capital, it is of equal, if not greater, importance to the theory of industrial fluctuations. Perhaps the concept of net investment pure and simple, as chief motor of economic change, has by now yielded us all that it is ever likely to yield. Between 1900 and 1915 economists like Cassel, Spiethoff, and Professor Robertson, basing their conclusions, not on alleged “psychological laws,” but on a study of the actual events of the time, laid the foundations of a theory which takes account of intersectional maladjustment as a result of disproportionate growth of different groups of capital resources. The overinvestment theories currently in fashion are now seen to be fallacious. But what are we to substitute for them? This problem of factor substitution in economic theory will, if we may hazard a guess, occupy economists for many a day to come.
Mrs. Robinson on the Accumulation of Capital
In the literature of this decade, not otherwise remarkable for the quality of its economic writing, Mrs. Robinson's latest book stands out as a landmark.1 It is not merely the most elaborate contribution to post-Keynesian literature to date. It has, of course, all the qualities of rigour, lucidity and sophistication which we have come to expect from its author. But in certain respects it is quite unique.
The author, deliberately renouncing the instruments of marginal analysis, attempts to view the problems of economic progress from a classical perspective; her theme is the conditions of continuous expansion. Most of the analysis is conducted with the help of a model of a high degree of abstraction. But Mrs. Robinson has, as few other model-builders have, a flair for realism. She takes great care to tell the reader which are the important features of reality excluded from the model. From this endeavour to combine a measure of realism with a fairly high degree of abstraction there arise certain problems, as we shall see. But in the interest of more palatable economics than we have had of late, it is to be hoped that Mrs. Robinson's candour in stressing the limitations of her model will find many imitators.
The title of the book is, of course, borrowed from Rosa Luxemburg. Of its main problem the author says that it presented itself to her as “The Generalisation of the General Theory, that is, an extension of Keynes's short-period analysis to long-run development.” In spite of these appearances, however, Mrs. Robinson is neither a Keynesian nor a Marxist, but a latter-day Ricardian.
Reprinted from South African Journal of Economics 26 (June 1958).
Keynes, of course, was mainly concerned with underemployment equilibrium, a short-run problem, whereas our author deals with the long run. Keynes, she says, “left a huge area of long-run problems covered with fragments of broken glass from the static theory and gave only vague hints as to how the shattered structure could be rebuilt.” But Mrs. Robinson does not accept at least two major hints Keynes gave to his disciples for the long run. She explicitly rejects the “Psychological Law” of the declining marginal propensity to consume which, rather curiously, she terms the “Liberal underconsumption thesis,” and which she ridicules as “the inevitable destiny of prosperous economies to drown themselves in cream.” She also points out that a “lack of investment opportunities” is not a necessary result of rapid capital accumulation, but a possible result of a decline in the intensity of competition, while Keynes, of course, assumed perfect competition throughout. Mrs. Robinson's status as a Keynesian must, therefore, remain in doubt.
As a Ricardian, Mrs. Robinson embraces a cost-of-production theory of value, but not a pure labour theory. “Interest enters into the cost of capital goods both in respect of the period of gestation when equipment is being constructed and the pipe-line of work-in-progress filled up, and in respect of the period of the earning life of equipment,” a sentence which would, of course, be anathema to Marxists.
A wish to return to the classical mode of thought implies, of course, a rejection of much of modern economics which is so largely concerned with human choice and decision. In Mrs. Robinson this rejection is quite deliberate. “Economic analysis, serving for two centuries to win an understanding of the Nature and Causes of the Wealth of Nations, has been fobbed off with another bride—a Theory of Value.... Faced with the choice of which to sacrifice first, economists for the last hundred years have sacrificed dynamic theory in order to discuss relative prices.”
One may question the truth of this statement since modern economics is as much concerned with relative quantities as with relative prices. One may also wonder whether it is possible to discuss economic progress while ignoring not merely relative prices but also, for instance, intersectional shifts in output and resources. But such criticism would here be out of place. In the book Mrs. Robinson obviates it by assuming all output to be homogeneous. And although, as we shall see, this assumption gives rise to a host of difficulties, we must not question the level of abstraction as such on which an author chooses to conduct the argument.
In the next section an attempt will be made to present a brief and concise outline of the central argument of the book. The following two sections of this paper are devoted to critical reflections on what appear to be crucial issues arising from this argument. In the concluding section certain methodological aspects of the attempt to revive the classical style of analysis in the midst of the twentieth century will be examined.
There can, of course, be no question of doing justice to such a book within the space at our disposal. We shall have to ignore whole sections of it and some important strands of thought, and concentrate on what appear to us to be the crucial issues. The reader, we trust, will not allow himself to be misled by the preponderance of critical matter in this paper. In the first place, an argument such as this, fenced in as it is by such a formidable set of assumptions, can hardly be discussed adequately without criticism. But, secondly, it is precisely because the issues raised are so crucial for our science and, thirdly, because the book is in any case bound to become a focus of widespread discussion, that it requires to be subjected to close scrutiny. But on no account, we hope, will the reader allow himself to be deterred from reading the book itself. It is worth it.
In the classical manner Mrs. Robinson's main concern is with the conditions of progress through capital accumulation, and in particular with its origin in and effects on the distribution of incomes between wages and profits. Her chief problem is whether, and in what circumstances, continuous progress under “the capitalistic rules of the game” is possible. These circumstances are enshrined in a model first set out in Chapter 7 and subsequently modified in many respects. “With the aid of this model we shall examine the problems of accumulation over the long run.... Our chief concern is with the relation between wages and profits, and the argument is conducted in terms of (1) the relations of the stock of capital to the available labour force, (2) the influence of competition, and (3) the technique of production.”
At first our author assumes that all profits are saved and all wages consumed; there are, at this stage, no other incomes. The rate of accumulation is therefore identical with the rate of profit on capital and, if we assume a constant capital-output ratio, with the rate of expansion of output as a whole.
The assumptions embodied in the model engender a high degree of abstraction. All index number problems are eliminated by assuming complete homogeneity of labour and output. A “given technique of production” means fixed coefficients of production. The stock of capital goods “required to produce a given flow of output is rigidly determined by the technique in operation. Since commodities are produced in rigid proportions, the stock of equipment of all kinds must be in appropriate proportions.” Technical progress thus means that the cost per unit of the composite commodity of which all output consists is reduced. The influence of variable expectations is eliminated by the assumption “that at every moment entrepreneurs expect the future rate of profit obtainable on investment to continue indefinitely at the level ruling at that moment; that they expect the rate of technical progress (which may be nil) to be steady; and that they fix amortisation allowances for long-lived plant accordingly. When something occurs which causes a change, we assume that expectations are immediately adjusted, and that no further change is expected.” There are at first only entrepreneurs and workers in the economy, though rentiers and landlords enter later on. The economy is a closed system and there are no economies of scale.
Superimposed on this model there is another set of assumptions determining what Mrs. Robinson calls a golden age, a moving equilibrium of the economic system as a whole. It is thus described: “When technical progress is neutral, and proceeding steadily, without any change in the time pattern of production the competitive mechanism working freely, population growing (if at all) at a steady rate and accumulation going on fast enough to supply productive capacity for all available labour, the rate of profit tends to be constant and the level of real wages to rise with output per man. There are then no internal contradictions in the system.” It is important to note that in this moving equilibrium not only does the rate of profit tend to be constant and uniform for all industries, but “total annual output and the stock of capital (valued in terms of commodities) then grow together at a constant proportionate rate compounded of the rate of increase of the labour force and the rate of increase of output per man.” In other words, the capital-output ratio remains constant. Capital per worker increases, but output per worker also increases in such a fashion as to leave the capital-output ratio constant through time.
We are, of course, repeatedly warned that the conditions of a golden age are unlikely to be found in reality, but, says our author, “The persistence of capitalism till today is evidence that certain principles of coherence are imbedded in its confusion.”
How is the rate of progress linked to the distribution of incomes? The answer is provided by the well-known Keynesian maxim that while workers spend what they earn entrepreneurs earn what they spend. “Thus each entrepreneur is better off the more investment his colleagues are carrying out. The more the entrepreneurs and rentiers (taken as a whole) spend on investment and consumption, the more they get as quasi-rent.”
But there is an upper limit to the amount of investment possible at each moment which is set by what our author calls the inflation barrier. “Higher prices of consumption goods relative to money-wage rates involve a lower real consumption by workers. There is a limit to the level to which real-wage rates can fall without setting up a pressure to raise money-wage rates. But a rise in money-wage rates increases money expenditure, so that the vicious spiral of money wages chasing prices sets in. There is then a head-on conflict between the desire of entrepreneurs to invest and the refusal of the system to accept the level of real wages which the investment entails; something must give way. Either the system explodes in a hyper-inflation, or some check operates to curtail investment.”
On the other hand there is no minimum level of profits as such. Profits are the result, not the cause of investment. But for the inflation barrier “accumulation is limited by the energy with which entrepreneurs carry it out” and nothing else.
Under the assumptions set forth the accumulation of capital by making capital less scarce and labour scarcer tends to raise real wages unless it is accompanied by such an increase in population that capital per worker cannot increase, or actually decreases. But the extent to which this happens depends upon the degree of competition. “The mechanism which ensures that actual output expands more or less in step with the rise in potential output due to technical progress is the competition which keeps prices in line with costs, and so raises the real-wage rate with productivity.” When this does not happen, when entrepreneurs do not permit prices to fall as productivity rises, the economy is in danger of falling into stagnation, since entrepreneurs can succeed in keeping prices high only by keeping output low. Once prices have become inflexible “the main defence against the tendency to stagnation comes from pressure by trade unions to raise money-wage rates. When they succeed, the stickiness of prices tells in their favour, for entrepreneurs may prefer (within limits) to accept a cut in margins rather than to alter their price policy. Insofar as this occurs, real-wage rates rise. If by this means real wages can be made to rise as fast as output per man the root of the trouble is cut, and the economy can accumulate capital and increase total product at the rate appropriate to the pace at which technical improvements are being introduced just as though competition were still active.”
But though such a “high wage economy” is better than stagnation it is far from being an ideal. “A kind of live-and-let-live system is then established, and provided that real wages are rising somewhat (over the long run) no one is concerned to inquire if they might be made to rise faster by a more rapid rate of accumulation.”
What happens if output increases less than capital so that the capital-output ratio increases? The rate of profit will then tend to fall and entrepreneurs substitute capital for labour by choosing a more capital-intensive method of production. While, if capital accumulates faster than the population grows, the distribution of incomes shifts in favour of labour, this process will also be arrested when entrepreneurs choose a more capital-intensive technique. “They cross the mechanisation frontier” in Mrs. Robinson's terminology. “Our argument brings out the fact that it is accumulation as such which tends to raise wages, while mechanisation checks the fall in the rate of profit that would occur if accumulation continued in the absence of scope for mechanisation.”
The argument is also significant in another way. It shows how far Mrs. Robinson has moved away from her Keynesian moorings. “A failure of accumulation to be maintained in actual economies is often attributed to a ‘lack of investment opportunities’ but, in a technical sense, there is never a lack of investment opportunities till bliss has been reached. There is always a use for more capital so long as it is possible to raise the degree of mechanisation.... The conception which underlies ‘the failure of investment opportunities’ is rather that the capitalist rules of the game create a resistance to a rise in the ratio of capital to labour when it entails a fall in the rate of profit.”
The essence of Mrs. Robinson's thesis is that accumulation of capital raises real wages. Where it is accompanied by sufficient technical progress, capital-output ratio and rate of profit remain constant. Expansion then follows the path of a golden age. Where this is not so and output grows less than capital the rate of profit will tend to fall. Entrepreneurs then take evasive action by more intensive methods of production (“capital deepening”) which check the rise in real wages. If they do not, if they reduce investment instead, they will thereby reduce their own earnings since they are the people who earn what they spend.
The model is later on modified in many ways which do not affect the validity of the main argument. Allowance is made for the fact that a part of profits is consumed. Hence, the rate of profit now exceeds the growth ratio of the economy by the proportion of their incomes capitalists devote to consumption. In Marxian terms, “The prices of consumption goods exceed their wages costs to a sufficient extent to permit of capitalists' consumption, as well as investment.”
Other sections of the book are devoted to the short period, “a period within which changes in the stock of capital can be neglected but output can alter,” to finance, land and various other topics. But the main outline of the analysis as described above is not affected by arguments presented in these sections.
The notion of a stock of capital the growth of which accompanies the growth of output is crucial to Mrs. Robinson's analysis. It is also crucial that “over the long run the stock of capital corresponds more or less to the sum of all the net investments made” (p. 334). We shall call this the integrability condition. The author says that “it is broadly true” that this condition holds in reality. Evidently where this is so there can be no capital change other than investment and disinvestment. There can be no capital gains and losses, or at least, when they occur they are without economic significance. The model has no room for them. The question arises, however, whether the integrability condition is consistent with the conditions of technical progress, a question we shall take up in the following section.
But how can we measure capital? Our author emphasises that “the absence of tranquility makes it impossible to define precisely the meaning of a quantity of capital.” How, then, can we make sense of the notion of a stock of capital in a changing world?2 The answer is that this is just the purpose which the notion of a golden age is meant to serve: it enables us to combine “tranquillity” with change.
It is well known why in a world of unexpected change the quantity of capital is a meaningless notion, but in a golden age all change is expected change. In a stationary state the whole problem would not arise. Here all capital values can be ascertained without ambiguity since all capital goods are worth their cost; cost values and discounted earning values are identical. But our author is concerned with progress. The real significance of her golden age concept is that it denotes a moving equilibrium, a dynamic counterpart to the stationary state, the latest version to date of Cassel's “Uniformly Progressive Economy” of forty years ago, in which all those relationships the constancy of which enables us to determine the quantity of capital in a stationary state remain constant, yet are projected on to a dynamic world. In this moving equilibrium entrepreneurs always discount future earnings at the rate of profit which has obtained in the past, and there is only one such!
The reader is scarcely surprised to learn that in her endeavour to retain the benefit of stationary conditions when dealing with a world of change, our author soon runs into trouble. In the conditions of a golden age, to be sure, it is possible to measure the quantity of capital since “the value of the stock of capital is then determined by the rate of profit ruling in the given golden-age conditions.” But how can we compare stocks of capital in economies at different stages of development, each of them in a golden age of its own, where the over-all homogeneity postulated for our model does not exist? “One set of difficulties flows from this difference in the composition of output in the different economies. Another set of difficulties flows from the fact ... that a different wage rate in terms of output entails different relative values of commodities, capital goods and labour time, so that there is no simple unit of value in which to reckon.”
In the chapter on “The Evaluation of Capital,” perhaps the most penetrating discussion of this forbidding subject in the literature, our author, having at length expounded all these difficulties, rather surprisingly concludes that the problem of the measurement of capital is really a purely verbal one. “The problem of measuring capital is a problem about words. The capital is whatever it is, no matter what we call it. The reason for taking so much trouble about how we describe it is to save ourselves from being tricked by our own terminology into thinking that different things are alike because they are called by the same name. Since no way of measuring capital provides a simple quantity which reflects all the relevant differences between different stocks of capital goods we have to use several measures together.”
Among the several measures of capital now introduced by our author, it becomes apparent that the key-concepts are productive capacity (“an outfit of capital goods that can be used by the appropriate quantity of labour to produce a flow of output specified in physical character and in its future time-pattern”) and the real-capital ratio (“the ratio of capital reckoned in terms of labour time to the amount of labour currently employed when it is working at normal capacity”). The latter, we are told, “corresponds most closely to the conception of capital as a technical factor of production,” and is really the measure of the degree of mechanization or capital intensity. We are warned, however, that this relapse into the labour theory of value does not mean that all labour time is homogeneous: the two kinds of labour time expressed in this ratio are not in pari materia; “one consists of past labour time, compounded at interest, embodied in a stock of capital goods, the other is a flow per unit of time of current labour.” This, of course, is the heresy Rosa Luxemburg would never forgive.
The notion of productive capacity has no unambiguous meaning unless the output produced is homogeneous. This fact not merely precludes us from introducing into the model new products, a normal feature of economic progress. How are we to compare output in different economies with different rates of investment? Mrs. Robinson candidly admits that “this comparison has an exact meaning only for economies in a state of zero net investment. When, as is generally the case, accumulation is going on at different rates in economies using different techniques, the composition of output (which includes increments of capital goods) is different in each, and the comparison is subject to the same index-number ambiguity that we encountered above.” It is, of course, common knowledge that international comparisons of production index figures make little sense.3 To say that the growth of productive capacity is a measure of economic progress is therefore not to say very much, except in a world of homogeneous output.
What about the other key-concept, the real-capital ratio, our measure of the degree of mechanization? In a golden age it remains constant along with the capital-output ratio and the rate of profit since productivity increases uniformly throughout the system. But technical progress may affect the relative scarcity of labour and capital and thus the rate of profit. When this happens, and in general whenever entrepreneurs are impelled to change the degree of mechanization, the real-capital ratio changes in a situation in which the change in the rate of profit makes it impossible to compare the value of capital assets before and after the change. We have here a transition from one golden age to another, that is, from one equilibrium to another, a problem in comparative statics. But where is there a system of coordinates which, unaffected by the change, can serve to measure it?
To most economists this would be just another instance of the impossibility of comparing the quantity of capital in two different equilibrium positions. But our author is undaunted. She replaces the set of assumptions defining the golden age economy by another set of special assumptions “designed to make it possible to analyse the transition from one technique to another as though it took place without any disturbance to tranquillity. The argument, for this reason, is somewhat fanciful, but setting it out in this way enables us to see the workings of the mechanism, which are hard to follow in the hurly-burly of short-period disequilibrium in which it actually operates.”
By then, however, the moment has come when even the most patient reader cannot but ask himself whether the game is worth the candle. Does an argument confined by such stringent abstractions throw any light at all on the industrial world as we know it? Why do we have to measure capital in circumstances in which we know that it cannot be done?
Mrs. Robinson, as a Ricardian, would probably reply that in labour time we have an “objective” measure of capital embodied in the real-capital ratio which we can compare before and after the change. There is, to be sure, the problem of adding up labour hours spent in different years and paid for at different wage rates. But if we have a constant “notional interest rate”4 to compound our labour units, to compute the present value of hours worked in the past, the problem seems not insurmountable. It would appear that in this way a labour theory of value, albeit in a modified version, can be put to economic use.
But what have we really gained? What does an hour of work done in Britain in 1957 have in common with one done two hundred years ago except that they both last sixty minutes? The attempt to find in a changing world somewhere an unchanging entity to serve as a measure of change is bound to fail. Economic change affects the economic significance of hours of work along with everything else. Labour hours have no “intrinsic qualities” which do not change and have economic significance.
We cannot but suspect that this is another instance in which a method developed in the natural sciences is being used in economics without due care for the limits of its meaning. In physics (at least prior to Bohr and Heisenberg) the space-time continuum was used as the universal system of co-ordinates. All processes in nature were then reduced to changes in space and time which could be regarded as the “ultimate categories.”
In the realm of human action, however, the mere lapse of time has no significance, except possibly as a framework of chronological order. As a dimension of human action a labour hour does not remain constant over the years since more or less may be done in it. When Mrs. Robinson writes, “Work takes time, but time does not do work,” we have to add that the same work does not always take the same time. Labour hours are being bought and sold in markets and interact with other economic magnitudes in a sense which has no counterpart in classical physics. The heroic attempt to find a measure of capital invariant to time, whether as real-capital ratio or in any other form, thus far cannot be said to have succeeded. Mrs. Robinson has failed to do what cannot be done.
It would be hardly fair to criticise our model for its level of abstraction, high though it is. The same might be said, after all, of such neoclassical notions as the stationary state, or of certain models of economic expansion which have of late won wide acclaim among economists. It is, on the contrary, Mrs. Robinson's striving for realism, the endeavour to let her model reflect circumstances and processes we know from the world around us, which so often arouses the reader's misgivings as to whether such circumstances and processes are at all compatible with the conditions of her model. It is when our author suddenly lowers the level of abstraction to enable her to “catch” an interesting feature she has observed, that the most embarrassing situations are likely to arise. Only too often the reader remembers well other occasions on which what must be regarded as at least equally important features of reality were left out, and had to be left out, because the model had no room for them.5 This “selective” lowering of the level of abstraction becomes most awkward when our author has to deal with technical progress. A good deal of this section will therefore be concerned with the paradoxes which the introduction of this topic creates in Mrs. Robinson's model. But we shall first give a more general example.
Mrs. Robinson is much concerned with the modus operandi of what she calls capitalism. Again and again, we are told that “under the capitalist rules of the game” such and such will happen. The question whether these rules, and how many of them, are at all applicable to her model economy is, however, never asked. In reality the most important of these rules is surely that capital is invested where “net of risk” it promises to yield the highest return. But in an economy in which the stock of capital always has exactly the composition required to produce a given flow of composite output, the whole problem disappears. Malinvestment is abolished by definition. All investment yields the optimum return. The whole range of choices which in reality confront those who have to make investment decisions vanishes from sight. In what sense, then, can we still meaningfully speak of “the rules of the game” if we are actually confined to the choice between a very few moves? It would still be possible to play chess and obey “the rules of the game” even though each player is given, say, only a king, a queen and a bishop to play with. But most of these rules then become inoperative, for instance, all rules about the movements of knights and rooks. The reader of Mrs. Robinson's book is never warned that her rules of the game are a rather mutilated version of the real thing.
It is easy to see why the collision between realism and abstraction, latent in the whole of our author's technique of analysis, becomes most disturbing when she comes to grapple with technical progress. Homogeneity and progress are at bottom incompatible with each other. A progressive economy is an economy in which at each moment a number of experiments is being conducted with new products and new methods of producing old products. Even were all of these to succeed, their results would not be consistent with each other; at the very least relative opportunity costs would change. Mrs. Robinson later on admits as much. But even though some of these experiments will fail they are nevertheless indispensable elements of economic progress as they provide valuable knowledge, a kind of “negative know-how,” to others. But they will also leave what our author calls “fossils” in the capital structure and thus affect the composition of the capital stock.
Nevertheless, if the same new methods of production were adopted by everybody at once there might not be much of a problem. But for Mrs. Robinson progress means the diffusion through competition of innovations introduced by entrepreneurs; her conception is here essentially Schumpeterian. The innovators at first make large profits, but sooner or later the imitators catch up with them, prices fall, real wages rise, and in the end the uniform rate of profit is restored. We are back in a golden age equilibrium.
Two problems arise. How can a capital stock of “appropriate proportions” continue to exist during a period of technical innovation? And will the new equilibrium which will be reached at the end of the process of diffusion, when the innovation has gained universal acceptance, be independent of the events taking place during the period of transition?
As regards the first problem, Mrs. Robinson conceives of the change from one technique of production to another as a gradual process during which old equipment is being replaced by new equipment as it wears out. As long as this is so, the second problem does not arise as the duration of the process of transition is entirely determined by the age and durability of the existing equipment. During the transition, it is true, the rate of profit cannot be uniform. But competition is at work all the time, and if we confine ourselves to a comparison of equilibrium positions, viz. to a problem of comparative statics, it seems that we can keep the second problem at arm's length.
But our author has to admit that other forces will influence the transition process. “The speed at which new methods are diffused throughout the economy depends partly upon the physical life of capital goods,” but where this is long it largely depends on the intensity of competition. The mechanism of competition “tends to grow weaker as the economy progresses, for the more vigorous is competition between entrepreneurs the more rapidly do the strong swallow up the weak, so that the number of separate sellers in each market tends to fall as time goes by.” In other words, not all firms survive the transition process. What happens to the resources of those who do not survive it?
We are told that they may be forced to scrap their equipment before it has been fully amortized, a possibility which is of course inconsistent with the integrability condition. Another possibility, well known in industrial history, is that the strong “swallow up” the weak by taking them over as going concerns. But the strong are unlikely to make such “take-over bids” to the weak unless they see a possibility of using the resources of the latter in ways in which they have not been used hitherto. One of the things which will happen on our path of transition is that existing resources will be turned to different (more appropriate?) uses.
Technical progress does not mean merely the introduction and diffusion of new and better machines, it also means the more efficient use of existing resources. Even though we may ignore this possibility in our formal model we cannot keep it out of our description of the secondary processes of adjustment to change. Whatever may be the innovation with which we start, how golden the next golden age is going to be depends also on the changes in use of from one equilibrium to the next.
In order to make a smooth transition plausible, from one technique to the next better technique, our author also has to assume that innovations come forward sufficiently slowly for the economy to have adapted itself completely to the first before the next begins to make its impact. Where this is not so, where innovations follow each other so fast that the economy never has time fully to digest one before the next appears, there never will be equilibrium. At each moment of time we shall find ourselves in the midst of a process of transition. When, then, do we return to the golden age? What happens to our moving equilibrium with its uniform rate of profit?
Mrs. Robinson's attempt to insert progress into her moving equilibrium model thus succeeds only where the speed of diffusion is very high and the speed with which innovations follow each other, i.e. the speed progress itself, fairly low. The important case where different entrepreneurs attempt to improve their methods by experimenting in different directions without in the end all accepting the same new method, is of course excluded from the model, as are all cases of product differentiation. In the end it would appear that more features of progress as we know it are left out of the model than are included in it.
For Mrs.Robinson, as we saw, the stock of capital equals the sum of all investments. To measure capital means to add up the annual investments over the years. The integrability of these investments is the sine qua non of such capital measurement. But progress means that men acquire new knowledge. It is therefore inevitable that the capital goods existing at any moment in time will not provide a homogeneous structure. Some of them would not have been constructed at all had today's knowledge been available at the time of their construction. They are the “fossils” of an earlier age we mentioned above.
Our author's method of dealing with these, of safeguarding the continued maintenance of a homogeneous capital structure, is based on the assumption that these fossils will all be eliminated in the normal course of replacement, or even be scrapped earlier as soon as they cease to yield a return over prime costs, if competition is sufficiently fierce. But the latter possibility actually destroys the integrability of capital since it means that something that once was capital has ceased to be capital without being replaced. On the other hand, there are durable capital goods, like buildings, the productive capacity of which may be increased without replacing them, simply because men learn to utilise them more efficiently, for instance, by installing lifts. These capital resources can be made to fit into different capital structures reflecting different states of knowledge.
The parallelism between the growth of capital and output which underlies the constant capital-output ratio, a fundamental condition of the golden age, is therefore inconsistent with many manifestations of progress. Where capital has to be scrapped without being replaced, capital is being decumulated without being disinvested, yet in measuring today's capital such decumulation would have to be deducted from the current investment. On the other hand, more output now flows from the remaining capital resources.
But increased productive capacity of existing resources is also incompatible with a constant capital-output ratio. We may regard it as a “capital-saving innovation.” Such capital-saving innovations, however, may not actually save much capital if the capital “saved” exists in such a specific form that it cannot be turned to other uses. Progress in the form of better utilisation of existing resources, so far from being capital saving, may actually increase the demand for capital by opening up new investment opportunities for complementary capital resources, for instance, an innovation may make it possible for more work-in-progress to be processed by the same plant. In all such cases capital gains and losses will be made which Mrs.Robinson, as a Ricardian, is forced to ignore, but which in reality often determine direction and magnitude of change and investment.
Mrs. Robinson who, with her usual candour, admits that we introduce a “patch of haziness into the analysis” whenever “the relation between the rate of investment in physical terms and in terms of value is highly variable,” has carefully excluded all these possibilities by one of the special assumptions introduced when she deals with variations in the real-capital ratio in a “quasi-golden age” where accumulation takes place without inventions. Here she explicitly assumes that “the length of life of individual capital goods is short so that an individual entrepreneur can readily change his stock of capital goods from one form to another, without loss of value.” But the very same problem arises wherever innovation makes existing specific capital redundant.
The conclusion seems inescapable that we face a dilemma here. We must either exclude all premature redundancy by assuming all capital to be sufficiently short-lived, that is, by extending the special assumption mentioned to all phases of a golden age, in which case a change of technique could hardly take the form of a process in time. It would then become clear that the model, revealing its true nature, works smoothly only where change is followed by instantaneous adjustment. Or, if in our model we wish to allow for such features of the world around us as durable equipment and time taken by processes of adjustment, we shall also have to allow for others. We then can, for instance, no longer regard the existing stock of capital (whatever that may mean) as the result of simple accumulation, hence the notion of a constant capital-output ratio becomes untenable. We also have to realise that investment opportunity is not independent of the efficiency with which existing resources are being utilised, and that new capital goods compete with some, and co-operate with other old resources.
When we have reached this insight it is not perhaps too difficult to understand why hardly any form of progress is compatible with the notion of a stock of capital which, whatever happens, invariably retains its “appropriate” composition.
The distinguishing characteristic of the school of economics which flourished from 1871 to 1936 is the axiom that the ultimate causes of the economic processes we observe in reality have to be sought in the individual human minds, in choice and decision; and that economic phenomena are what they are because of the purposes pursued, the plans made and revised by millions of people in households and workshops. In this view, the quantities of the various goods produced and the prices paid for them are all compromise results reflecting the push and pull of these millions of decisions, of which there is of course no reason at all to believe a priori that they will be consistent with each other. It is only the continuous market process which gradually brings them into consistency as knowledge spreads throughout the market. The essence of the thought of this school of economics is the method by which we reduce objective market phenomena, like prices and quantities of goods, to the subjective preferences and expectations which give rise to them.
Every attempt to abandon this scheme of explanation has to find the causes of economic phenomena not in the multifarious variety of human minds, but “something else.” The classical economists, true to their eighteenth-century intellectual origins, found it in “natural forces,” like the Malthusian Law or the diminishing fertility of the soil. These natural forces were the true determinants of all human phenomena. All economic action came to be regarded as merely a response to them. Since, moreover, it was a major classical tenet that all men respond to economic stimuli in a virtually identical fashion, the human mind and its acts (interpretation of experience, the making and carrying out of plans) could be ignored. It is well known that, for all its methodological crudity, the classical mode of thought proved remarkably successful in its time and day: it provided a unifying principle of explanation for a large body of experience.
But those who wish to return to the classical style of thought today are facing a peculiar dilemma. Since the demise of Malthusianism (at least in the West) and the rise of modern scientific technology, there are not many “natural forces” left to serve as the independent variables in the economic system. The most notable recent attempt in this direction, Keynes's “Psychological Law” of the declining marginal propensity to consume which, as we know, Mrs. Robinson rejects, has not been much of a success.
But Mrs. Robinson is not really a naturalist, the eighteenth century is not hers, and the attempt to dress in a rococo costume when discussing industrial progress in the twentieth century remains unconvincing. Confronted with the dilemma she falls back upon another classical device. The actors in her model are not real individuals but “ideal types” of economic agents with a restricted but predictable range of action. Thus “workers” and “entrepreneurs” become the protagonists of the drama, later to be joined by “rentiers” and “landlords.” We are back in a Richardian world in which the functional distribution of incomes between workers, capitalists and landlords is the main determinant of progress. This means a great simplification of the issues with which economists have to contend; since workers and entrepreneurs can act only in their collective capacities, we neither can nor need bother about all those cases in which different sections of each group move in different and often incompatible directions. The whole area of choice and decision-making in which some entrepreneurs show their mettle by being better than others at grasping what it is that the market wants from them, disappears from sight. If we think that the style of thought which freed us from the classical cliché of profit-maximising Economic Man and enabled us to explore the whole area of choice and decision, whatever the aim pursued, was a step forward, it is hard to avoid the conclusion that the reappearance of similar clichés in 1956 is a backward step.
It is interesting to observe that Mrs. Robinson, for all her devotion to the classical method, is on occasion unable to persevere in it. When she comes to grapple with the reality of progress she cannot but remember that some entrepreneurs are more progressive than others and that competition is sometimes more intense than at other times.
Would it be a very long step, one wonders, to the realization that all progress does not start with investment in new machinery, but often with thousands of entrepreneurs experimenting with, and in the process reshuffling, their existing capital combinations; or that in addition to the innovators and their imitators there are also those who try to go one better than those whose achievements they emulate, so that a new technique of production becomes modified and diversified in the very process of diffusion? How bold, then, would the next step be, viz. the realisation that the notion of a stock of capital which invariably has the “appropriate” composition required by circumstances, is an obstacle rather than a help to our understanding of the nature of economic progress?
Sir John Hicks on Capital and Growth
For thirty years or so the appearance of a new book by Sir John Hicks has been an event eagerly looked forward to by the cognoscenti. The title Capital and Growth1 combines two subjects of peculiar interest today. The theory of Capital, after several decades of neglect, in which only investment, but not changes in the stock itself, had interested economists, has of late come into its own again. But this renaissance of the theory of capital is also closely connected with the other subject: economic growth can hardly be described, and certainly not explained, without reference to the composition of the capital stock as a whole.
In recent years the literature on Growth has grown to such an enormous size that a survey, or at least a guide for the baffled readers of economic journals, has become an urgent need. Professor Hicks is not the only one who has endeavoured to supply it.2 But there are certain reasons why his proved talents seem particularly suited to this task. For many years his success in setting economic ideas in historical perspective, and in blending his own analysis with the writing of the history of ideas, has impressed his readers. Never content merely to present his own thought, he has shown an ability (alas, only too rare among contemporary economists) to set it out in a perspective in which various, apparently disconnected, aspects of known ideas, suddenly acquire new meaning and become related to one another in unsuspected ways.
Reprinted from South African Journal of Economics 34 (June 1966).
It is noteworthy that our author must be the only prominent British economist who grew up in the 1920s, but was not brought up in the Marshallian household. A Paretian and Wicksellian, rather than a Marshallian,3 he displayed a certain aloofness towards the “Keynesian Revolution,”4 a fact which permitted him to see in Keynesian theory a variant of, rather than a contradiction to, the neo-classical tenets. Starting from a fundamentally neo-classical point of view, he has been able to absorb successive waves of thought, first Keynes, then Harrod-Domar, later on Linear Theory, and to master them all with remarkable success and alacrity.
In this way he has become a prominent mediator between different strands of thought, a broker of ideas whose influence has been far greater than is often realised today. In this role he has been much helped by another Hicksian characteristic, viz. a sturdy sense of realism, an aversion to those “heroic” assumptions which may simplify analysis but will not pass muster before a critical eye. To be sure, he builds his models, and does so with skill and evident relish, but he usually manages to keep them down to earth. In this book his insistence on the heterogeneity of capital is a good case in point.
The book consists of four parts of which the first two are concerned with the theory of growth as such, while the third is devoted to “Optimum Growth,” the Welfare Economics of the subject, and the fourth to the implications of growth theory for other parts of economic analysis. It ends with five Mathematical Appendices.
The first part, “Methods of Dynamic Economics,” at a superficial glance looks like a historical background to the Hicksian Growth Equilibrium model set out in Part II, a brief summary of growth theory from Adam Smith to Sir Roy Harrod. But, as is so often the case with Hicksian prose, the first impression turns out to be deceptive. The eleven chapters of the first part, which comprise almost half of the text without appendices, are a veritable seed-bed of ideas. With almost incredible terseness the author sets forth his main points on dynamic theory, drawing frequently on the history of economic thought for illustrations, but also often interspersing the historical chapters with analytical matter which is then brought to bear on features of contemporary reality.
At the end of the first chapter, after paying tribute to Cassel as the much neglected originator of the idea of steady growth, the author warns us “Growth Theory ... is no more than a particular method of Dynamic Economics. It is not claimed (it ought not to be claimed) that it is the method—that there do not remain many dynamic problems to which some other approach would be more relevant. It may indeed be questioned whether it is ‘dynamic’ enough.” (14) On the other hand, “In statics, equilibrium is fundamental; in dynamics, as we shall find, we cannot do without it; but even in statics it is treacherous, and in dynamics, unless we are very careful, it will trip us up completely.” (15)
Chapter II, “The Concept of Equilibrium,” contains the important distinction between equilibrium at a point of time and equilibrium over a period of time. (24) The former is thus defined: “The system is in equilibrium in this sense, if ‘individuals’ are reaching a preferred position, with respect to their expectations, as they are at that point.” The latter equilibrium presupposes the existence of the former equilibrium at every point of time within the period. “But for period equilibrium there is the additional condition that these expectations must be consistent with one another and with what actually happens within the period.” But consistent expectations are not the only requirement of Growth Equilibrium.
There is another requirement the need for which we realise as soon as we abandon the assumption of the homogeneity of our capital stock. “An equilibrium path ... is a path that will (and can) be followed if expectations are appropriate to it, and if the initial capital stock is appropriate to it; both conditions are necessary.” (116)
In a sense, this sentence contains the basis of all subsequent Growth Equilibrium analysis in the book. Our author insists that, whatever may be legitimate in statics, in dynamic theory we must give up the notion of a homogeneous capital stock. “It is the big thing that was wrong with classical theory. If there is just one homogeneous ‘capital’, there is nothing to do with out savings but to invest them in this ‘capital’; there can be no problem of malinvestment—or of savings going to waste.” (35) The problem of the appropriate composition of the capital stock is thus shown to be one of the fundamental problems of all dynamic theory, whether of the growth equilibrium variety or otherwise. But the reader who had hoped that the causes and consequences of malinvestment in a world of uncertainty and divergent expectations would now be explored, is sadly disappointed. Except for the last chapter, in which Professor Hicks shows that technical progress will cause capital losses on specific resources, this remains the only time that malinvestment is mentioned in the book!
Two other matters of great significance are dealt with in the first part of the book. As others have done before him, Professor Hicks finds it necessary to stress, in his chapter on Marshall's method, that our world differs from that which Marshall took for granted in that we live in a world of prices “administered” by manufacturers, “but in those days even manufactured goods usually passed along a chain of wholesalers and retailers, each of whom was likely to have some independent price-making opportunity.” (55) Again, like others before him, our author attributes the cause of this change to the virtual disappearance of the wholesale merchant and his price-setting function after 1900.5 Formerly “the initiative would come from the wholesaler or shopkeeper, who would offer higher prices in order to get the goods which, even at the higher price, he could re-sell at a profit. Similarly, when demand fell, it would be the wholesaler who would offer a lower price. The manufacturer would have to accept that price if he could get no better.” (56) Hence, while Marshall's was a world of flexible prices, even though not of “perfect competition,” ours is a “fixprice world” with prices set on a “cost plus” basis and wage rates as ultimate price determinants.
The analytical significance of this historical change lies, on the one hand, in the fact that the “Temporary Equilibrium Method” which Hicks himself, following Lindahl, used in Value and Capital in 1939, has lost much of its validity. “The fundamental weakness of the Temporary Equilibrium method is the assumption, which it is obliged to make, that the market is in equilibrium—actual demand equals desired demand, actual supply equals desired supply—even in the very short period.” (76) Hence we have to look for another method of dynamic analysis. To find it we must move nearer to Keynes and his successors who are here given credit for having understood, earlier than others, that a fixprice world requires a fixprice method of analysis. Here the reader cannot help wondering why, if we are to choose our method by the criterion of realism, we should have any reason to prefer Growth Equilibrium to Sir John's erstwhile favourite of 1939. We shall return to this point at the end of our penultimate section.
In Chapters IX and X we find another significant change of a Hicksian tenet: Sir John explicitly revokes not merely the Acceleration principle, but any “Stock Adjustment principle” for which universal validity is claimed. The revocation is announced, it is true, in almost an undertone. “It is hardly a discovery to find that we are unable to “simulate” the behaviour of intelligent business management by any simple rules.” (102) But he adds significantly: “If we find—as we do find—that mechanical principles of adjustment do not offer a good representation, we shall have gained something in the way of scepticism about the use of such principles in more ambitious undertakings. And this ... will be quite useful to us later on.” It is possible to feel, however, that in putting this scepticism to work on some of the more esoteric growth models Sir John is practising the same excessive modesty as when announcing his recantation sotto voce.
In Part II our author presents his own growth model. It is of the familiar 2-sector variety and, since constant returns to scale are assumed, relative prices are determined by cost of production. The wage level is “given” and the rate of profit thus determined as a residual. The rate of growth depends on the savings rate and the supply of labour. What happens if, in the Harrodian manner, “natural” and “warranted” growth rates diverge? It is shown that the ability of the system to adjust itself to such changes via price changes depends on the existence of a difference between the capital-labour ratios in the two sectors. In the following three chapters the author shows that these results are not seriously affected if we allow for a multiplicity of known techniques and of capital goods. But we are warned that technical progress is incompatible with a given growth path. “I insist that any particular growth equilibrium path is an equilibrium with respect to a given technology; changes in technology ... must imply a shift from one equilibrium growth path to another.” (171)
Chapter XVI, “Traverse,” is perhaps the most interesting in the book, as here the notion of Growth Equilibrium is put to its crucial test. We shall return to some of the fundamental problems raised in it in our next section. It opens on a cheerful note which soon proves deceptive. “Now at last we begin to emerge from Growth Equilibrium.... It has been fertile in the generation of class-room exercises; but so far as we can yet see, they are exercises, not real problems.... They are not even hypothetical real problems.... They are shadows of real problems, dressed up in such a way that by pure logic we can find solutions for them.” (183) Nevertheless there follow several pages of formal analysis in which the conditions of a successful Traverse are examined. Suddenly we are told, “Our analysis of the Traverse, in the one-capital-case, is no more than a bogy ... it is quite misleading. An actual economy—any actual economy—does not, indeed cannot, work just like that.” (190)
It appears that price flexibility is a major condition of a successful Traverse. “An economy which insists upon making its transitions on a Fixprice basis is doing so with ‘one hand tied behind its back’.” (196) But then there arises the question how, in the transition from old to new equilibrium path, the right new price system is to be found. This “cannot be an easy matter,” yet on it the success of the whole Traverse depends, since choice of technique and appropriate composition of the capital stock depend on relative prices. At the end of the chapter we find our author throwing up his hands in despair: “In an actual economic situation, all these problems arise at once, while (because of the advance in technology) the equilibrium at which the economy is aiming is continually shifting. No wonder that there is a problem of business management!” (197)
In Part III, “Optimum Growth,” Sir John turns with an audible sigh of relief from Positive to Welfare Economics, from the market place to the Turnpike. “The central problem of dynamic Optimum theory is the planning problem. Given an initial endowment of capital, embodied in particular capital goods ... what is the plan of production, in present and future, which will enable some given aim to be reached in the most efficient manner?” (203) But to maximize the rate of growth over a period may mean either of two things: we may either try to maximize the flow of consumable outputs during it, or maximize the size of the terminal capital stock. The Turnpike Theory, which is considered first, “is concerned with an optimization problem of the second type.” In Chapter XVIII the famous Neumann model which seeks to establish the conditions of continuous optimum growth (without consumption!) is set out in lucid language. In the next our author turns to the Turnpike Theorem itself. The problem here is: What is the optimum path to be followed by an economy which starts with a capital stock which is not appropriate to the balanced growth Neumann path; in what circumstances would it be better to discard the surplus parts of the stock for the sake of obtaining a balanced composition? Professor Hicks shows that it is largely a matter of time. Only over long periods would the advantages of balanced growth necessarily outweigh the capital losses from discarding surplus capital.
In the next three chapters he turns to the alternative type of Optimum theory which is concerned with a stream of consumption outputs. The argument here follows the line familiar from the second part of Value and Capital. With a given rate of interest, constant over time, there is an “intertemporal production frontier” in the sense that there is a limit to the substitution of future for present outputs. This frontier determines the optimum shape of the consumption output stream. At the end of Part III the author criticises Mr. Kaldor's Technical Progress function on the grounds that, to a large extent, technical progress stems from non-economic causes, such as scientific discovery. He therefore rejects a model “which would bring too much of the phenomenon into the strait-jacket of its ‘equilibrium.’” (276)
The last part contains what apparently are Hicksian afterthroughts on matters of contemporary interest. In Chapter XXIII money is introduced and liquidity preference comes up for review. An extension of the concept of stock equilibrium to assets in general enables us to “generalize the conception of demand for money, and assert its equilibrium in the form of saying that the whole system of debits and credits must be in equilibrium.” (281) In Keynes's theory “the rate of interest on long-term bonds is taken to stand for the whole gamut of rates and yields, on securities of all kinds, that are established on the market. As soon as one begins to ask questions about the structure of these rates, it becomes apparent that the choice between money and bonds is only one of the many possible choices between forms of asset-holding into which similar considerations of liquidity enter.” (283) From these considerations the following picture emerges: “There is a maximum to all rates of interest, set by the expected rate of return on real investment (I simplify by the assumption that there is just one rate of return); there is a minimum set by the rate of interest paid by the bank.... All other rates of interest (those paid by firms to savers, and those paid by firms to the bank) must lie, in equilibrium, between these limits. Where they will lie will be determined by a balance of liquidity considerations in the balance-sheets of lenders and borrowers respectively.” (286) Within this gap there is a place for financial intermediaries. “The financial intermediary can prosper if it can make use of specialized knowledge about the prospects of particular kinds of real investment; so that it can make advances to firms ... which the bank would not know were sound investments; and if it can acquire resources which enable it to make these financial investments at a less loss of liquidity than they would entail upon the private saver.” But while such action will reduce the gap, it can never close it altogether, a fact which has certain obvious implications for monetary policy in a Radcliffian world.
In the last chapter, “The Production Function,” Professor Hicks examines Mrs. Robinson's famous criticism of this elusive notion.6 Here at last technical progress is introduced, though it occurs discontinuously. “There are inventions (let us say) in 1900, 1910, 1920; in 1909 and 1919 the economy has settled into a stationary state.” (295)
Technical progress requires a transmutation of the capital stock. “Can one treat the supply of capital as fixed, when capital has been transmuted according to our particular rule? The answer is that one can.” (297) In fact “so long as we are only concerned with the comparison of equilibrium positions, the production function (or a production function) gets through.” (298) But our mentor adds significantly: “How much use it is, when it has to be put into this sophisticated form, may indeed be questioned.” He then admits “that the rate of profit on new investment is raised, while the profit that is earned on past investment may be lowered.” (301) In other words, technical progress entails capital losses on specific resources.
This is certainly a matter of great importance. It is to be regretted that it is only mentioned in the concluding pages of the book. After all, technical progress is not the only cause of capital losses and gains. Any disappointment of expectations concerning the use of specific resources has the same effect. Why, the reader cannot help asking himself, did not Sir John tell us that before? Would it not have been useful, at least on the Traverse, to know that the transmutation of the capital stock will be affected by such losses and gains? Should we not also have been told that, together with the classical notion of a homogeneous capital stock, we must abandon the corresponding notion of the uniform rate of profit?
We return to the Traverse. Chapter XVI is, in a sense, the pivot of the book. It is here that we have to decide whether the notion of Growth Equilibrium is a tenable conception. The problem is posed early on in the chapter: “But let us now suppose that the Harrod difficulty has been got over: that a suitable change in the overall propensity to save, for whatever reason, has occurred—will that be the end of the trouble?” (185) Our author has told us as early as on page 17 that, if the equilibrium assumption is to be justified, we must be able to assert the existence of a tendency to equilibrium, and that it must be a strong tendency. Can we assert this for the Traverse from an old growth path to a new?
The problem of the Traverse consists essentially in the need for a time interval to elapse before the new equilibrium path is reached, because the transmutation of the capital stock, the change of its mode of composition from that appropriate to the old to that appropriate to the new conditions, takes time. But if any of our conditions of equilibrium, which include expectations and wealth distribution, changes during the interval, the final equilibrium will be modified. This is an old and familiar problem which Edgeworth and Walras saw clearly and, within their stationary framework, attempted to solve by means of “recontract.” Sir John spurns these “artificial arrangements.” (54) But how does he tackle the problem?
Recontract is out of the question and a suspension of all business dealings during the Traverse hardly feasible. The transmutation of the stock obviously requires firm commitments. We are thus driven to the conclusion that, so far from being able to assert a tendency to it, we do not even know what the new equilibrium will be like until we get there—if ever we do. Nor are we entitled to speak of a transmutation of the stock since we are unable to specify the terminus ad quem beforehand. To speak of an “adjustment to new conditions” is positively misleading when we do not know what they are.
How does our author avoid these conclusions? He tells us that, when prices have to change, “a corresponding Fixprice policy would presumably imply that prices are adapted at once (or sought to be adapted at once) to the new equilibrium.” (196) Nothing is said here about what would happen with flexible prices, but here, too, the system would evidently have to adapt itself to the new set of equilibrium prices at once, if malinvestment and the adoption of disequilibrium techniques are to be avoided. But this could only happen miracle and hardly permits us to assert a strong tendency to equilibrium.
What lessons are we to draw from this disconcerting experience?
In the first place, we must realise that our discomfiture is due to a misguided attempt to use the equilibrium concept in fields far away from its natural habitat. With the household and the firm equilibrium makes very good sense as here it is something actually aimed at. Interindividual equilibrium already raises issues concerning mutual knowledge which have never been properly appreciated or fully discussed. But in the Marshallian type of commodity market with flexible prices it still has a clear meaning. To extend the concept to the economic system as a whole was a bold venture, but Walras and Pareto showed that, in a stationary state, it could still be done. But to extend it even further, to an economic system in motion, would appear to lie beyond the range of the feasible.
Secondly, therefore, we must consider the possibility of a retreat to a more congenial terrain. Two positions can now be seen to have become untenable.
On the one hand, once we acknowledge, with our author, the inadequacy of all mechanical rules about human reaction to change, we also have to acknowledge the autonomy of expectations at every point of time, because this autonomy is the true cause of that inadequacy. But with this all possibility of an equilibrium over time, based upon convergent expectations, vanishes. For real expectations always diverge. This simple fact appears to destroy the, even theoretical, possibility of a determinable time path of economic processes. All this, however, does not invalidate the possibility of equilibrium at a point of time, an equilibrium in which each price reflects a balance of contemporary expectations.
On the other hand, there can be no such thing as a dynamic macro-economic equilibrium. For outside the stationary state there is, in general, owing to the ubiquity of “lags,” no market mechanism to bring the divergent expectations of all individuals within the same economic system into simultaneous consistency with each other. Nor is there any reason why the quantities of the various capital goods held in different sectors should necessarily be such as to earn their owners an actual, let alone expected, uniform rate of profit.
We are thus forced back to a micro-economic version of the Temporary Economic Equilibrium at which Professor Hicks and Lindahl tried their hands in 1939. We have to assume a market, an intemporal market which of course permits of forward transactions, on which individuals express their expectations, with a resulting equilibrium price reflecting a balance of such expectations.
This may seem a poor “optimum” for equilibrium analysis. But we may draw some comfort from at least two qualifications (there may be more) which we may permit ourselves to make to the rule about the necessary micro-economic character of our markets.
In the first place, there is, in a market economy, a Stock Exchange, a market for future yield streams, in which expectations are brought into consistency every day and a price reflecting the balance of such expectations is struck. And since the Stock Exchange is also, in every reasonably developed economy, the central market for existing capital goods, or titles to them, we can say that expectations pertaining to the whole economy are here coordinated without a necessary lag. In fact, if the classical notion of a uniform rate of profit, the corollary of the assumption of capital homogeneity, is to retain any significance at all in the real world, it is only on the Stock Exchange, where a uniform rate of yield is produced every day by the price changes of existing assets, that we can really speak of it.
Secondly, once we recognise, with our author, the heterogeneity of all capital, we must also recognise that existing capital combinations have to be dissolved from time to time, as expectations change. Existing capital combinations will thus have to be “re-shuffled,” at intervals which may, but need not, coincide with those between our “market days,” by the discarding of some and the purchase of other existing capital goods, such as buildings, equipment, ships, etc. This secondhand market for certain kinds of capital goods provides another link between various sectors of the economy. But here of course there will be lags.
Lastly, we should remember that equilibrium analysis, and indeed all formal analysis couched in terms of functional relationships, is neither the beginning nor the end of economic theory. When confronted with a disequilibrium situation, we certainly have to assume that each individual seeks to attain a (flow and stock) equilibrium. But these individual equilibria may not be compatible with one another and therefore be unattainable. Economists will have to learn to live with, and give an intelligible account of, circumstances which have no determinate outcome.
In the opening section of this review article we described Sir John Hicks as a great mediator of economic thought, a most successful broker of ideas. In reality of course there is no broker, however successful he may be, to whom it does not happen, from time to time, that a deal falls through. Similarly, we find at least one conflict inherent in modern economic thought which our mediator has been unable to appease. We shall hardly be surprised that it first comes to our notice in the historical chapters of the first part, and even less that it fully comes to the surface in Chapter XVI. The question at issue is that of the compatibility of subjective attitudes (tastes, expectations) with the requirements of modern formal analysis in the shape of models. The elements of our models, parameters and variables, must be, at least in principle, objective and measurable entities. But are subjective attitudes?
This problem has existed, in one form or another, at least since the “marginal revolution” of the 1870s in which human preferences were acknowledged to be the ultimate basis on which the economic edifice rests. To trace it in the work of the major neo-classical writers would be a fascinating task. All we can do here is to make a few comments on the way in which it affects the present work.
Quantifiability is not, as has often been thought, the root of the matter. The outcome of the long discussion on cardinal versus ordinal utility showed that tastes qualify for inclusion in our models provided they can be ordered; it is unnecessary for them to be quantifiable in any cardinal sense. There seems to be no reason why the same should not apply to expectations.
The root of the matter is the autonomy of the human mind: men can and will change their tastes and expectations for no objectively ascertainable reason. Pareto saw this problem, as he saw so many others, far more clearly than most of his contemporaries. He insisted that the individual, having once recorded his preferences for us, “having left us this photograph of his tastes,” as he put it, must disappear from the analytical scene and worry us no further with the unpredictable acts of his mind.7 Whether he realised equally clearly that, by making this postulate, he also limited the validity of his whole system to the conditions of a stationary state, in which alone today's photographs will still be valid tomorrow, it is hard to say. But we may safely assume that he would have been willing to pay that price.
But around 1930, just about the time when our author joined the staff of the London School of Economics, expectations arrived on the scene. And expectations, since in a stationary state they are in any case without significance, cannot be disposed of in the Paretian fashion. The assumption of their continuous convergence, made in all the familiar growth models, is simply an attempt to sterilize them, as Professor Hicks sees clearly.
While constant tastes over a period of time are at least conceivable, expectations cannot remain constant as soon as they diverge, since some of them must turn out to be wrong sooner or later, hence be revised, though we can say very little about the mode of their revision. While therefore expectations cannot be constants, we must not treat them as variables either. They are clearly not dependent variables as they do not “depend” on any observable events. But if we try to treat them as “exogenous” data, we soon find that they will “take over” and “swallow up” most of our other data. This is the real lesson of the story of the Traverse. Divergent expectations, prompting transactions at non-equilibrium prices, will themselves affect the composition of the capital stock as well as the interindividual distribution of resources.
We must therefore conclude that expectations, and other subjective elements, constitute an alien body within the organism of formal model analysis. The conflict remains unresolved. Marshall was uneasily aware of it. Pareto saw it, drew his sword and cut the Gordian knot, but, alas, knew nothing of expectations. Our mediator, for once, has been unable to mediate in a conflict of the existence of which he is clearly aware. This of course is hardly his fault. Sir John Hicks has failed to do what cannot be done. It remains a tribute to the qualities of this remarkable book that for one brief moment, in Chapter XVI, a reader could bring himself to imagine that he might do it.
Sir John Hicks as a Neo-Austrian
In the opening passage of the Preface of his latest book1 Sir John Hicks tells us about the place it holds in his work on capital theory. “This is the third book I have written about Capital: Value and Capital (1939); Capital and Growth (1965); Capital and Time (1973). They were not planned as a trilogy. I had no idea, when I finished the first, that I would write the second.... Nor do the later volumes supersede the earlier, save in a few quite limited respects.... It is just as if one were making pictures of a building; though it is the same building, it looks quite different from different angles. As I now realize, I have been walking round my subject, taking different views of it. Though that which is presented here is just another view, it turns out to be quite useful in fitting the others together.”
This is certainly true. We notice, e.g., that Part II of the new book, its central part, has the same heading, “Traverse,” as had chapter XVI of Capital and Growth. In fact, what we now find here, in chapters VII to XII, is a careful restatement and elaboration, much qualified but also more sharp edged, of the earlier argument.
The real significance of the new book, however, lies elsewhere. It is impossible to describe its character adequately by indicating its place within the Hicksian oeuvre. It also has a place, which may turn out to be an important place, in the context of the present crisis in economic thought.
Reprinted from South African Journal of Economics 41 (September 1973): 195–207.
Value and Capital (1939) belongs to the epoch of neoclassical ascendancy of which our author was such a protagonist and during the struggle for which he won fame. Capital and Growth (1965) belongs to a period of neoclassical “expansionism” when the concept of general equilibrium was to be extended from the stationary state to economic growth. Our author then weighed up and critically surveyed various methods that might be employed to this end.
Today neoclassical economics is very much on the defensive. It is under fire from many sides. When Mr. Sraffa in 1960 gave his famous book the subtitle Prelude to a Critique of Economic Theory, few of his readers can have had a clear conception of the direction the critique might take. The end of the 1950s found neoclassical economics still powerfully entrenched. If, in 1973, Professor Shackle adds to the title of his book Epistemics and Economics the subtitle A Critique of economic doctrines,2 the reader cannot but realize that what is challenged in the plural is no longer a single predominant doctrine. Moreover, the challenge is issued in circumstances in which our certainties are few and the future of economic theory is by no means assured.
In this situation Sir John Hicks is taking command of the neoclassical forces already in some disarray. With the cool and dispassionate air of the veteran soldier he decides which positions are to be given up, and which must be defended at all costs. His strategy is the defence of the central neoclassical notion of general equilibrium, and in particular its modern extension, “steady growth.” He tries to show that, on assumptions most of us would regard as reasonable, there are strong forces impelling the system towards a new steady growth path whenever a former growth equilibrium has been disturbed by technological change, and that some plausible generalizations can be established about the forms such “Traverse” might take. Growth equilibrium makes sense because the equilibrating forces are likely to be strong enough to prevail. Our author calls his approach “A Nee-Austrian Theory.” As in Böhm-Bawerk, the production and use of capital goods are given a time dimension. The main difference, according to him, lies in the fact that Böhm-Bawerk used a model in which a flow of inputs produces a “point output,” while his is a “flow input-flow output” model.
In a note to Chapter I he rightly points out that “the concept of production as a process in time” is nothing peculiarly “Austrian.” “It is just the same concept as underlies the work of the British classical economists, and it is indeed older still.” A poignant example from Boccacio's Decameron is given. Certainly Böhm-Bawerk was a Ricardian capital theorist who asked questions about the causes and magnitude of interest Ricardo had been unable to answer. “What Böhm-Bawerk did was to take the classical concept of capital, and to marry it with the theory of individual choice which he got from Menger”(p.13). This is only partly true since Menger did not like Böhm-Bawerk's interest theory at all.3 The question arises whether this neo-Austrian theory is not altogether too “classical” to be characteristically “Austrian.” To his question, by no means of interest only to historians of thought, we shall return in the concluding section.
At the end of the note mentioned the Cambridge “post-Keynesians,” today perhaps the best known, but by no means the only, opponents of neoclassical orthodoxy, receive actual praise. “It is the post-Keynesians who would better be called neoclassics; for it is they who, to their honour, have wrought a Classical Revival.” But for all this Hicksian courtesy their arguments fare no better. We are reminded that, e.g., the Wage Fund, to which our author ascribes great importance, was also a Ricardian idea (pp.58–62).
With so many labels lying scattered all over the floor of our wine cellar no wonder it is hard to know which one to stick on to the vintage Sir John is offering us here.
The method of analysis employed in the book is described as sequential analysis. We are concerned with what happens in a sequence of “weeks.” “The one-week relations ... determine the course of the model in week T, when everything that has happened before week T is taken as given. Having determined the course in week T, we can then proceed to week T+I, applying similar relations, but with the performance of week T now forming part of the past” (p. 63). The method bears some resemblance to, but is not identical with, the kind of sequence analysis Lindahl4 and Professor Lundberg5 propounded in the 1930s as an alternative to short-run equilibrium analysis. An important difference is that in the Hicksian model the labour and capital market are the only markets. “All ‘original’ inputs are taken to be homogeneous, and all final outputs homogeneous; so there is just one non-intertemporal price, the input-output price-ratio” (p.37). As with Böhm-Bawerk, we are in a one-commodity world. This sequential analysis is used to trace the effects of a technological change on the production system through time. As distinct from the Walrasian model, the effects of change are here not instantaneous but lagged. From our knowledge of the sequence of stages of production we can determine how long it will take such effects to permeate our system. Since technical change is mainly “embodied,” the coexistence of old and new processes and gradual replacement of the former by the latter provide the time dimension of change. In a “steady state” all processes are of the same kind. A productive process is defined “as a scheme by which a flow of inputs is converted into a flow of outputs” (p.14). We have to think of it as essentially a sequence of stages of production (coal, iron, steel, machinery, cutlery), but have no remember that there is only one “output good.” Therefore in a “steady state” only one process is in operation.
In Part I, Model, the analytical tools are displayed, some of them already known to us. In Chapter II we have a Fundamental Theorem: “It is always true that a fall in the rate of interest will raise the capital value curve of any process—will raise it throughout—while a rise in the rate of interest will lower it” (p.19). In the next chapter we are told “the fact that a process is in use does not imply that it would now be profitable to start it. When it was started, it appeared to be profitable, but conditions have changed. Either because of new invention, or because of changes in prices, its profitability has gone; so the starting of new processes of that kind would no longer be payable. It may nevertheless be profitable to carry on the remainder of such a process” (p. 32). How, we wonder, do prices change in a one-commodity world?
Chapter IV, “Technique and Technology,” contains a discussion of the “Re-switching” problem. Like every one else, Sir John admits the possibility of re-switching, of a fall in the rate of interest leading to a substitution of labour for capital instead of the other way around, “but it looks like being on the edge of the things that could happen” (p. 44). He notes that the re-switching possibility impairs the “lengthening of the period of production” of “the older Austrians” as much as the neoclassical substitution of capital for labour. “Both are special cases, in which the differences between techniques are reduced to differences in a single parameter. Neither, in general, is admissible” (p. 45).
In the next chapter, V, two important analytical tools are presented. We are reminded “that steady state theory ... divides into these two branches. There is (1) the Fixwage theory, as I shall call it, in which w (the real wage) is given but employment is variable, and (2) the Full Employment theory, where there is full employment of a labour supply the movement of which is given exogenously” (p. 48).
In the former, with an elastic supply of labour, the limit of activity is set by savings. We thus have Full Performance as a counterpart to Full Employment. “We can nevertheless accept that an economy may run at less than Full Performance; and if confidence is insufficient, that is what it will do” (p. 52). We are warned “that Full Performance has nothing to do with the monetary system.... Money is not the cause of fluctuations; it is a complication, but no more than that” (p. 55).
Secondly, in this chapter the assumption of “static expectations” is adopted “since it probably throws as much light on actual processes of development as we can expect to get from our general approach” (p. 56). To this important assumption we shall have to return later on.
Thirdly, we have the distinction between major and minor switches. “A major switch is one that can only be made at the start of a process; but a minor switch can be made to a process that has already been started” (p. 61). We have to remember here that, since labour is our only input, all such switches refer to the amount of labour per unit of output within a process. Our author makes it clear that his “minor switches” are more or less the kind of supply adjustments permissible within Marshall's short period. There appears to be no place here for the reshuffling of existing capital combinations in response to unexpected change.
The chapter ends with a defence of the Wage Fund theory likely to give little satisfaction either in Cambridge or at M.I.T. Professor Kaldor's well-known views on wages are said, “more or less surreptitiously,” to imply a resuscitation of classical Wage Fund theory. “It should never have been supposed that the Wage Fund (however carefully qualified) was a complete theory of wages; it does no more, at the best, than explain how the wage is determined in the current ‘week,’ the past course of the economy being given. It is a very short-run theory; it needs to be completed by the consideration of longer-run effects. Our method of dealing with longer-run effects will be developed ... we shall try to exhibit them sequentially” (p. 60).
Mill is criticised for having abandoned this classical doctrine. “The article, in which the recantation occurs, is not one of Mill's better economic writings; one suspects that by 1868 he was much less interested in economics than he had been as a younger man” (p. 59).
The problem of Part II (Chapters VII–XII) is the Traverse. “It is the determination of the path of our model economy (the Full Performance or maintainable path) when the economy is not in a steady state. Such a path must have a definite time-reference; for, out of the steady state, one point of time is not like another. In particular, it must have a beginning” (p. 81). Somewhat apologetically our author tells us he “would like to assume that this initial state is itself a mixed state, itself the result of a transition which is still incomplete; but a state of that sort we do not yet understand” (ibid).
Thus we have to start in a steady state, “and should proceed to trace out a path which will be followed when the steady state is subjected to some kind of disturbance.... We begin with an economy which is in a steady state, under an ‘old’ technique; then, at time O, there is an ‘invention,’ the introduction of ... a new technology” (ibid). The new technology is embodied in new processes. Gradually, as these become completed and old processes disappear, the system adjusts itself to the change. While this process is under way our system can, of course, not be in a steady state since its capital stock does not have the composition requisite to either the old or the new equilibrium. We confront a “sequence, involving changes in wages and interest, in production and employment, which we have to work out.... It cannot be taken for granted that the sequence generated in this matter, will tend to a new equilibrium. It may or it may not” (p. 82).
To be assured of the completion of the Traverse, of the attainment of a new equilibrium growth path, we have to make a number of special assumptions one of which is that the relative periods of construction and utilization of our capital goods are not affected by the new technology. This is called the Standard Case.
It is then seen that the Fixwage Path (Ch. VIII) presents the simplest case. Here there is only one switch from the old to the new technology which then remains “dominant throughout the Traverse.” All the benefits of progress accrue as profits (by assumption not to be consumed) and result in more investment and growth. When the new technology has been completely absorbed, wages rise in one jerk, the growth rate declines and we continue our journey on the new steady state level. Even here, however, the replacement of labour by better machines may cause temporary unemployment soon to be absorbed by increased accumulation. We are of course reminded that this is the problem of Ricardo's Chapter 31 “On Machinery.”
Sir John is able to draw a practical lesson, perhaps of some relevance to African countries today: “To industrialize, without the savings to support your industrialization, is to ask for trouble. That is a principle which practical economists have learned from experience. It deserves a place, a regular place, in academic economics also” (p. 99).
As soon as we allow for wage flexibility, however, the problem of expectations naturally raises its head. Here “the choice should in general depend on expected wages as well as on current wages” (p. 110). But our author brushes it firmly aside: “I shall in this book leave that complication out of account. I shall assume static expectations.“
The main difficulty with flexible wages on the Traverse is of course that every time the wage rate rises a different technique (within the range of the new technology) becomes the most profitable. There will be repeated substitution against labour, but the wage rise is only slowed down, not held up. “The function of substitution, in an expanding economy, is to slow up the rises in wages that come from technical improvement; but the effect of the retardation is to stretch out the rise, making it a longer rise, so that a larger rise than would otherwise have occurred, is ultimately achieved. That is the Principal Proposition I am advancing in this chapter” (p. 115).
In Chapter XI, “Shortening and Lengthening,” the Austrian aspect of the problems of the Traverse at last comes into view. If processes are “lengthened” by more investment in the construction industries, the even flow of their products through the system requires, at each processing stage, the presence of additional savings, in the form of working capital, to buy them. “Even when the wage is variable, lengthening of the construction period causes jerks.... When the wage is stabilized, the disturbances to the productive process (as a whole) are intensified” (p. 132). The intertemporal complementarity of some of our processes may fail, their parts no longer fit together.
At the end of the chapter Sir John pays a tribute: “To have drawn attention to vertical displacements was a major contribution; it is due to Professor Hayek.
“Where (I may as well emphasize here) I do not go along with him (or with what he said in 1931) is in the view that the disturbances in question have a monetary origin” (p. 133). We may point out here (as seems indeed to be admitted in the parenthesis) that already in his Copenhagen lecture of December 1933 Hayek put the main emphasis on divergence of plans and expectations rather than on “monetary disturbances.”6
In Part III the author is at last descending into the arena of Controversy, armed not with his sword but with his camera. The connoisseur of Hicksian art expecting revealing glimpses of the, as yet, imperfectly known, crevices where all seemed solid rock, is not disappointed.
Chapter XIII deals with The Measurement of Capital—Value and Volume. It is redolent of a famous wrangle on the same topic between Mr. Sraffa and our author that took place on the island of Corfu in 1958.7
Objective value is market price, but in the Hicksian model “there are no markets in intermediate products” (p. 157). After all, the reader reflects, the one-commodity world assumption exacts a price! “We nevertheless associated with every process, at every stage of its ‘life,’ a capital value. These values could not be market values; they must thus be subjective values, steps in the process by which technique is chosen” (p. 157). But, “Whose are the expectations, of future net outputs, from which the forward-looking value is to be derived? ... The expectations of different individuals are not harmonious, and the statements which they record in their balance-sheets of magnitudes which depend on these expectations are not harmonious” (p. 161). Hence they cannot be added up. Most economists have concluded that it is therefore impossible to measure capital. Sir John Hicks seems hesitant. He spares a kind thought for the statistician and advises him to measure capital “by volume,” though admitting that “it also, in its more sophisticated form, requires a value measure at a base date” (p. 163). The reader notices that the divergence of human expectations plays here a vital part.
In Chapter XIV “The Accumulation of Capital” comes under discussion. We learn that the owners of capital invested in old processes will suffer capital losses even if these processes do not have to be cut short, because future output has to be discounted at the new, higher rate of interest. The word “malinvestment” is never used. It is noteworthy that no other case of it is ever mentioned.
Our author realizes that on a Full Employment path, with capital values changing all the time, the assumption of static expectations becomes hard to maintain. “A sequence of capital values, in which each term is calculated on assumptions that are belied by later elements in the sequence, does not look like being worth the trouble of writing it down” (p. 172). The only alternative, however, is “correct expectations of the wages and interest which in the course of the Traverse will be realized.” Sir John firmly rejects it: “In positive economics we must not endow our actors with perfect foresight; for to do so would abolish Time, which is our subject” (ibid). But static expectations, the reader may feel, imply no less the abolition of Time as the dimension in which knowledge becomes diffused. And what entitles us to endow our actors with convergent expectations when we know that in reality they are bound to diverge? To “Austrian” thinking the diversity of expectations is a feature of the world no less significant than the diversity of preferences. They really belong together.
The chapter ends with another significant warning: “In a progressive economy, with wages rising, the increment of capital at cost is almost certainly much lower than appears from social accounting statistics. A great deal of saving is needed to prevent the volume of capital from declining. It should cause no surprise if it were found that there were happily progressive economies, with rising real incomes, in which the volume of capital was declining; the rise in real incomes would then seem to be ‘due’ to technical progress, and to technical progress alone. But that would not mean that the saving was unnecessary; it would be necessary, to keep the ‘real’ wage-fund rising, so that full employment could be maintained with the rising real wages” (p. 176).
In the last chapter The Production Function, described as “the nub of the Controversy,” comes under review. “So static a concept does not fit at all readily into our present line of thought” (p. 177). On the other hand, “it may reasonably be claimed that the neo-Austrian approach is richer; it gives us a deeper understanding ... not only because it offers some comprehension of the whole of a process of adaptation.... Still more important is the inability of the static method to relate the process of growth to saving and investment....for it works with Equipment, not with Capital; it is negligent of Capital in any accounting sense” (p. 182). The chapter ends with the statement, “A reminder that the Distribution of Income is not, in the short-run, a well-founded economic concept is perhaps not the least important point which has emerged from our enquiry” (p. 184). An appendix, “The Mathematics of Traverse” ends the book.
It is futile to quarrel about labels. A thinker who carries on Böhm-Bawerk's work cannot be gainsaid the predicate “Austrian” if he claims it. The question, however, whether this “neo-Austrian theory” is not more “classical” than “Austrian,” inspired by Ricardo and Walras rather than by Menger and Hayek is more than a mere matter of intellectual genealogy.8 It concerns the consistency of the new work. It also is germane to some aspects of the Grand Controversy now raging. Can neoclassical equilibrium theory be successfully defended on the macro-economic level alone? Can Sir John Hicks defeat the neo-Ricardian counter-revolution now gathering strength at Cambridge by showing himself the more subtle Ricardian?
We may look at these important questions in various perspectives and should not confine ourselves to one of them. Seven years ago, when reviewing Capital and Growth in this journal, I raised the issue of subjectivism versus formal analysis. The issue remains as germane to the new book as it was to the old.9
Economics has two tasks. The first is to make the world around us intelligible in terms of human action and the pursuit of plans. The second is to trace the unintended consequences of such action. Ricardian economics emphasized the second task, the “subjective revolution” of the 1870s stressed the urgency of the first, and the Austrian school has always cherished this tradition. The pursuit of the second task, to be sure, need not, in principle, impede that of the first. Experience has shown, however, that formal analysis on a fairly high level of abstraction is indispensable to accomplishing our second task, in particular where the number of possibilities is large and, in order to reach any firm conclusions, we have to limit this number by restrictive assumptions which may hinder us in the pursuit of our first task. For it is just part of this latter to explain the dazzling diversity of our world, and restrictive assumptions do not serve this purpose.
Seen in another perspective, even in the analysis of macroeconomic processes the micro-basis, the true springs of human action, must not be abstracted from. Yet, in the present book it is almost completely ignored. It is not to be thought that the author of Value and Capital has really come to believe that autonomous changes in demand and the diversity of expectations do not matter. But so eager is he to “get results,” to show that feasible forms of the Traverse are at least possible (since otherwise the “steady state” remains a mere figment of the imagination) that he seems ready to make any assumptions sufficiently restrictive to ensure them. We all understand that the present weakness of the neoclassical position may call for desperate measures. It is hard to see what is “Austrian” about them.
To substantiate our misgivings, two Hicksian assumptions lend themselves as ready examples, the one-commodity world and static expectations.
The weaknesses of Böhm-Bawerk's original construction were many. No doubt Sir John's flow output is a great improvement. But the fatal weakness of the former surely lies in the fact that we cannot apply it to a multi-commodity world which requires a price system invariant to changes emanating from the capital structure. Böhm-Bawerk's “subsistence fund” must always have that composition which corresponds to the tastes of the workers, otherwise there will be capital losses. Our author, of course, is not unaware of these problems (pp. 143–46), but the absence of a price system in his model does not a seem to bother him. Yet, in the current controversy this problem plays a significant part.
In any transition from disequilibrium to equilibrium a good deal depends on the events occuring “on the path.” In 1939 our author at least mentioned the consequences of trading at “false” prices.10 In 1965 he dismissed Edgeworth's “recontract” and Walras's “tâtonnement” as “artificial arrangements.”11 In the new model there can be no trading at “false prices” while we are in out Traverse for the simple reason that there are no markets at all! Is this “arrangement” any less artificial than Edgeworth's or Walras's were?
We cannot but feel similar misgivings about the heterogeneity of capital. “This has often been thought to be a difficulty, but I do not think it is” (p.178). The intermporal complementarity of intermediate products at the various stages of our processes impiles heterogeneity of one kind. Can we really neglect the “synchronical” heterogeneity of buildings, equipment, tools and stocks of goods? The faithful reader of Hicksian prose cannot help remebering how the assumption of a homogeneous “capital substance” was once said to be “the big thing that was wrong with classical theory. If there is just one homogeneous ‘capital’ ... there can be no problem of malinvestment—or of saving going to waste.” (Capital and Growth, p. 35). Will not the “minor switches” of the new model in reality often take the form of the reshuffling of existing capital combinations? Will not “old” capital goods released from such combinations compete with some of the new ones? There is also the possibility that the same capital combination, in response to shifts in demand from one final product to another, will switch from one output stream to another, producing capital gains and losses. While in reality all the more interesting cases of “minor switches” appear to arise in this context, in the Hicksian model all this vanishes from sight. This is a good example of one of the ways in which the exigencies of macro-economic formalism impede our understanding of the ways the market economy works.
In turning, once more, to static expectations we can now see that they provide another instructive example of the same kind. Our author is compelled to maintain this assumption because otherwise the number of possible consequences is virtually infinite. As long as our sole aim remains to predict the unintended consequences of action it is legitimate enough to narrow the range of possibilities by means of restrictive assumptions in order to achieve “results.” But if another of our aims is to render the world intelligible, exactly the opposite course of enquiry is indicated: we must convey to our readers an impression of the complexity and diversity of circumstances and try, as far as we can, to describe the range of possibilities. A widening, not a narrowing, of the scope of our enquiry is then what is required.
It was not personal caprice that prompted Menger's dislike of Böhm-Bawerk's capital theory and Walras's general equilibrium system; it was a conviction that in both a false picture of uniformity disguised the diversity of the world.
It is a curious fact that in 1965, when in Capital and Growth he renounced the Acceleration Principle of which he had made use in earlier writings, Professor Hicks did so in words suggesting that he was ready to follow this “Austrian” line of thought: “It is hardly a discovery to find that we are unable to ‘simulate’ the behaviour of intelligent business management by any simple rule.... If we find—as we do find—that mechanical principles of adjustment do not offer a good representation, we shall have gained something in the way of scepticism about the use of such principles in more ambitious undertakings” (Capital and Growth, pp. 102–03).
The Acceleration Principle is of course merely a special instance of static expectations. It is ironical that, just in a “neo-Austrian theory,” an even more general “mechanical principle of adjustment” should occupy such a prominent place.
We have to remember that this work is part of a continuing tour d'horizon. “It is just as if one were making pictures of a building; though it is the same building, it looks quite different from different angles.” Perhaps next time a few pictures will be taken at such angles that some of the problems mentioned will come into full view.
The book is, in a sense, a tract for the times, a powerful contribution to a current discussion of fundamental issues. What we are being told is that no answers to the questions raised can be found within the orbit of the Ricardian or Marshallian “long period,” while this is precisely where the Cambridge neo-Ricardians and their neoclassical opponents are trying to find them. “New Equipment, the increment of Equipment, is among the least suitable of all macro-economic magnitudes to be treated as an independent variable. That is really what is wrong with the Production Function” (p. 182), the mainstay of the neoclassical position. But since even long-period forces must operate within short periods, we can (sometimes) determine what will happen by tracing their action over a sequence of short periods.
When, forty years hence or so, the history of economic thought in the twentieth century comes to be written, historians will find, no doubt to their delight, that in the work of Sir John Hicks they hold in their hands a true mirror of the age. The interplay of ideas, the impact some had and the changes all underwent as a consequence, are to be found there, reflected as in a glass. We are no less in his debt for being his contemporaries.
A Reconsideration of the Austrian Theory of Industrial Fluctuations
The Austrian Theory of Industrial Fluctuations has lately been under a cloud.1 By 1940, its most faithful adherents have to admit to themselves that few of the high hopes it held out in the halcyon days of the early 1930s have been fulfilled. To some extent this is, of course, due to the erstwhile ascendancy of the doctrines of Mr. Keynes and his followers, and although this is but a negative reason, it is probably the one that would readily occur to three out of four present-day economists.
It is probable, however, that to the historian of the future this ascendancy will be less of a problem than it is to some contemporaries of ours. For, when the history of economic thought in the second quarter of the twentieth century comes to be written, it will have become clearer than it is now that Mr. Keynes's theory—so far from being “general”—derives its fascination for the present generation of economists mainly from the fact that it is a most vivid description of a peculiar historical situation, an impressive picture of our world. In this disordered world the institutional and political framework of economic progress has broken down and in the resulting international chaos the capitalistically most advanced countries find it impossible to fulfil their natural function of assisting the economic development of the more backward parts of the world. The economic theorist of sterling purity, who in constructing his models chooses to ignore all this, may then, of course, summarise this situation by speaking of a “lack of investment opportunities”!
Reprinted from Economica 7 (May 1940).
Reasons more positive—and of less ephemeral value—for the temporary eclipse of the Austrian theory may have to be sought in the manner of its first presentation and the intellectual milieu of its protagonists. Its theoretical pedigree was Wicksellian, and Wicksell's major claim to fame was to have linked the Böhm-Bawerkian theory of capital to the Walrasian equilibrium system. Hence, recent attacks on the former could not but affect its apparent derivative in the field of industrial fluctuations, while the charge of assuming “Full Employment” from the outset appeared no less serious a gravamen to a generation to which the monthly unemployment figures had become an integral part of its acquaintance with economic life.
Of both these charges Professor Hayek has now effectively disposed.2 And if it could be hoped that the major obstacles to a more general understanding of the thory were thus removed, we might well leave matters at that. The only justification we have to offer for reconsidering the theory in the light of certain of its dynamic aspects consists in that we are unable to entertain any such hopes. For it seems to us that in the discussion about the Austrian theory “The Structure of Production” and “Full Employment” have received an altogether exaggerated attention, and that those who rejected it did so mainly because of its apparently too static character. It is curious to observe how the very same people would then wholeheartedly subscribe to another doctrine which, although at heart far more static than the Austrian, succeeded in conveying a distinctly dynamic impression, with all its static characteristics carefully tucked away.
In spite of this we believe that the reluctance with which the Austrian theory has met so far is actually due less to its being too static than to the fact that the mind of our generation, impregnated with static equilibrium notions, is incapable of realising its real dynamic significance.
In what follows we shall try, first to re-state what to us appear to be the essentials of the Austrian Theory of Industrial Fluctuations, a theory about the effects of cyclical fluctuations on the inter-industrial relationships between prices, profits and real wages. At the end of this paper we shall briefly confront this theoretical construction of ours with whatever knowledge we may be able to glean from trade cycle history in order to test its relevance to different periods of cyclical fluctuations. We hope to show that the Austrian theory is essentially dynamic, and we believe that any appearance to the contrary in its first presentation was really due to the upbringing of its protagonists to whom Walrasian equilibrium conditions appeared as the natural jumping-off ground for all excursions into the real world. We believe it to be vital to a correct understanding of the Austrian theory to stress its dynamic features and, in particular, to point out that certain of its assumptions, which have caused in the past and are likely to continue to cause much misunderstanding and bewilderment, have to be interpreted as symbols of a world of change.
That the Austrian theory does not readily fit into a static equilibrium system is easily seen, albeit in a very general and simplified manner, if we bear in mind that while reversibility is the essence of the latter, the Austrian theory rests fundamentally upon the non-reversibility of the investment operation. Once “free Capital” has been converted into buildings and machinery, any failure of events to conform to expectations will upset everything.
We do not revert to our initial position, but are worse off than we would have been had we never departed from it. For all static equilibrium analysis, on the other hand, it is essential that every deviation from the equilibrium point will set in motion forces which will lead us back to this point.
If the foregoing is thought to afford some justification for a reconsideration of the case, there are two special reasons why the present moment appears particularly propitious for this endeavour. On the one hand, the recent publication of Professor Schumpeter's Business Cycles3 will no doubt rekindle interest in the dynamics of the process of capitalistic evolution, and his concept of “Innovation,” as we shall see, provides us with a most valuable tool of analysis. By its help, we shall try to explain the peculiar function of the capital-goods-industries in a world of change. On the other hand, in the new version of the Austrian theory real wages begin to fall at the moment that “Full Employment” is reached.4
This result, at first sight rather astonishing, is based on the assumption of an intercyclical increase in the productivity of Labour so that in successive cycles identical output quantities are produced by less and less Labour, and “Full Capacity” may mean considerably less than “Full Employment.” Here again the theory requires dynamic interpretation.
It goes without saying that if in what follows we endeavour to set forth what to us appear to be essentials of the Austrian theory, we are acting entirely on our own responsibility. As long as thought is free, there is no guarantee whatsoever that, because some men's ideas coincide at some moment, they will do so at the next. By the same token, “schools of thought” lead a precarious life. At best of a transitory nature, they grow and wither as the human spirit moves.
We earnestly believe that what we have to say will be unobjectionable to all who are counted among the Austrian school, but we may well be wrong. We shall try to present the doctrine in such a way as will safeguard it against most of the attacks to which so far it has been exposed, but here we may well fail. In the end the reader will have to judge for himself whether he is able to recognise in our sketch essential features of the world in which we are living.
In this and the following sections we shall state our assumptions regarding the structure of the industrial system and the relations between the various factors of production. Thereafter we shall study the cyclical process, i.e., our system in motion, and at the end of the paper make a brief attempt at verification.
In every economic system in which the division of Labour has reached a certain stage it is possible to distinguish:
For the sake of brevity we shall speak of C-, E-, and R-industries. But in a progressive economy there will exist a further group of industries, the special function of which is the provision of the means for progress. And in an economy that is liable to change there will have to be industries providing the means for change.
Our first task consists in convincing the reader that Growth is but one aspect of Innovation and that therefore the industries providing the means for both will be identical. There is little we have to add to Professor Schumpeter's brilliant analysis of the problems of industrial change. It is, of course, the fashion to-day to describe all dynamic phenomena in terms of aggregate quantities(like investment, incomes, output) and to regard Growth as an upward movement of a system of variables interpreted as the response of the system to changes in external conditions, say population. As such an attitude is only too prevalent among contemporary economists it is necessary for us to insist that there is no such thing as “natural Growth” and that a casual glance at the economic history of countries like India and China is sufficient to make us understand that industrial Growth is the outcome of conscious and sustained human effort about which “dynamic equations” tell us less than nothing. Growth then is the cumulative effect of individual efforts directed towards the improvement of the productive apparatus of society.
To deny that the results of these efforts can be adequately described in dynamic equations is, however, not the same as to ignore the effects they may have on the structure and composition of the economic system by stimulating some industries while thwarting others. On the contrary, it would be true to say that the Austrian theory is a theory about the inter-industrial effects of certain dynamic processes.
In a progressive economy it is usually possible to discern industries which are particularly sensitive to entrepreneurial efforts towards change and innovation. We might call them “dynamic key industries” and shall refer to them as K-industries. If the reader is satisfied that Growth does not just consist in aggregate quantities sliding harmoniously upwards along an imaginary “trend,” he will have made the first step towards understanding why the demand for the products of these industries is unlikely to be closely geared to that for consumers' goods.
Our next step consists in showing that “capital-intensification” or the “deepening of capital” is merely another form of Innovation. Once we have rid ourselves of the notion of capital as a homogeneous aggregate and bear in mind its essentially heterogeneous character as an agglomeration of houses, ships, machinery, etc., it is easy to see that “an increase of capital per unit of output” does not just mean the addition of another piece of machinery to an otherwise unchanged equipment park, but that as often as not it will entail a complete re-arrangement of the existing productive apparatus, including depreciation of specific factors, and possibly a change in the character of the final product. This is but another way of saying that the “deepening of capital” is a non-reversible process by which the conditions of production are definitely changed.
For our purpose what matters is that the industries which in a progressive economy provide the means for capital intensification are identical with those providing the means for changes in production in general (i.e., under modern conditions the “heavy” industries producing iron and steel). In economic history, as a matter of fact, it is often virtually impossible to distinguish between the one and the other: the evolution of the railways can be described either as the production of an entirely new service or else as capital-intensification of the pre-existing transport system. The same applies to electrification.
Furthermore, we shall assume that labour in each of the industries described above is homogeneous—which does not, however, exclude differences between average and marginal product where homogeneous labour co-operates with equipment of different quality—but that it is not mobile between industries. In other words, labour in each industry is a non-competing group.
Furthermore, we are assuming a fairly rapid intercyclical increase in the productivity of labour as a result of technical progress. Thus we shall expect to see in successive cycles physically identical output quantities produced either by a steadily diminishing labour force or in shorter working weeks or by a combination of both.
Let us now analyse our system in terms of complementarity and competitiveness. Broadly speaking, consumers' goods industries (C), equipment goods industries (E), and raw material producers (R) are complementary in the sense that, on the whole, a change in demand for C will entail a corresponding change in demand for the other two. As to our dynamic key-industries (K), they certainly compete for raw materials with C and E. But what determines the demand for K-products? Is K-output complementary to or competitive with the output of C and E? It is impossible to answer this question straight away, yet it is on this answer, as we shall see, that the issue between the Austrians and their opponents ultimately turns.
There is no prima facie reason for a belief that demand for the products of our K-industries must be closely linked to that for consumption goods. It is true that these industries are partly engaged in building up new C-industries, but just because the latter are new, their demand schedules are unknown and it is in no way possible to deduce such schedules for particular industries from any general demand function. Demand for K-products depends thus largely on expectations regarding a distant, unknown and uncertain future. We only know two factors which are most likely to have a decisive influence on it:
(1) The relationship between present costs and expected future yield. “The rate of interest relates a future income stream to a present capital outlay. With a given rate of interest, the investor's decision depends on the cost of this present outlay and the size of the expected future income stream, i.e., he has to compare a present outlay exclusively determined by the present level of costs and prices with an expected income stream which ... is unlikely to be affected by this at all. It follows that, in the case of durable investment, the average yield of which is independent of present conditions, a rise in costs will check the inducement to invest and vice versa.”5
In referring to this factor we shall speak of the Lundberg effect.6
(2) Real Wages. By the real wage paid in an industry we mean the ratio between money wage and price of the product of the industry. Real wages in different industries may hence be expected to be different. The higher the real wage in an industry the stronger is the urge to substitute labour-saving machinery and to increase the amount of capital per unit of output. Equally, where real wages are low, they will set up a tendency to diminish the amount of capital per unit of output and to turn over capital more quickly. In referring to this factor we shall speak of the Ricardo effect.7
From all this it follows that if our two factors were moving together, if real wages were to increase at the same time that investment costs rise relatively to future yields, this would tend to stabilise our system. For it would mean that while one source of demand for capital goods which is particularly sensitive to the cost-yield ratio became exhausted, another one—demand for labour-saving machinery—would help to maintain the level of investment activity. This is what, prima facie, we should expect to happen during the later stages of prosperity: While raw material prices soar and their forward quotations begin to display ominous “backwardations,” will not the point of Full Employment be approached? Unfortunately, in our economic system this is unlikely to be the case owing to the intercyclical increase of the productivity of labour. There is no reason to believe that in an economy such as ours the introduction of labour-saving machinery has to wait for Full Employment to become profitable. Moreover, inspection of British and American statistics for the 1920s and 1930s suggests considerable increases in the productivity of Labour at considerably less than Full Employment.8 In this case, unless there has been a corresponding increase in equipment, Full Capacity will be reached before Full Employment. Hence, real wages will begin to fall at exactly the moment that the boom gets under way, and the Ricardo effect will come into play. As the percentage of profit per unit of output rises, it will pay to turn over capital more quickly rather than to invest it for longer periods. Hence, the dynamic relationship between real wages and the cost-yield ratio typical of our world has a strong destabilising effect on investment. And it is rather cold comfort for us to learn that once the system has slid into the phase of recession the improvement in the cost-yield ratio as well as the rise in real wages will both come to our help and tend to arrest the downward process. By 1940 we have all learned that an “elastic” monetary system is likely to engender forces which, once our mechanism is set on its downward course, are apt to push it further and further.
The cyclical effect on employment of the intercyclical increase in the productivity of labour will, however, be modified to the extent to which an increase in equiment and output will absorb unemployed. Now, statiscal evidence goes to show that years of rapid increase in the productivity of labour are usually also years of heavy capital accumulation. Yet, for several reasons it must appear very doubtful whether such investment can actually have a compensatory effect on unemployment. In this context it is of utmost importance to realise that not all investment, but only some investment, can have such mitigating effects.
First, even where the increase in the productivity of labour is merely the outcome of capital intensification9 in the “classical” sense, i.e., an increase in capital per unit of output which leaves the existing productive apparatus unaffected, as much new capital as is necessary in order to produce the same output with less labour can have no compensatory effect on unemployment. Only investment in excess of this quantity can have such an effect.
Secondly, in most cases the increase in the productivity of labour is, of course, due to “technical progress,” with or without a change in the ratio between capital and output. In this case new investment will be necessary in order to replace the whole set of existing machinery, unless the new equipment is only gradually introduced as the old wears out. But this piecemeal procedure is unlikely to be adopted, partly for economic reason—because each entrepreneur will strive to be the first in the field—and partly for technical reasons—since a rationalisation plan is an integrated whole that cannot be carried out piecemeal. We may therefore conclude that in the case of “technical progress” only investment beyond the magnitude necessary for the replacement of the existing machinery will be capable of mitigating unemployment.
Third, if in such cases for the reasons just mentioned it is not possible to wait for the existing equipment to wear out before new equipment is installed, it follows that such innovations are bound to leave a backlog of unutilised old equipment to fall back upon—if at higher unit cost—in cases of emergency. Hence, the very fact of a change in the methoed of production will entail an increase in the capacity to produce output. Every increase in capacity capable of absorbing unemployed would again have to be in excess of this magnitude.
We thus may conclude that from whatever point of view we are looking at our problem, the chances of an early mitigation of technological unemployment must appear to be slender.
Having hitherto studied the elements of our system and the relationships between them, we are now ready to tackle our main task. The stage is set for “The Trade Cycle” to be performed.
Let us assume that in a situation, which cyclically is one of Depression with Unemployment, idle equipment and surplus stock, an entrepreneur decides to carry out some “Innovation.” This is as likely as not to happen in depressions. On the cost side low money wages and costs of building materials will be favourable factors, and on the receipts side we know that the man who plans far ahead cannot take account of cyclical situations, but has to calculate some long run average yield. Whether his innovation be a new consumption good (for which no present demand schedule exists)or an improved method of producing an already existing good (where he is as likely as not to revolutionise the whole market), economic activity devoted to innovation is apt to be but loosely linked to present consumers' demand.
Such entrepreneurial decisions involve increased investment activity, more employment in K-industries and more demand for C-goods. The next step is that C-industries, which probably so far were unwilling or financially unable to replace their equipment as replacements fell due, will make up for arrears. The delayed replacements will have the same effects on E as an increase in investment; larger orders for E-firms, more employment in E and, hence, increased demand for C-goods. Thus a cumulative process of expansion, once the impact effect has come from K, will begin to work between C and E in a shuttle-like fashion.
It is of some interest to note the relative effects which the upward process is likely to have on E and K. At a first glance it would seem that to the extent to which firms in C are replacing obsolete equipment by other which is more “capital intensive,” demand will be deflected from E to K. But, first, even where this is the case, it will not interfere with the working of our process, since any increase in activity in either E or K is investment activity in the sense that it sets the “Multiplier” rolling. In the second place, it is quite unnecessary to assume that K and E are competitive to such a degree that any increase in demand for one spells a fall in demand for the other. The introduction of labour-saving machinery will, of course, give rise to a demand for steel products which otherwise would not have come forward, partly because this is what “an increase in capital per unit of output” means and partly because it is hardly possible that a programme of capital intensification could be realised as gradually as equipment becomes obsolete by age. (In practice, as we pointed out above, every change in methods of production leaves a backlog of unutilised old equipment which, although at peak levels of business one may have to fall back on it, suffers intermittent loss of its capital character.) We must always bear in mind that demand for machinery is produced by capital intensification and that, where firms in C change methods of production, this may, of course, raise awkward problems of adjustment in E; but, on the whole, it means demand for a different type of equipment and not no demand for equipment. In other words, where ordinary replacement means demand for E-products, capital intensification means demand for E-and K-products. This holds true whether the initial impact on our system came from a programme of capital intensification, or whether, the primumagens being some other type of innovation, capital intensification is “induced” and takes place by way of replacing obsolete equipment in C. As long as there are ample surplus resources all over the system K and E need not be competitive and may even become complementary.
As the process of expansion gets under way, with employment, incomes and consumption all rising pari passu, a stage is gradually approached where our K-industries will become competitive with C and E. To indicate this point in that general and abstract manner which is all of which economic theory—at least at our present level of abstraction—is capable, suffice it to say that some resources which enter the output of more than one industrial group must have become scarce.
Why this should have to be a point of “Full Employment” it is difficult to see, unless one either assumes a short-run variability of the coefficients of production which is little short of miraculous or can show reasons why, if this point is reached, labour should be scarcer than equipment. If, however, our account of the intercyclical increase in the productivity of labour is accepted, it will be the other way round: full capacity of (new) equipment will be attained while there is still unemployed labour. It does not, however, follow from our assumptions that, this point being reached, it is physically impossible to increase the output of consumption goods. This, of course, will always be possible, if we fall back on antiquated equipment. If, as we pointed out above, the new machinery has not been installed gradually by replacing old equipment, but at one stroke, such a reserve park of obsolete machinery for intermittent use at peak levels of production must exist. What matters to us is that as this less efficent equipment is taken into use again, the marginal product of labour will fall below its average product. Prices will rise and so will profits, while real wages will fall.
We know that a diminution of the stocks of industrial raw materials is a characteristic feature of the upswing.10 As soon as this phenomenon makes itself felt and raw material prices begin to rise, our K-industries will come under fire from two sides. The combined Lundberg- and Ricardo effects will now come into play. For, while in C and E, with the strong pressure of demand for consumption goods, the higher cost of raw materials is easily borne, for K this is by no means so.
We know that for the people on whose demand activity in K mainly depends the higher cost of investment is not offset by a higher price of the product they are selling, as this product mostly belongs to the future. Thus, as the boom is getting under way with prices soaring, there is a weakening of the stimulus to genuine innovation, as distinct from speculation—which by adopting the outer trappings of innovation has only too often snared economic historians and financial journalists alike.
The Ricardo effect, on the other hand, accounts for the simultaneous decline in capital intensification and the increase in all kinds of speculative activity. Little though we know about the cyclical behaviour of stocks of consumers' goods, it seems fairly obvious that if the rate of profit is high, business men will try to turn over their capital as often as they can in the profitable present. They will neglect long-term investment—which means forgoing present profit opportunities for the sake of an uncertain future—and devote themselves to profitable short-run operations instead. In an economy without a capital market, where every firm would entirely depend on its own resources without being able either to borrow or to lend, business men would now tend to devote their savings and the amortization quotas of their fixed capital to reinforcing their circulating capital. In an economy with a fully developed capital market demand for the financing of speculative holdings of commodities and securities will now come to compete with the demand for the finance of innovation and capital intensification. Given the high profitability of the former with rising prices and the declining profitability of the latter because of the Lundberg effect, there can be little doubt what the outcome will be and what type of demand will become extramarginal.
We have thus far endeavoured to present the bare outlines of what to us appears as the main contents of the Austrian Theory of Industrial Fluctuations, up to the preceding paragraph at least, “in real terms.” But as we have already had to bring in the capital market in order to explain the working of the Ricardo effect in an exchange economy, we may just as well go one step further and examine, from the level of insight thus far gained, the cyclical consequences of a “Cheap Money policy.”
It appears that, whatever the merits of such a policy in depression or during the early stages of revival, there is one aim it cannot achieve: to maintain the level of investment activity under boom conditions. It may seem that by such a policy we are able to facilitate the financing of long-term investment. But, under conditions of scarcity of resources and with rising profits, by holding out the prospect of higher prices we shall add to the bargaining strength of those who seek finance for short-term operations, and who compete with long-term investors for raw materials. The bargaining position of prospective long-term investors would thus not really improve. Moreover, unless such a policy is also capable of affecting expectations of future yields—for this the elasticity of expectations would have to be unity or more—it cannot but have a detrimental effect on the cost-yield calculations of those entrepreneurs on whom, as we saw, activity in K largely depends. While, as soon as marginal costs in C begin to rise, such a policy is bound to encourage the piling up of stocks of consumable goods—the intertemporal transfer of goods from points of lower to points of higher marginal cost—and other speculative operations of a similar kind at the expense of investment in equipment. Thus real wages will be depressed even further. Nor may we pin our hopes on E to offset the decline of activity in K. Even if marginal costs in E should rise less steeply than in C, E will hardly be able to rescue us from our dilemma. This industry is devoted to the replacement of outworn equipment, and, to a certain extent, to the “linear” extension of existing equipment in C. Hence, all production in E is “gross investment.” But, precisely for this reason, every order C gives to E involves the tying up of capital which, under boom conditions, can be employed far more profitably in uses which will yield a quick return. We may thus conclude that, where there are scarce resources, no monetary device will overcome the consequences of the simple fact that the economy as a whole cannot have its cake and eat it.
Before concluding this section we may add a few remarks about the consequences to which our theory leads as to wages and wage policies. This would seem all the more propitious, since it is exactly in this connection that the oddest of misunderstandings arose. By some of its less charitable critics the theory has almost been decried as a “gospel of low wages.”
Now, the first point to be noted in this connection is that the theory, not being of the “macrodynamic” variety, can say nothing about such abstract aggregates as “The Wage Level.” It is obvious, indeed, that a doctrine which derives its significance from the fact that different elements of the economic system are competitive rather than complementary, will have to rely on differential wage movements in the different parts of the system.
In C and its ancillary industries changes in the wage unit will, as long as the higher (or lower) wage incomes are wholly spent (or economised) on consumers' goods, not affect the rate of profit, which depends on the ratio of marginal to average cost. Wages in K, since their present and expected future level affects the cost-yield-calculations of our “innovators,” are of cyclical importance and have much the same effects as changes in raw material prices. To this extent it is correct to say that relative money wage levels in K and C determine the inducement to invest. But it is not true to say that the Austrian theory, in order to bring about adjustment after the crisis, advocates a general reduction of wages. On the contrary, it is to a rise of real wages in C that we have to pin our main hope. For, as consumers' demand declines, real wages will, for the reasons known, rise, unless money wages in C are extremely flexible. And if this rise goes far enough, we may hope it will give a stimulus to renewed capital intensification. On the other hand, a fall in money wage rates in K will, like a fall in raw material prices, reduce the cost of investment and thus improve the cost-yield basis of long-term investment. Thus the Austrian theory does, partly, rely on a stimulus to investment engendered by a fall in wages in cost sensitive industries (K). But a reduction of money wages in C would only render the situation more difficult, as what matters here is the fall in prices relative to wages. If money wages in C fall, prices will have to fall all the more before we can hope for recovery.
We now have to confront our last task in this paper. We shall make a brief attempt to test our theoretical model in the light of historical facts. Needless to say, within the space at our disposal it would be quite impossible to run the whole course of trade cycle history in order to find out whether the Austrian theory “fits the facts.” All we can do here is to venture a few very general, and necessarily vague, remarks on the verifiability of our theory. Our conclusions will be seen to contain nothing startling and will possibly disappoint readers who cling to a belief in the infallibility of time series.
It seems to us that, broadly speaking, the Austrain theory when confronted with evidence gathered from nineteenth-century fluctuations, comes out very well indeed. We now have Professor Schumpeter's excellent testimony as to the course of American events in the twenties and thirties of last century,11 and we see no difficulty in interpreting most of the business fluctuations which accompanied the construction of railroads on both sides of the Atlantic terms of our model. If we learn that the inability of railway share subscribers to pay the full amount of their installments was one of the outstanding features of the British crisis of 1847,12 what else does it mean but that railway promoters had grossly overrated consumers' willingness and ability to save and that, in real terms, more resources had been devoted to long-term investment than consumers' preferences would warrant? If, as Professor Schumpeter points out,13 American railroad promoters, confronted with the same dilemma, were “in every major instance” only rescued by the timely arrival of European—mostly English—capital, what else can we infer but that the mobile resources of the American economy—raw materials and consumption goods—were insufficient to carry the burden of as large an investment activity as the railroad plans involved, and that a large rise in imports from Europe was needed in order to bridge the gap? Moreover, whatever price and commodity stock data we have for the period seem to indicate that, in every major instance of a breakdown, scarcity of resources (industrial raw materials) did actually exist.14
But we must admit that as an explanation of the crisis of 1929 and of the developments leading up to it our model does not fare so well. To all our knowledge there is no evidence to suggest that the economic evolution of the 1920's was stopped short by scarcity of resources. We shall not dwell upon the continued existence, in Britain and the United States, of unemployment throughout this period, for, as was shown above, where industrial productivity increases rapidly, unemployment is not inconsistent with a strain on resources (the combination of labour with equipment under conditions of non-optimum cost). More important as a symptom of the absence of any such strain is, of course, the stationary behaviour of consumption goods prices between 1924 and 1929. But what we should regard as most significant in this connection, since it stands in open contradiction to all our other experience, is the increase in raw material stocks after 1925.15
It is thus not easy to account for the crisis of 1929 by the help of the Austrian theory. We may infer that the economic conditions of the 1920s must have been very different from those on which our model is based. It is hardly possible for us, in this context, to go beyond the stage of tentative suggestion. All we can do is to hint at two facts which appear to us to be germane to the issue.
First, the evolution of the automobile has changed the economic function of the “heavy” metal industries. In the ages of railroad construction and electrification the cyclical position of these industries corresponded, more or less, to that of our K-industries. Demand for their products was not geared to that for consumers' goods, and a sufficient degree of competitiveness existed within the system. The evolution of the automobile, the demand for which is so large y dependent on consumers' incomes,16 has changed this. Thanks to it, the iron and steel industries have to-day adopted the character of E-industries in the sense of our model.
Second, where much of the investment activity of the upswing is directed towards increasing the production and productivity of raw materials, there need be no scarcity of them. There can be little doubt that between 1920 and 1930 the production of most industrial raw materials underwent revolutionary innovations,17 mostly of the capital intensification kind (e.g. tin dredging and the selective flotation process for copper and zinc) and that the rise in raw material stocks was largely consequent upon these changes in productive technique. An industrial society which increases the output of industrial raw materials and lays in a handsome stock of them before setting itself to the task of making available more and better consumption goods is acting as prudently as an agricultural community which will not release half of its labour force for the construction of a bridge before a stock of grain which is sufficient to maintain them during their absence from primary production has been piled up.
We are inclined to think that such a society would, indeed, be relatively immune against the type of crisis that has been sketched out in this paper. Yet, as we had to learn to our grief, not even such prudence will protect us from other calamities of a dynamic world. The extreme complexity of such a world in which almost any constellation of circumstances is capable, without notice, of giving rise to destructive forces, defies all facile generalisations. What chances of success under the circumstances all attempts at “social planning” that are based on such facile generalisations are likely to have is one of the melancholy reflections which, by 1940, the student of economics cannot eschew.
[]In the realm of statics the theory of marginal productivity is, of course, a set of variations on this theme. In dynamics, on the other hand, most of Professor Hayek's work implies complementarity of different capital resources. What constituted the novelty was the explicit introduction of complementarity into dynamics.
[]“Professor Hicks' Statics,” Quarterly Journal of Economics 54 (February 1940):277–97.
[]Oscar Lange, “Complementarity and Interrelations of Shifts in Demand,” Review of Economic Studies 8 (October 1940): 58–63.
[]Price Flexibility and Employment, 1944, p. 9n.
[]R. F. Harrod, “Review of Oscar Lange's Price Flexibility and Employment,” Economic Journal 56 (March 1946): 102–7.
[]Value and Capital, p. 98. Cf. also J. R. Hicks, Théorie mathématique de la valeur (Paris: Hermann & Lie, 1937), p. 49.
[]“The Interrelations of Shifts in Demand,” Review of Economic Studies 12 (1944):73.
[]The factor in question may have to be taken out of another plan, or may be temporarily unemployed, or may be newly created for the purpose.
[]Walras's “coefficients de fabrication.” Cf. his Éléments d'économie politique pure, éd. défin., 1926, pp. 211–12.
[]The term is due to Dr. G. L. Shackle. Cf. F. A. Hayek, Pure Theory of Capital (London: Routledge & Kegan Paul, 1941), p. 251n.
[]The revision of plans is the function of the entrepreneur, the carrying out of existing plans is the function of the manager.
[]Some economic and financial aspects of capital regrouping are discussed in “Finance Capitalism?” Economica 11 (May 1944):64–73.
[]Professor Hayek's work is, of course, the outstanding exception.
[]For example: “The prices of existing [author's italics] assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new [author's italics] assets through their reaction on the marginal efficiency of capital.” J. M. Keynes, General Theory of Employment, Interest, and Money (New York: Harcourt, Brace & World, 1936), p. 142.
[]Böhm-Bawerk's “third ground,” the higher productivity of roundabout processes, lends itself easily to interpretation in terms of complementarity over time.
[]The Pure Theory of Capital, p. 286.
[]J. R. Hicks, “Mr. Keynes' Theory of Employment,” Economic Journal 46 (June 1936):249.
[]“Investment That Raises the Demand for Capital,” Review of Economic Statistics 19. (November 1937): 174–77. (Now reprinted in F. A. Hayek, Profits, Interest, and Investment [London: G. Routledge & Sons, 1939], pp. 73–82.)
[]It is not necessary to assume that the film industry is the only expanding industry. But we have accepted the empirical generalization that at each moment current accumulation is likely to show itself prominently in a few expanding industries. What we wish to rule out, and would regard as highly unrealistic, is an increase of capital in all industries in the same proportions.
[]We assume that total demand increases pari passu with total supply. It is, of course, possible to deduce the depressing effect of accumulation merely from the postulate that total demand falls short of total supply, as “the marginal propensity to consume is always less than one.” But there is no reason to believe that this is necessarily so. Cf. A. F. Burns, Economic Research and the Keynesian Thinking of Our Times (26th Annual Report of the Nat Bureau of Economic Research, June, 1946, pp. 18–19).
[]That total demand increases pari passu with total supply does not entail that this will be so in every market.
[]In this respect, the discovery of the fact that “sympathetic shifts,” i.e., dynamic demand changes, are liable to throw our whole system into indeterminacy, should have served us as a warning.
[]Joan Robinson, The Accumulation of Capital (London:Macmillan & Co., 1956).
[]The whole Keynesian edifice rests on the possibility that capital can be measured; Keynesian investment is net investment, Keynesian income is net income.
[]On the numerous ambiguities surrounding the meaning of productive capacity, see now G. Warren Nutter, “On Measuring Economic Growth,” Journal of Political Economy 65 (February 1957):51–63.
[]The effect of changes in the rate of interest has therefore to be treated as negligible, see p.144 n2.
[]Against what we have said it is no defense to claim that every author must be free to choose his own level of abstraction. Quite so, but once he has chosen it he must adhere to it. It is quite legitimate to abstract from any class of facts, but it is illegitimate, once such a class has been admitted into the model, to make an arbitrary selection between the members of the class.
[]John Hicks, Capital and Growth (Oxford: Clarendon Press, 1965).
[]See, e.g., F. H. Hahn and R. C. O. Matthews, “The Theory of Economic Growth: A Survey,” Economic Journal 74 (December 1964): 799–902.
[]“We were such ‘good Europeans’ in London that it was Cambridge that seemed ‘foreign.’” Hicks, The Theory of Wages, 2d ed. (London: Macmillan & Co., 1963), p. 306.
[]It is true that in the autobiographical sketch added to the 2d edition of Theory of Wages (1963) he says that in 1936 “I was (I think I may say) an almost whole-hearted Keynesian.” (310)
[]Cf. L. M. Lachmann, Capital and Its Structure (London: London School of Economics and Political Science, 1956), p. 64.
[]Joan Robinson, “The Production Function and the Theory of Capital,” Review of Economic Studies 21(1953–4): 81–106.
[]“L'individu peut disparaitre pourvu qu'il nous laisse cette photographie de ses goῦts.” V. Pareto, Manuel d'Economie Politique, 2d ed. (Paris, 1927), p.170.
[]John Hicks, Capital and Time: A Neo-Austrian Theory (Oxford: Clarendon Press, 1973).
[]G. L. S. Shackle, Epistemics and Economics: A Critique of Economic Doctrines (Cambridge: Cambridge University Press, 1973).
[]“This is the more noteworthy because Menger, far from welcoming that theory as a development of suggestions of his, severely condemned it from the first. In his somewhat grandiloquent style he told me once: ‘The time will come when people will realize that Böhm-Bawerk's theory is one of the greatest errors ever committed.’ He deleted those hints in his second edition.” J. A. Schumpeter, History of Economic Analysis (Oxford: Oxford University Press, 1954), p.847, note 8.
[]E. Lindahl, Studies in the Theory of Money and Capital (London: Allen & Unwin, 1939).
[]E. Lundberg, Studies in the Theory of Economic Expansion (London: P. S. King, 1937).
[]F. A. von Hayek, Profits, Interest, and Investment (London: G. Routledge & Sons, 1939), pp. 135–56.
[]See F. A. Lutz and D. C. Hague, eds., The Theory of Capital (London: Macmillan & Co., 1961), pp. 305–6.
[]“Böhm's analysis was much too one-dimensional for Menger, in whose own vision everything immediately ramified in some five to ten dimensions. Menger would describe the accumulation of capital as an increase in the range of capital goods and an ever-increasing complexity of the web of complementarities, while Böhm unified capital by the concept of the period of production.” Erich Streissler, “To What Extent Was the Austrian School Marginalist?” History of Political Economy 4 (Fall 1972): 435.
[]“Sir John Hicks on Capital and Growth,” South African Journal of Economics 34 (June 1966): 121–23.
[]J. R. Hicks, Value and Capital (Oxford: Clarendon Press, 1939), p. 128.
[]J. R. Hicks, Capital and Growth (Oxford: Oxford University Press, 1965), p. 54.
[]The present paper contains results of an investigation into problems of secondary depressions which the author undertook as Leon Fellow of the University of London during 1939–40.
[]F. A. von Hayek, Profits, Interest, and Investment (London: G. Routledge & Sons, 1939).
[]J. A. Schumpeter, Business Cycles, 2 vols. (New York: McGrawHill, 1939).
[]F. A. von Hayek: Profits, Interest, and Investment, p. 11. The description of the point at which scarcities begin to make themselves felt as one of “Full Employment” seems to us most unfortunate. As will be seen presently, what is meant is Full Capacity (of first-line equipment) rather than Full Employment of Labor. Its theoretical significance consists in that it is the point at which cost curves begin to slope upward.
[]L. M. Lachmann, “Investment and Costs of Production,” American Economic Review 28 (September 1938):475.
[]Erik Lundberg, Studies in the Theory of Economic Expansion (Stockholm Economic Series, 1937), p. 230. Dr. Lundberg, it is true, relates receipts to the rate of interest only. But, as the present author has shown (i.e., p. 475), it is easy to extend the theorem so as to cover costs other than interest.
[]F. A. von Hayek, Profits, Interest, and Investment, pp. 8–10.
[]For Great Britian: G. L. Schwartz and E. C. Rhodes, Output, Employment, and Wages in the United Kingdom, 1924, 1930, 1935 (London and Cambridge Economic Service, Special Memorandum No. 47). See in particular the Introduction by Professor A. L. Bowley. For the United States: D. Weintraub: Technological Trends and National Policy (National Resources Committee, Washington, 1937).
[]The reader will notice that we distinguish between the cyclical and intercyclical aspects of capital intensification. To the former belong its effect on investment, employment, and incomes in K, to the latter its effect on employment in C. In Dr. Hawtrey's terminology, while the effects of capital being deepened are confined to the Cycle (“The Short Period”) those of capital having been deepened extend over a longer period of time. It is only with the latter that we are here concerned.
[]L. M. Lachmann and F. Snapper, “Commodity Stocks in the Trade Cycle,” Economica 5 (November 1938):445–6.
[]J. A. Schumpeter, Business Cycles, 2 vols. (New York: McGrawHill, 1939) 1:296n.
[]E. V. Morgan, “Railway Investment, Bank of England Policy, and Interest Rates, 1844–48,” Economic History 4 (February 1940):331–34.
[]J. A. Schumpeter, op. cit., p. 335.
[]Lachmann and Snapper, “Commodity Stocks in the Trade Cycle,” p. 436, table I.
[]Lachmann and Snapper, op. cit., p. 437, table II.
[]S. I. Horner, et al., The Dynamics of Automobile Demand (New York: General Motors Corporation, 1939).
[]Melvin T. Copeland, A Raw Commodity Revolution. Harvard Business Research Studies, No. 19.