Category: Economics

Teaching & Learning History of Economic Thought (HET): Some Observations

The following is a short reflection and response to the lectures, questions, and conversations at the recently concluded 3-day HET workshop at MIDS, Chennai. In personal conversations, many people thought that HET is about economic ideas that originated in a particular context. 

That is, Smith’s economics is a response to his sociopolitical context. And therefore, the implication is that Smith’s political economy be placed in a museum—an archaeological site that we visit occasionally. Another implication to this appears to be that HET is not relevant to contemporary thought because our context is different from that of Smith’s. 

Such an approach to HET, to me, makes it a rather dead subject. Consequently, in the economics curriculum, it serves other core papers such as micro and macro by providing it with context/history and thereby improving student learning/understanding. Yes, this is important, but it makes HET an instrumental subject. However, that, per se, is not an issue because all knowledge in one way or the other are instrumental. 

I see 3 problems with such a view. 

One, it is a reductionist approach because it reduces ideas to the context, be it intellectual (i.e., texts, speeches) or sociopolitical (i.e., laws, wars, conflict). How do we then account for human ingenuity and creativity? Also, how do we understand classics—that have a timeless quality? Or, are we saying that there is nothing in economics that may be applicable across time and space? [On the question of applicability of economic theory, see the discussion in Chapter 6 of my macro book.] 

The second problem is that such a reductionist view of HET inevitably succumbs to the linear view of intellectual progress. Wherein the ideas of Solow are better than Smith objectively speaking and that the ideas of Solow are more relevant to us because, in terms of calendar time, Solow’s work is closer to us than Smith’s. 

The third problem is that we are okay about marginalized ideas remaining forgotten. Studying ideas—texts written by women (and folks whose texts were not popular)—remain invaluable for contemporary thought and action. This perhaps depends on how comfortable we are about ignoring the ideas of our ancestors. (I am currently reading The Penguin Book of Feminist Writing edited by Hannah Dawson; the first text belongs to 1405 and the last one to 2020.)

HET: Understanding Economics

HET allows us to organize past ideas in a meaningful manner. The simplest organizer is that of calendar time. But ideas are forgotten, revived, exhumed, bolstered, expelled, popularized for a variety of reasons and so a simple chronological account cannot provide a sufficient historical account of economic ideas. 

We need to have other ways of organizing so that we understand not only the past better but also the present. Another organizing principle among historians of economic thought is that of ‘school of thought’ or ‘paradigms’. For instance, HET books discuss ‘classical’ and ‘neoclassical’ general equilibrium (Harvey & Gram 1980); ‘neoclassical’, ‘Keynesian’ and ‘Marxian’ (Wolff & Resnick 2012); ‘classical political economy’ and ‘supply and demand theories’ (Bharadwaj 1986). 

Many historians of economic thought, including me, reject the ‘neoclassical’ label. This is because it suggests that there is continuity between ‘classical’ (associated with economists such as Quesnay, Smith, Ricardo) and ‘neoclassical’ (associated with economists such as Say, Walras, Marshall). The analytically satisfactory label is ‘marginalist’—because of their reliance on concepts such as marginal utility, marginal cost, etc. 

HET tells us that competing ideas have always existed; we often only learn about those that have been popular/dominant. For instance, Ricardo disagreed with Say that exchange value is determined by use value. And today’s microeconomics textbooks teach us that commodity prices are determined by cardinal/ordinal utilities. When Keynes and Sraffa were writing, the economic ideas of Marshall were dominant and those of Smith and Ricardo were forgotten. HET allows us to understand that the evolution of ideas has been anything but linear. 

And today as well, research happens in all schools of thought—contrary to what is implied in mainstream textbooks on micro, macro, econometrics, labour. 

The study of HET

We study the world by dividing it into different parts; for instance, the physical and social worlds. Or the natural sciences and human sciences. Or physics and economics. Economics may be further sub-divided into micro and macro. Or labour and ecological economics. 

Within HET, scholars sometimes distinguish between ‘history of economic analysis’ and ‘history of economic thought’ where the former is a subset of the latter. We can find economic thought in Arthashastra but there is no evidence of any theorizing/analysis. 

Another division in HET is that between the internalists and externalists although I think that most of us operate somewhere in that spectrum. The internalists study economic ideas by focusing on previous economic ideas and on the logical framework of that ideas. For example, when studying Ricardo, we read his texts and the texts he was influenced by such as Smith’s Wealth of Nations. My 2021 article ‘On “effectual demand” and the “extent of the market” in Adam Smith and David Ricardo’ is an example of this. When an externalist studies Ricardo, they include his social and political context and interpret his ideas as responses to them. A good example of this is Timothy Davis’s Ricardo’s Macroeconomics: Money, Trade Cycles, and Growth (2005). A good biography warrants a synthesis of the externalist and internalist approaches. 

Summing-up

HET allows us to understand the ebb and flow in dominant paradigms. It makes us aware that history is replete with debates across as well as within paradigms. Indeed, debates spur knowledge production. While most economics textbooks suggest consensus, economics journals (both orthodox and heterodox) suggest dissensus. There are conceptual debates, refinements, revivals and contextual critiques, challenges, applications. Furthermore, adopting an HET perspective in the teaching of microeconomics and econometrics will provide the learner with a critical grounding in history, politics and philosophy. 

I thank Thair Ahmed for helpful comments.

On the Capital/Output Ratio

A post on the capital output ratio was perhaps inevitable given my teaching and research engagements with macroeconomics, growth theory, and capital theory. This blog post seeks to critically discuss some of the manifestations of the capital-output ratio (K/Y ratio henceforth) in economics. 

K/Y ratio in Macroeconomics

The K/Y ratio captures a technological characteristic of the economy as a whole. It conveys to us the amount of capital required to produce one unit of output. A reduction in it therefore implies we require less capital to produce one unit of output. 

Since capital refers to the stock of produced means of production, which are of a heterogenous nature, K for the economy as a whole requires aggregation via prices: k1p1+k2p2+…+knpn=K. That is, K refers to, as H. G. Jones puts it (p. 17) in his 1975 book An Introduction to Modern Theories of Growth, “an index of aggregate capital.” Of course, Y too requires aggregation via prices.

Roy Harrod, in the chapter ‘Capital Output Ratio’ in Economic Dynamics (1973) treats K/Y ratio as a “kindred concept of the capital-labour ratio” (p. 46). Subsequently, he outlines the scope of the capital-labour ratio in economic studies. 

“It is to be stressed that the capital-labour ratio is a useful weapon for comparing alternative methods of producing a given object, for comparing methods of producing different objects or for comparing the changes through time of methods of producing a given object. It is on the whole an unserviceable tool in relation to national income as a whole, but it can be employed in a very rough sort of way for comparing different countries” (p. 48, emphasis added). 

Similarly, Harrod writes that “the concept of the capital labour ratio is not very helpful, if applied to the economy as a whole, owing to the difficulty of assessing the value of K, namely capital as a whole” (p. 50). 

Additionally, I think that such an aggregate conceptualization conceals more than it reveals. For instance, it conceals the nature of interdependence of production in an economy. What if K/Y changes because of a change in the nature of structural interdependence? Or, what if it changes because of a change in the volume and composition of aggregate consumption demand? After all, the volume of investment influenced by consumption. As Keynes rightly writes in Chapter 8 of The General Theory, “capital is not a self-subsistent entity existing apart from consumption”. 

K/Y ratio in Growth Theories

The K/Y ratio is used as an argument in Kaldor’s (1957) stylized facts: ‘steady capital-output ratios over long periods’. Here too, what is it saying about the structural nature of production and consumption in the economy? 

While Kaldor is talking about ex-post K/Y ratios, the ex-ante K/Y ratio plays a crucial role in Harrod’s growth equation g=s/v. Here, s refers to the marginal propensity to save and v refers to the desired or normal K/Y ratio. A decrease in v raises g, or more accurately, the ‘warranted rate of growth’. 

In the super abstract setup of the corn model (as in Ricardo) or the single-commodity model (as in Solow), since the input and the output are the same commodity, aggregate K is a homogenous set. This assumption allows us to sidestep the problems associated with the measurement and aggregation of ex-ante K. 

One cannot help but wonder how Solow’s single-commodity growth model (expressed via the aggregate production function) continues to be applied in growth accounting exercises on actual multi-commodity economies. We had noted some of the theoretical and empirical problems with one such exercise on the Indian economy in a short note in Economic & Political Weekly.  

K/Y ratio and Capital Theories

Capital theories are concerned with the conceptualization, measurement, valuation, determination, and aggregation of capital. Owing to the central role capital plays in production, the choice of the capital theory has a significant impact on both microeconomics and macroeconomics. Moreover, since capital accumulation is central to growth theory, the choice of the capital theory has a significant impact on development theories too. Similarly, on international trade theories; on this subject, you can consult the 1979 book Fundamental Issues in Trade Theory edited by Ian Steedman. 

In sum, while mathematization of the growth models gives us a better sense of its grammar, capital theory helps us understand its epistemology. And it is the latter which can better guide the use of K/Y ratio in economic theories, empirics, and policies.  

Revisiting J. H. Clapham’s ‘Empty Economic Boxes’

This blog post revisits the economic historian J. H. Clapham’s1922 classic paper ‘Of Empty Economic Boxes‘ published in The Economic Journal, and raises some critical questions about the continued use of constant returns to scale (CRS hereafter) assumption in marginalist (or neoclassical) microeconomics and macroeconomics. In 1926, Piero Sraffa took Clapham’s 1922 paper as a starting point to mount a more devastating logical critique of Marshallian notions of increasing returns and the representative firm; this was published as part of a symposium in the Economic Journal.

What is returns to scale’ According to marginalist economics, the technique of producing a commodity may be represented by a functional relationship between inputs (say, k’and l) and output (say, y): y’= f(k,l). If all the inputs are multiplied by a positive scalar m, and the resultant output is expressed as mr’y, then r’represents the magnitude of the returns to scale. If r = 1, the technique exhibits CRS, if r < 1, it exhibits diminishing returns to scale (DRS), and if r’> 1, it exhibits increasing returns to scale (IRS).

Despite the ‘advances’ in mainstream economics research, the marginalist theory of value and distribution still requires the CRS assumption (and the diminishing returns to a factor assumption) to make several key claims. The aggregate production function employed in the Solow growth model is assumed to exhibit CRS. And the Solow growth model forms the core of supply-sidegrowth accounting exercises which are used to make policy prescriptions (for a critique of one such exercise for the Indian economy, see Joshi & Thomas 2013).

The central argument in Clapham’s article is that the categories of diminishing returns, constant returns, and increasing returns industries are ’empty economic boxes’. In other words, from the standpoint of actual economies, these categories lack empirical and historical content. Consequently, industries cannot be classified into one or the other box a priori.

Clapham asks: what does AC Pigou (in his Economics of Welfare) mean when he writes ‘when conditions of diminishing returns prevail’ (p. 305)’ According to Clapham ‘constant returns…must always remain a mathematical point, their box an empty one’ (p. 310). He acknowledges that different kinds of returns have a ‘logical’ and ‘pedagogic value’ which ‘goes so prettily into graphs and equations’ (p. 312). How can we then use this framework to draw policy conclusions given the inability to classify industries a priori into constant, diminishing, and increasing returns’

The following observation by Clapham is insightful and worth thinking about further. He writes that diminishing returns must be balanced with increasing returns to arrive at constant returns (p. 309). Surely, this makes no conceptual sense and neither does it have any basis in empirical reality. As Clapham puts it, with CRS ‘the conception of the balance of forces, man’s organization versusNature’s reluctance, was worked out’ (p. 309). In other words, is CRS an expression of the balancing of the symmetrical forces of IRS (‘man’s organization’) and DRS (‘Nature’s reluctance’)’ For a visual representation, see the images below. If so, it would add to the symmetrical concepts found in the marginalist toolbox, most notably that of supply and demand. However, beyond the ease of exposition symmetry provides us, is it really how the actual world works’

Source: meritnation.com

CRS, DRS, and IRS posit an a priori functional relationship between labour (L) and capital (K), the ‘factors of production’ and output (Y) for an individual firm and for an economy: Y=f(L,K). While the idea underlying the production function, whether industry-level or aggregate-level, that outputs are produced by inputs is commonsensical and intuitive, its expression as a mathematical function isn’t as benign. Since marginalist economics requires continuous functions (often, of a monotonic nature) to ensure the existence of equilibrium, the ‘f’ is able to map infinitesimal combinations of Land Kto a unique Y. This ‘one-way street’, to use Sraffa’s phrase in his 1960 classic Production of Commodities by Means of Commodities(see my blog post Sraffa), between ‘factors of production’ and output is conceptually unsatisfactory because it misses a fundamental aspect about modern economies: the structural interdependence between inputs and outputs. In addition, it assumes that capital goods (K) are infinitely divisible, a very difficult assumption to uphold.

John Eatwell (2008; first published in 1987), in his entry on ‘returns to scale’ published in The New Palgrave Dictionary of Economics, also notes the apparent symmetry between IRS and DRS but points out its spuriousness. While there is no evidence of functional relationships in Adam Smith and David Ricardo, Smith’s discussion of division of labour, capital accumulation, and economic growth indicates that he recognised scale-enabled technological progress and Ricardo recognised diminishing returns to land, a non-reproducible input in production. Subsequently, Alfred Marshall, in his Principles of Economics, ‘attempted to formulate a unified, symmetric, analysis of returns to scale which would provide the rationale for the construction of the supply curve of a competitive industry, derived in turn from the equilibria of the firms within the industry’ (Eatwell 2008, p. 140). This point was initially noted by Sraffa 1926, and later much more thoroughly investigated also by Krishna Bharadwaj (1978).

It is well understood that the question of returns to scale is important in the construction of the supply curves which are integral for the marginalist price theory. Therefore, a thorough critical study of mainstream price theory and a renewal in the interest in rival price theories (found in Ricardo, Marx, Sraffa, and Kalecki, among others) are warranted. This is crucial because it is value or price theory which provides us with the economic possibilities a competitive economy generates. If it generates unemployment and worsens inequality, we know that intervention of a particular kind is necessary. However, if it generates full employment and reduces inequality, then it supports the idea of making markets more competitive and reducing government intervention.

REFERENCES

Clapham, J. H. (1922), “Of Empty Economic Boxes.”‘The Economic Journal,’vol. 32, no. 127, pp. 305-14.

Eatwell, John (2008), ‘Returns to Scale’. In: Durlauf S.N., Blume L.E. (eds.) The New Palgrave Dictionary of Economics. London: Palgrave Macmillan.

Sraffa, Piero (1926), “The Laws of Returns under Competitive Conditions.”‘The Economic Journal,’vol. 36, no. 144, pp. 535-50.

Acknowledgement

I thank Mohib Ali for his helpful comments.

 

Frank Ramsey and the Rate of Interest

I first came across Frank Ramsey in the preface to Piero Sraffa’s classic Production of Commodities by the Means of Commodities: Prelude to a Critique of Economic Theory (1960). My recent interest in Ramsey is primarily motivated by the following news. Cheryl Misak, a philosopher based at the University of Toronto has recently completed a biography of Ramsey. This blog post provides an introduction to Ramsey’s life and his contribution to the growth theory literature. [It was reassuring to notice that I first blogged about History of Economic Thought (HET) explicitly more than 10 years ago.]

Ramsey was born in 1903. In the year 1920, he read around 45 books, which included Karl Marx’s Capital, Sidney Webb and Beatrice Webb’s The History of Trade Unionism, J. A. Hobson’s The Industrial System, J. S. MiIl, and Alfred Marshall’s Industry and Trade. At the age of 19, he was commissioned to review Ludwig Wittgenstein’s Tractacus Logico-Philosophicus (1922), a significant treatise in philosophy, for the journal Mind; the review was published in 1923. Subsequently, he was commissioned to translate Wittgenstein’s work into English. In Wittgenstein’s later work, Philosophical Investigations, there is an explicit acknowledgement of Ramsey. He was acknowledged for his critique/interventions of Bertrand Russell’s and Alfred Whitehead’s Principia Mathematica in a new introduction by the authors. Sraffa, in his PCMC, had acknowledged Ramsey for mathematical help. In 1929-30, Ramsey met with J. M. Keynes, Sraffa, and Wittgenstein to discuss the theory of probability advanced by Keynes and Ramsey and also to discuss Freidrich Hayek’s theory of business cycles. Ramsey also had a close engagement with AC Pigou, a leading marginalist economist who was also the target of criticism in Keynes’s General Theory. Ramsey died in 1930.’

Under the patronage of Keynes, who was the editor of the’ Economic Journal, Ramsey published in it articles on the ‘theory of taxation’ (1927) and the ‘theory of saving’ (1928). In my 2019 article which critically evaluated the Nobel contributions of Paul Romer and Nordhaus, I had highlighted that Nordhaus employs a marginalist growth model drawing from Ramsey (without further comment). Ramsey’s question was the following: how much should a nation save today for future consumption tomorrow so as to maximise consumption across generations’ Nordhaus employs the optimal growth model with environmental protection as an important constraint. And, the rate of interest is seen as a price which equilibrates the society’s time preference. In other words, the rate of interest equilibrates the society’s preference for the future with that of the present. The policy implication when marginalist economists have a significant say in practical matters is as follows. Since the (actual) rate of interest captures the time preference of the society, this rate can be used to decide how much of current gross domestic product (GDP) should be devoted to environmental protection. In effect, not enough resources are being allocated to mitigate climate change and undertake environmental protection.’

Ramsey’s optimal growth theory also underlies Thomas Piketty’s position on economic growth. In his 2015 article in the American Economic Review, he writes that in the standard model ‘where each individual behaves as an infinitely lived family, the steady-state rate of return is well known to be given by the modified ‘golden rule’ r = ‘ + ‘ g (where ‘ is the rate of time preference and ‘ is the curvature of the utility function)’ (p. 2). The reciprocal of ‘ is the intertemporal elasticity of substitution which captures how much the representative family wishes to smoothen consumption over time. He uses this to point out that in general (marginalist) economic theory, we arrive at the r>g result–the focal argument in his book Capital in the Twenty First Century (2015; for a critical assessment see Thomas 2017). Furthermore, ‘in steady-state each family only needs to reinvest a fraction g/r of its capital income in order to ensure that its capital stock will grow at the same rate g as the size of the economy, and the family can then consume a fraction 1 ‘ g/r‘ (p. 3). To a marginalist (or neoclassical) economist, as Joseph Stiglitz wrote in an article in 1974, ‘interest rates are just intertemporal prices’ (p. 901).’

Therefore, for both Nordhaus and Piketty, interest rates are ‘intertemporal prices’ which allocate today’s income between today’s consumption and tomorrow’s consumption (today’s saving). As Ramsey (1928) writes, ‘The more we save the sooner we shall reach bliss, but the less enjoyment we shall have now, and we have to set the one against the other’ (p. 545). It is also interesting to note that their use of optimal growth models yields vastly different policy suggestions. While Nordhaus is conservative in his proposals for environmental protection, Piketty is progressive in his proposals to tax wealth.’

The rate of interest in Ramsey, as in Alfred Marshall, is a reward for waiting. Therefore, inequality in Ramsey necessarily arises from the heterogeneity of tastes or preferences; if a family is (relatively) more patient, it saves more than the (relatively) impatient one, and ends up owning all the capital stock (Attanasio 2015). How does this conception differ from the notions of interest rate found in Marx and Keynes’ For Marx, the rate of interest is the part of surplus value which is expropriated by the financial capitalist; the source of it is from the value added by labour. Keynes views the rate of interest as an expression of the preference for liquidity. To conclude, is the conception of the rate of interest found in Ramsey satisfactory for understanding a competitive economy’

REFERENCES

Attanasio, Orazio P.’ (2015), ‘Frank Ramsey’s Mathematical Theory of Saving’, The Economic Journal, 125 (March), pp. 269’294. https://doi.org/10.1111/ecoj.12229

Duarte, Pedro (2017), ‘Frank Ramsey’, In: Robert Cord (ed.) The Palgrave Companion to Cambridge Economics, Palgrave Macmillan, vol. 2, pp. 649’671.

Monk, Ray (1990), Ludwig Wittgenstein: The Duty of Genius, London: Vintage Books.’

Stiglitz, Joseph E. (1974), ‘The Cambridge-Cambridge Controversy in the Theory of Capital; A View from New Haven: A Review Article,’ Journal of Political Economy, vol. 82, no. 4, pp.’ 893‘903.

Further reading

Collard, David (2011), ‘Ramsey, saving and the generations’, Generations of Economists, London: Routledge.’

[Most of the contents of this post was informally discussed with my Economics colleagues at Azim Premji University on 19th February 2020.]