Tag Archives: nicholas kaldor

The World Needs A Kaldorian Response

Dani Rodrik has a new article, The Abdication Of The Left written for Project Syndicate. He says:

The good news is that the intellectual vacuum on the left is being filled, and there is no longer any reason to believe in the tyranny of “no alternatives.” Politicians on the left have less and less reason not to draw on “respectable” academic firepower in economics.

Consider just a few examples: Anat Admati and Simon Johnson have advocated radical banking reforms; Thomas Piketty and Tony Atkinson have proposed a rich menu of policies to deal with inequality at the national level; Mariana Mazzucato and Ha-Joon Chang have written insightfully on how to deploy the public sector to foster inclusive innovation; Joseph Stiglitz and José Antonio Ocampo have proposed global reforms; Brad DeLong, Jeffrey Sachs, and Lawrence Summers (the very same!) have argued for long-term public investment in infrastructure and the green economy. There are enough elements here for building a programmatic economic response from the left.

This is fine, but it wouldn’t be enough to solve the world’s problems because the world as a whole is balance-of-payments constrained as most individual nations are. What is needed is a coordinated response at the international level – a concerted action.

In his 1984 book Causes Of Growth And Stagnation In The World Economy, Nicholas Kaldor wrote:

I should like to end this series of lectures by suggesting the outline of a world-wide agreement on the necessary policies for recovery. The programme could be summed up under four main heads:

  1. The first is coordinated fiscal action including a set of consistent balance of payments targets and “full employment” budgets.If this does not prove to be politically feasible, it is inevitable that the growth of unemployment will sooner or later force governments to take measures that would make it necessary for them to expand demand without being frustrated by the inevitable balance of payments consequence of expanding their economies relative to their trading partners. This means that there needs to be some form of restriction that would limit the increase in “competitive” imports to some target ratio in relation to exports. Trade liberalisation, which played such an important part in the rapid economic progress during the years of expansion, becomes a serious obstacle to economic recovery in the case of prolonged stagnation due to the inability of countries to achieve a coordinated set of policies. But, given a proper recognition of the problem, that under conditions of unrestricted free trade the actual volume of production and trade may in fact be considerably less than under some system of regulated trade – a system which relates the volume of imports in manufactures from a particular group of countries, such as the members of the EEC, to some mutually agreed ratio to the exports of individual members to the rest of the group – there is no reason why full employment should not be restored through policies of expansion, preferably directed by the expansion of State investment. This coordinated action by all countries, instead of isolated actions by each country, is the first and most important requirement of recovery.

At present all countries have fairly large deficits in the general government budget, but these are largely the consequence of the low level of activity. On a “full employment” basis they would show a highly restrictive picture – they would show surpluses and not deficits. Contrary to appearances, the requirement of stability is for expansionary budgets with lower taxes and higher expenditure, and not further fiscal restriction (as is advocated, for example, by M. de Larosiere of the International Monetary Fund).

Before the crisis, the economics profession believed in two orthodoxies:

  1. crude version of Monetarism, which treats the stock of money as exogenous and also claims that fiscal policy is impotent.
  2. free trade.

While policy response following the 2008 crisis have made economists realize that the first orthodoxy is wrong, they are yet to realize the orthodoxy of the second. As Joan Robinson said in her 1973 article, The Need For A Reconsideration Of The Theory Of International Trade, “there is no branch of economics in which there is a wider gap between orthodox doctrine and actual problems than in the theory of international trade”. The recent consensus of the economics profession on the debate about the UK EU referendum highlights it. Instead of the invisible hand, we need a visible hand, i.e., a coordination at the international level. The leftist response as highlighted by Dani Rodrik are welcome but still leave the problem open. So one needs both this and a world-wide fiscal expansion with balance-of-payments targets.

 

Wynne Godley On The EU

In the previous post, I highlighted Nicholas Kaldor’s view on the EU. I want to quote Wynne Godley’s views as well. Wynne Godley was highly influenced by Nicholas Kaldor so it is not surprising his views were similar.

In an article Wynne Godley Asks If Britain Will Have To Withdraw From Europe, written for London Review Of Books, written in October 1979, Godley writes:

The implications for Britain of EEC membership are rapidly becoming so perversely disadvantageous that either a major change in existing arrangements must be made or we shall have, somehow, to withdraw.

I strongly support the idea of Britain’s membership of the Common Market for political and cultural reasons. I would also support co-ordinated economic policies which were mutually advantageous to all the member countries. But this is not what we have got at the moment.

So we are all to be losers. The taxpayer through the Budget contribution, the consumer through higher food prices, the farmer through costs rising more than selling prices, and the manufacturer through rapidly rising import penetration.

… And if we may also take into account the dynamic effects, our balance of payments would be better by several thousand million pounds than it is at present. This would by itself have had a favourable effect on real national income and output, but, more important, it would have enabled the Government to pursue a less restrictive fiscal and monetary policy. According to preliminary estimates, the real national income could have been at least 10 per cent higher than at present and the rate of price inflation several points lower than if we had never joined the EEC.

The UK Should Leave The EU

It’s the United Kingdom European Union membership referendum tomorrow. In my opinion, the UK should leave the EU.

When discussing the Euro Area, it is emphasized frequently that Euro Area governments do not have the power to make expenditures by making drafts at the central bank as argued by Wynne Godley in 1992:

It needs to be emphasised at the start that the establishment of a single currency in the EC would indeed bring to an end the sovereignty of its component nations and their power to take independent action on major issues. As Mr Tim Congdon has argued very cogently, the power to issue its own money, to make drafts on its own central bank, is the main thing which defines national independence. If a country gives up or loses this power, it acquires the status of a local authority or colony. Local authorities and regions obviously cannot devalue. But they also lose the power to finance deficits through money creation while other methods of raising finance are subject to central regulation. Nor can they change interest rates.

The Euro Area was formed because Europeans wanted to come together and create a union which is big and powerful enough to be not affected by financial markets. The original intent was right but soon the whole idea came to be influenced by neoliberalism. The thing which was hugely missing (“the incredible lacuna” in Wynne Godley’s words in the above cited article) was the absence of central government of the Euro Area itself, which will have the power to collect taxes from Euro Area economic units and make expenditures. After some years of boom, the Euro Area found itself in crisis and could not deal with it well because there was no central government and fiscal policy to the rescue. The European Central Bank tried to save the monetary union but isn’t as powerful enough as a central government. More importantly, the Euro Area was brought into existence with the idea of free trade. Not only was power taken away from relatively economically weaker nations such as Greece but free trade was imposed by bringing their producers compete in the common market. In summary, there were two reasons why some Euro Area nations suffered.

  1. The monetary arrangement
  2. The common market.

Typically the former is emphasized more than the latter. Perhaps the reason is simple. It is easier to explain the former than the latter. In my experience, the latter is more difficult for people to understand and appreciate. Very few have emphasized it. Few exceptions are: Nicholas Kaldor, Wynne Godley.

Because economic growth is “balance of payments constrained”, free trade is devastating. The Euro Area could have had free trade if it had a central government which keeps imbalances in check because of fiscal transfers and regional policies.

Which brings us to the European Union itself and Britain’s membership. Although the UK government neither didn’t surrendered its sovereignty to make drafts at the central bank nor irrevocably fix the exchange rate in 1999, the nations’ producers still compete in the common market. It is better off leaving the European Union and have powers to impose tariffs on imports. Free trade is destructive to trade and one needs a lot of protection – at least the power of the optionality to impose such things any time a nation needs.

It was surpising to see less heterodox noise on this.

Nicholas Kaldor wrote a lot on this in the 1970s before the United Kingdom European Communities membership referendum in 1975. In his Collected Economics Essays, Volume 7, Nicky wrote (Introduction, page xxvi, October 1977) :

The final section of this volume, Part III, reproduces papers written in the course of the “Great Debate” on the question of British Membership of the Common Market in 1970 and 1971, and includes as a postscript a lecture on Free Trade written in 1977. As this debate came to an end when Britain entered the market, a decision which was later confirmed in popular referendum with a 2:1 majority, the reproduction of these papers may strike as otiose and serving little purpose other than somewhat ignoble one of self-vindication in the eyes of future historians. However, if the long-run effects of our membership turn out to be as disastrous as I feared they would be in 1971—and nothing that has happened has caused me to change my views—I think it is of the utmost importance that the true arguments against membership should be accessible to successive generations of students, the more so since the political debate continues to be dominated by issues (such as our effects of membership on the cost of food, on our agriculture, or the net budgetary cost of membership) which I regard as secondary and which could be brushed aside if the long-run effects on Britain’s manufacturing industry and on our capacity to provide employment were favourable.

[page xxviii] … the last essay of this volume, “The Nemesis of Free Trade”, which recounts the arguments in the great debate on Free Trade and Protection conducted at the beginning of this century between Herbert Asquith and Joseph Chamberlain. The points made on both sides seem to have lost none of their freshness or relevance in the intervening years. What has changed is our freedom to act. In 1905 we were free to decide whether to continue with the policy of free imports or to protect our industries. In 1977 the choice is no longer open to us, except at a political cost of withdrawing from the Common Market, an act which few people would contemplate seriously so soon after accession.

But after so many years, here is the chance to undo all this and withdraw from the EU. The UK should leave the EU.

Nicholas Kaldor On The Foreign Trade Multiplier

This is the basis of the doctrine of the ‘foreign trade multiplier’, according to which the production of a country will be determined by the external demand for its products and will tend to be that multiple of such demand which is represented by the reciprocal of the proportion of internal incomes spent on imports. This doctrine asserts the very opposite of Say’s Law: the level of production will not be confined by the availability of capital and labour; on the contrary, the amount of capital accumulated, and the amount of labour effectively employed at any one time, will be the result of the growth of external demand over a long series of past periods, which permitted the capital accumulation to take place that was required to enable the amount of labour to be employed and the level of output to be reached which were (or could be) attained in the current period.

Keynes, writing in the middle of the Great Depression of the 1930s, focused his attention on the consequences of the failure to invest (due to unfavourable business expectations) in limiting industrial employment below industry’s attained capacity to provide such employment; and he attributed this failure to excessive saving (or an insufficient propensity to consume) relative to the opportunities for profitable investment. Hence his concentration on liquidity preference and the rate of interest, as the basic cause for the failure of Say’s Law to operate under conditions of low investment opportunities and/or excessive savings, and the importance he attached to the savings/investment multiplier as a short-period determinant of the level of production and employment.

On retrospect I believe it to have been unfortunate that the very success of Keynes’s ideas in connection with the savings/investment multiplier diverted attention from the ‘foreign trade multiplier’, which, over longer periods, is a far more important and basic factor in explaining the growth and rhythm of industrial development. For over longer periods Ricardo’s presumption that capitalists only save in order to invest, and that hence the proportion of profits saved would adapt to changes in the profitability of investment, seems to me more relevant; the limitation of effective demand due to oversaving is a short-run (or cyclical) phenomenon, whereas the rate of growth of’external’ demand is a more basic long-run determinant of both the rate of accumulation and the growth of output and employment in the ‘capitalist’ or ‘industrial’ sectors of the world economy.

– Nicholas Kaldor, Capitalism and industrial development: some lessons from Britain’s experience, Camb. J. Econ. (1977) 1 (2): 193204, link

The World Balance Of Payments Constraint: Nicholas Kaldor Explaining The Way The World Works

Thirlwall’s Law is counter-intuitive and comes across as shocking. It says that the growth of a nation’s economy is directly proportional to the rate of exports and inversely related to the income elasticity of imports.

The reason it comes as shocking and difficult to believe is that our planet, with all inhabitants and institutions considered resident cannot export (unless there are non-residents such as aliens), but the world still grows.

Now there are several pitfalls in this argument. First, Thirlwall’s law doesn’t fail because the expression for growth rate is indeterminate. Rate of exports is indeterminate and the income elasticity of imports is indeterminate.

So we have

growth = inderminate/indeterminate

Second, the world does not have a central government. So the world as a whole is not comparable to a closed economy with a government.

There is a way in which the world as a whole is balance-of-payments constrained. The argument is by Nicholas Kaldor. In his 1980 article Foundations And Implications Of Free Trade Theory, written in Unemployment In Western Countries – Proceedings Of A Conference Held By The International Economics Association. At Bischenberg, France, Kaldor makes the argument for the world balance-of-payments constraint.

Nicholas Kaldor On Free Trade

Nicholas Kaldor on free trade

In a recent article on the ‘Causes of Growth and Recession in World Trade’,1 T. F. Cripps has demonstrated that a country is not ‘balance of payments constrained’ if its full employment imports, M*, are less that its import capacity M̅ (as determined by its earning from exports). Such a country is free to choose the level of domestic demand which it considers optimal for its own circumstances,2 whereas the other countries from whom M* > M̅, must, under conditions of free trade, reduce their output and employment below the full employment level, and import only what they can afford to finance. He then shows that the sum of imports of the ‘unconstrained’ countries determine the attainable level of production and employment of the ‘constrained’ countries, and the remedy for this situation requires measures that increase the level of ‘full-employment’ imports or else reduce the export share of the ‘unconstrained countries’. The ‘rules of the game’ which would be capable of securing growth and stability in international trade, and of restoring the production of the ‘constrained’ countries to full employment levels, may require discriminatory measure of import control, of the type envisaged in the famous ‘scarce currency clause’ of the Bretton Woods agreement.

In the absence of such measures all countries may suffer a slower rate of growth and a lower level of output and employment, and not only the group of countries whose economic activity is ‘balance-of-payments constrained’. This is because the ‘surplus’ countries’ own exports will be lower with the shrinkage of world trade, and they may not offset this (or not adequately) by domestic reflationary measures so that their imports will also be lower. Provided that the import regulations introduced relate to import propensities (i.e. to the relation of imports to domestic output) and not to the absolute level of imports as such, the very fact that such measures will raise the trade, production and employment of the ‘constrained’ countries will mean that the volume of exports and domestic income of the ‘unconstrained’ countries will also be greater, despite the downward change in their share of world exports.3

Footnotes:

1Cambridge Economic Policy Review (March 1978), pp, 37-43.

2Owing to the widespread view according to which a given increase in effective demand is more ‘inflationary’ in its consequences if brought about by budgetary measure than if it is the result of additional investment or exports (irrespective of any limitations of import capacity) the inequality or potential inequality in its payments balance may cause a surplus country to regard a lower level of domestic demand as ‘optimal’ in the first case than in the second case.

3In other words, if countries whose ‘full employment’ balance of payments shows a surplus because M* < α W (where M* is the level of full employment imports, α is the share of a particular country’s exports of in world trade W) after a reduction of α to α̂ (α̂ < α) through the imposition of discriminatory measures, the country will still be better off if α̂ W* > α W where W* is the volume of world trade generated under full employment conditions.

[boldening mine]

What Kaldor is saying that because of balance of payments constraint of economies, the world as a whole has a slower growth because surplus nations do not expand domestic demand to the level needed. He is also saying that import controls raise imports rather than reduce them (this because of higher national income) and the exporters’ exports will also increase (even though their share is reducing.).

So the world as an built-in deflationary bias in the way it works.

Neochartalism, Balance Of Payments And Mainstream Economics

There have been many critiques of Neochartalism. Almost all of them, simply ignore the most important issue which makes Neochartalism the so-called “Modern Monetary Theory”, a chimera. A delusion.

Bill Mitchell has written a post on his blog about the balance-of-payments constraint, which among other things makes fun of physical appearance of Nicholas Kaldor. In that he correctly recognizes Nicholas Kaldor as the main proponent of this idea. Mitchell rightly represents Kaldor’s views:

In fact, Kaldor thought that exports were the only true ‘exogenous’ source of income growth, given that household consumption and business investment are considered to be ‘endogenously’ driven by fluctuations in (national) income itself.

In the post, Bill Mitchell doesn’t offer any argument as to why the literature behind it is supposedly wrong. He quotes Australia’s example but doesn’t recognize that Australia’s growth rate fits Thirlwall’s law. Had Australia grown much faster, its international indebtedness would grow to a much bigger size than now, which means its growth is limited by the balance of payments constraint.

Instead, Mitchell’s main point is:

While Thirlwall adopted a Keynesian position, the ‘balance of payments constraint’ he defined has underpinned the obsession with export-led growth strategies. It is a case where the IMF and others have co-opted the ‘Keynesian’ literature to impose neo-liberal solutions on nations.

In part, this is because ‘Keynesian’ literature was flawed.

Supposedly, its the Kaldorians who succumb into policies of the IMF because of their confusions! This is quite funny, given that Nicholas Kaldor was quite opposed to free trade which imposes a huge constraint on nation’s fortunes. In fact Kaldor and his colleagues at Cambridge were advocating import controls for Britain, which is obviously not a right-wing solution and was opposed by all.

One of my favourite articles is Foundations And Implications Of Free Trade Theory by Nicholas Kaldor, written in Unemployment In Western Countries – Proceedings Of A Conference Held By The International Economics Association. At Bischenberg, France. 

Nicholas Kaldor On Free Trade

Nicholas Kaldor on free trade

 

Kaldor main point in the essay is a major opposite to the doctrine of free trade. Free trade is a policy of international organizations such as the IMF. So it’s not Nicholas Kaldor and others who are being fooled by the IMF, but Neochartalists themselves who think that if nations simply float their currencies, they get rid of their external constraint.

Here’s Kaldor:

Owing to increasing returns in processing activities (in manufactures) success breeds further success and failure begets more failure. Another Swedish economist, Gunnar Myrdal called this’the principle of circular and cumulative causation’.

It is as a result of this that free trade in the field of manfactured goods led to the concentration of manufacturing production in certain areas – to a ‘polarization process’ which inhibits the growth of such activitiesin some areas and concentrates them on others.

So as you see, there is an opposition to the “consensus” view. But according to Neochartalists, there is no problem with free trade: just expand domestic demand by fiscal policy. Imports are benefits, exports are costs according to them!

The main point of the post is that it is Neochartalists whose views are orthodox, not other Post-Keynesians following the work of Nicholas Kaldor. It’s funny of them to assert the other way. Look at it this way: opposition to free trade requires import controls, tariffs and things such as that. Is that the mainstream view – to put tariffs? However it is funny if you see a Neochartalist arguing against free trade as it would mean an inconsistency. If fiscal policy alone can bring full employment, why oppose free trade?

Kaldor’s Footnote And Kaldor On Sraffa

This is an updated version of a post whose link has been removed and the content added below.

The world is more Kaldorian than Keynesian. After the crisis, Keynes became popular again but his Cambridge descendent Nicholas Kaldor is hardly remembered by the economics community. Even his biographers have some memory loss of him.

😉

Anthony Thirlwall and John E. King are biographers of Nicholas Kaldor. Superb books.

There’s a chapter Talking About Kaldor: An Interview With John King in Anthony Thirlwall’s book Essays on Keynesian and Kaldorian Economics. There’s an interesting discussion on money endogeneity (Google Books link):

J.E.K.  … I wonder if Kaldor would have gone as far as Moore in arguing that the money supply curve is horizontal.

Anthony Thirlwall replies saying he would have argued that the supply of money is elastic with respect to demand, instead of quoting him. Here’s Nicholas Kaldor stating explicitly in a footnote in Keynesian Economics After Fifty Years, in the book, Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983, on page 36:

Diagrammatically, the difference in the presentation of the supply and demand for money, is that in the original version, (with M exogenous) the supply of money is represented by a vertical line, in the new version by a horizontal line, or a set of horizontal lines, representing different stances of monetary policy

[italics: mine]

Anthony Thirlwall is one of the commenter in the book chapter. The book is proceedings of a conference on Keynes.

But that’s not enough. Turn to page 363 of the book.

A.P.T.  He had a very high regard for Sraffa but he never wrote on this topic.

J.E.K.  Not something that would really have concerned him very much? Too abstract and too removed from reality?

A.P.T.  Probably, yes. It is quite interesting that Sraffa was his closest friend, both personal and intellectual, and they used to meet very regularly – almost every day when Sraffa was alive. But there’s no evidence that they ever discussed Production of Commodities by Means of Commodities.

J.E.K.  That’s amazing. There’s certainly no evidence that he ever wrote anything on those questions.

A.P.T. There’s no evidence that he wrote anything, or that indeed he really understood Sraffa. Well, he had the broad thrust, but I don’t know that he ever read it carefully, or understood the implications.

In Volume 9, of Kaldor’s Collected Works, there are two memoirs. One of Piero Sraffa and the other on John von Neumann.

Kaldor-On-Sraffa

Nicholas Kaldor on Piero Sraffa

Interestingly the editors and F. Targetti (another biographer) and A.P. Thirlwall!

I guess if you know a person so closely – like the biographers do, of Kaldor- you tend to forget a few things about them.

Kaldor And Oil

…  a more fundamental proposition [is] that any large change in commodity prices – irrespective of whether it is in favour or against the primary producers – tends to have a dampening effect on industrial activity; it retards industrial growth in both cases, instead of retarding it in the one case and stimulating it in the other. There are, as I shall now show, two reasons for this. It is partly a consequence of the fact that whilst a fall in commodity prices tends to be an effective instrument in moving the terms of trade against the primary producers, a rise in commodity prices is not likely to be nearly as effective in moving the terms of trade in their favour. It is partly also a consequence of an asymmetry in the behavioural consequences as between a gain and a loss of real income, the result of which is that any sudden shift in the distribution of world income, caused by a change in the terms of trade, is likely to have an adverse effect on industrial demand (in real terms).

The important cause of the first asymmetry is that while commodity prices are demand-determined, industrial prices are cost-determined, and because of that the rise in commodity prices has a very powerful inflationary effect operating on the cost side. The rise in the price of basic materials and fuels is passed through the various stages of production into the final price with an exaggerated effect – it gets ” blown up ” on the way by a succession of percentage additions to prime costs which mean, in effect, an increase in cash margins at each stage. This causes (initially) a rise in the share of profits in the value added by manufacturing which in itself is a powerful factor (in countries where trade union power is strong) in causing pressure for wage increases. Added to this is the price-induced rise in wages caused by what Sir John Hicks called “Real Wage Resistance” – the reluctance of workers to accept a cut in their standard of living (which is not paralleled by similar reluctance to accept a rise). For these reasons a swing in the terms of trade in favour of the primary producers is not likely to last for long. The industrial sector with its superior market power, resists any compression of its real income by countering the rise in commodity prices through a cost-induced inflation of industrial prices.

Moreover – and here we come to the second reason mentioned above – the inflation itself has a deflationary effect on the effective demand for industrial goods in real terms, partly because the rise in the profits of producers in the primary sector is not matched by a rise in their expenditure – this was particularly marked on the present occasion through the vast accumulation of financial assets by the oil producers – and partly because the governments of most, if not all, of the industrial countries are likely to react to their domestic inflation by fiscal and monetary measures which reduce consumer demand and put a brake on industrial investment. Thus the rise in commodity prices may well result in a wage/price spiral-type of inflation in the industrial sectors which in turn causes industrial activity to be restricted. The latter tends to eliminate the shortages and thereby reverse the trend in commodity prices. A good example of this has been the U.S. inflation of I972-3, which was clearly cost induced but not wage-induced; it was caused by the rise in commodity prices (with wage rises trailing behind the rise in living costs) and which led to strongly restrictionist monetary policies in order to counter the inflation, which in turn brought about a considerable economic recession. (Somewhat later similar restrictionist policies were adopted by governments of other leading countries, such as Germany and Japan.)

If the above analysis is correct, the market mechanism is a highly inefficient regulator for securing continuing adjustment between the growth of availabilities and the growth in requirements for primary products in a manner conducive to the harmonious development of the world economy.

The emergence of commodity surpluses which should, in principle, lead to accelerated industrialisation may have a perverse effect by diminishing effective demand for industrial products. Similarly the emergence of shortages which should accelerate the growth of availabilities of primary products through improvements in the terms of trade may lead instead to an inflation of manufacturers’ prices which tends to offset the improvement in the terms of trade, and by its dampening effect on industrial activity, worsens the climate for new investment in both the primary sector and the industrial sector.

– Kaldor, Nicholas. 1976. “Inflation and Recession in the World Economy”. The Economic Journal 86 (344). [Royal Economic Society, Wiley]: 703–14. doi:10.2307/2231447. Link

The Kaldor-Verdoorn Effect

Brian Romanchuk has a nice post on how the case for productivity is something which is overstated by economists. There’s less discussion in the econoblogosphere on this. Here I’ll add a few things with a slightly different perspective.

Sometime in the historic past, nations’ economies started diverging. Some nations’ fortunes rose while others lagged behind. Nations which became rich saw high rises in productivity. It’s easy to then conclude that productivity is the raison d’être for the success or failure of nations. In fact this is what Greg Mankiw says in his textbook Principles Of Macroeconomics, 7th Edition, page 13:

The differences in living standards around the world are staggering …

What explains these large differences in living standards among countries and over time? The answer is surprisingly simple. Almost all variation in living standards is attributable to differences in countries’ productivity—that is the amount of goods and services produced by each unit of labor input. In nations where workers can produce a large quantity of goods and services per hour, more people enjoy a high standard of living; in nations where workers are less productive, most people endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth of its average income.

The fundamental relationship between productivity and living standards is simple, but its implications are far-reaching. If productivity is the primary determinant of living standards, other explanations must be of secondary importance … some commentators have claimed that increased competition from Japan and other countries explained the slow growth in U.S. incomes during the 1970s and 1980s. Yet the real villain was not competition from abroad but flagging productivity growth in the United States.

[bold in original, italics mine]

So although it cannot be denied that rich nations have seen rise in productivity, the above story entirely misses the reverse causality – i.e., from production to productivity. And because of that, it entirely misses the cause of success and failure of nations.

Nicholas Kaldor rediscovered the relation between rise in output and rise in productivity (which can be attributed to Petrus Johannes Verdoorn) in 1966 and interpreted the causality right: from rate of growth of production to the rate of growth of productivity. The main reason given was “learning by doing”.

This still leaves open the question about what determines production itself. Unlike the supply-side models of neoclassical theory, Kaldorians tell a story about a demand-led growth and the balance of payments constraint being the most important determinant of economic growth. Some nations had the fortune of growing fast earlier in history and in this process of cumulative causation became more competitive in the process. This not only increased their fortunes but immiserated other nations. This is because poor nations would get stuck with a balance of payments constraint and this would affect their competitiveness. Competitiveness can either be price-competitiveness or non-price competitiveness. Price competitiveness depends on pricing goods and services in international markets. This in turn depends on productivity. So nations which got an early lead in history saw rise in production and hence productivity via the Kaldor-Verdoorn process and also gained in price-competitiveness.

There is a feedback effect here. Do you see it? That’s circular and cumulative causation. The effect can be better understood by writing a model such as as done by Mark Setterfield in his chapter titled Endogenous Growth: A Kaldorian Approach in the book The Oxford Handbook Of Post-Keynesian Economics, Volume 1, Theory And Origins. 

Usually the story is told with price-competitiveness. I am unaware of any model which also includes non-price competitiveness in the story.

Anyway, to conclude, cheering for productivity is not going to help the world economy. The solution is to increase production: productivity will rise when production rises. The standard story as told in Mankiw’s textbook is erroneous.

Kaldor’s Vision Of The Growth And Development Process According To Thirlwall

Anthony Thirlwall’s new book Essays on Keynesian and Kaldorian Economics is out. It has a nice chapter (chapter 11) originally written by Thirlwall himself from 1991 titled Kaldor’s Vision Of The Growth And Development Process. The description from introduction (pdf from Palgrave’s website) is a good summary:

Essay 11 outlines Kaldor’s vision of the growth and development process – a topic that concerned him for most of his academic life after the Second World War. The Essay covers his growth laws; his export-led growth model incorporating the notion of ‘circular and cumulative causation’, and his two-sector model of the interrelationship between the agricultural (primary product) and industrial sectors of the world economy. Central to Kaldor’s vision was the distinction to be made between increasing returns activities on the one hand (manufacturing industry) and diminishing returns activities on the other (land-based activities such as agriculture and mining). This distinction lies at the heart of his three growth laws that (i) manufacturing is the engine of growth because of (ii) static and dynamic returns to scale in industry (also known as Verdoorn’s law), and (iii) increases in productivity outside of manufacturing as resources are drawn from diminishing returns activities. The question, of course, is what determines industrial growth in the first place. Kaldor’s answer was that it is the prosperity and growth of the agricultural sector in the early stages of development, and then export growth in the later stages. In an open economy, exports are the only true [exogenous] component of aggregate demand. Consumption and investment are largely endogenous.

This view of the role of exports is the basis of his ‘regional’ export-led growth model with cumulative features which has four structural equations: (i) output growth as a function of export growth; (ii) export growth as a function of changing competitiveness and income growth outside the region; (iii) competitiveness as a function of productivity growth, and (iv) productivity growth as a function of output growth (Verdoorn’s Law). Depending on the parameters of the model, regional growth rates may diverge or converge (see Essay 12). It is also possible to introduce a balance of payments constraint into the model which, if relative prices (or real exchange rates) don’t change in the long run, leads to the result that growth will approximate to the rate of growth of exports relative to the income elasticity of demand for imports, which is the dynamic analogue of the static Harrod foreign trade multiplier, which Kaldor argued was a more important multiplier than the Keynesian closed economy multiplier for understanding the pace and rhythm of growth in open economies.

In a closed economy, however, growth by definition cannot be determined by exports. The world as a whole is a closed economy, and Kaldor lectured in Cambridge for many years on a two-sector model of world growth in which the growth of the industrial sector of the world economy is fundamentally determined by the rate of land-saving innovations in agriculture as an offset to diminishing returns in that sector. The model shows that if growth is to be maximised, there must be an equilibrium terms of trade between the two sectors, otherwise growth will be demand constrained if agricultural prices are ‘too low’, or supply constrained if agricultural prices are ‘too high’. Kaldor himself never brought the model to fruition in published form, but attempts have been made to formalise it by Targetti (1985) and myself (see Essay 13).

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