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The Cambridge Controversy – a fundamental refutation of orthodox economic theory – Part 1

Summary:
Some years ago, I promised to write about the – Cambridge capital controversy – which saw economists associated with Cambridge University in England and MIT in Cambridge, Massachusetts argue about the validity of neoclassical distribution theory. I never wrote the blog posts because I considered the material was a little difficult for a blog audience. Also, while of great interest to me, the topic was not necessarily compulsory reading for those trying to come to terms with Modern Monetary Theory (MMT). But today, I relent. For two reasons. First, I think my readership has reached much higher levels of economic literacy over the last 15 years and can handle a challenge. But, more importantly, there are times when the mainstream characters, who have been claiming that there is nothing new

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Some years ago, I promised to write about the – Cambridge capital controversy – which saw economists associated with Cambridge University in England and MIT in Cambridge, Massachusetts argue about the validity of neoclassical distribution theory. I never wrote the blog posts because I considered the material was a little difficult for a blog audience. Also, while of great interest to me, the topic was not necessarily compulsory reading for those trying to come to terms with Modern Monetary Theory (MMT). But today, I relent. For two reasons. First, I think my readership has reached much higher levels of economic literacy over the last 15 years and can handle a challenge. But, more importantly, there are times when the mainstream characters, who have been claiming that there is nothing new in MMT and that they knew it all along and all the important results can be explained within an orthodox New Keynesian approach, reveal their true colours. Their hubris sees them get ahead of themselves and they show they never really understood the basics that undermine their own approach. Such was the case this week when Paul Krugman declared the Controversy “a huge intellectual muddle” and “a tortured debate that illuminated nothing much”. Well, that just goes to show how the mainstream denial functions. A body of work comes along and blows the dominant paradigm out of the water, and the response is to ignore it as a meaningless muddle. Their current attacks on MMT are just another application of that approach, which I first encountered as a student while studying the capital debates. Given the complexity of this issue and the amount of material, this will be a two-part series. Today, we learn the historical context, which will convince you that this was not idle or arcane discussion. This was a debate that went to the heart of the existence of capitalism and the defenders of that system – the mainstream economists did everything they could to defend the myths that they had erected to make the system look fair. They failed but went on anyway. Here is Part 1.

Krugman on Joan Robinson

Commenting on an interesting article in the New York Times last week (April 24, 2021) about the late Cambridge (UK) academic Joan Robinson – The Woman Who Shattered the Myth of the Free Market – Krugman tweeted three times on the issue:

Nice appreciation of Joan Robinson, although no mention of her later role. Sad to say, as a student I mainly encountered her through the “Cambridge capital controversy,” a huge intellectual muddle 1/

Somehow Robinson and others managed to convince themselves that the moral legitimacy of capitalism rested on the existence of a well-defined measure of “capital” that had a well-defined marginal product 2/

What followed was a tortured debate that illuminated nothing much, and eventually just faded away. Oh well. But Zach Carter is right: we value thinkers for their best work, not their detours, and Robinson made a huge contribution 3/

Zach Carter was the author of the NYT article.

To suggest that the Cambridge debates, which were categorically won by the British side (with Joan Robinson, Pierro Sraffa, Luigi Pasinetti, Nicholas Kaldor, Geoff Harcourt) leading the way, didn’t illuminate much, suggests that Paul Krugman is either a liar or didn’t really get the point, or both.

The Cambridge controversy was very important part of my own undergraduate and post-graduate education.

For those who were coming into mainstream economics after reading Marx and like extensively, the Controversy had great meaning.

As an academic, I later went on an taught capital theory as one of my electives (in addition to macroeconomics, labour economics, and econometrics).

So what was it all about?

A brief history lesson

First, you have to understand some history.

Marginal productivity theory emerged in the second-half of the C19th as the conservatives became scared of the growing popularity of Marxism. Industrialists hired economists to develop theories that made capitalism appear to be fair.

That appears to be what Krugman is referring to above when he talks about the “moral legitimacy of capitalism”.

The major insight provided by Marx’s theory of surplus-value was that capitalist profits are sourced in the production of surplus-value. In turn, surplus-value is produced by unpaid labour and so under capitalism workers remain exploited (as they were under previous modes of production).

Exploitation takes on the meaning that workers do ‘free’ labour for the owners of capital as a result of the unequal power relations in the labour exchange and that labour is expropriated as the return to capital.

It is clear that the return of profits is the reward for ownership per se.

And that insight suggested that if ownership changed so would the distribution of income.

That threatened the hegemony of the owners of the material means of production – the capitalists and became an existential threat to the entire system.

The interesting part of Marx’s analysis of capitalism is that the exploitation is hidden in what he called the ‘wage form’.

Under previous modes of production the exploitation was obvious and built into the norms of the system.

So under feudalism, workers produced surplus labour for part of the week on the feudal lord’s land and for the rest of the week produced their own means of subsistence on their own land allocated to them by the feudal lord.

In the capitalist labour market, the wage form is such that it appears that equals are being exchanged – the wage for the supply of labour-power (the capacity to work) usually specified as a given number of hours of work per day.

So it looks like the worker is being paid for the entire day.

But the labour contract is more complex than a normal exchange of commodities where the parties agree on an exchange price (which reflects their assessments of the use value they will get from the swap and then after the contract is finalised they enjoy the use value of the exchange independently.

In the labour contract, the use value to the capitalist is the labour emanating from the labour-power and the capitalist “consumes” that during the production process which sees the worker producing more than they are paid.

The point is that the worker has to be on the job while the capitalist consumes the use value of the labour power.

So exploitation to Marx related to this inequality in the labour contract which meant workers had to work longer hours than necessary (for their survival) as a result of the unequal ownership of the productive capital.

The important point of Marx’s theory of exploitation for the subsequent developments in economic theory is that it exposed the capitalist system as being unfair.

Any notion that a person gets back out of production what they put in is rendered false.

The workers clearly do not.

And the capitalists are seen to put nothing in (ownership is not a productive input) yet get back the surplus-value which is then realised in the goods market as profit.

With social and political unrest increasing in Europe in the mid-C19th, a major effort was undertaken to produce a theory of income distribution which demonstrated that all owners of productive inputs get back in the form of income payments what they put into the production process.

So the ideological push to make capitalism appear to be fair led to the development of Marginal productivity theory.

According to this theory workers are paid according to their contribution to production.

Moreover, the other productive inputs, land and capital (equipment etc) generated returns that were also commensurate with their ‘marginal’ contribution to production.

Accordingly, the theeory asserted that every factor of production received what it contributed to the overall pie.

That was then represented as a fair system and was used politically to negate the claims that workers were being exploited.

Marginal productivity theory both explained but also justified the outcomes that the capitalist system produced.

All was fair.

If you wanted higher wages you had to invest in skills to generate higher marginal products

Someone who had invested more in skill development would get a higher return.

But then it was observed that persistent differentials in wage outcomes remained that could not be explained in terms of productivity differentials.

Enter another piece of mainstream ad hocery – the theory of compensating wage differentials.

The basic idea is that wage differentials compensate for differences in the nonpecuniary characteristics of alternative jobs.

This dates back to the Wealth of Nations (Book I: Chapter X).

So you have two occupations which are similar in every way but one – danger of work.

The more dangerous job will attract a higher wage to compensate for the danger.

The general conclusion is that where jobs are boring, dangerous, dirty, more stressful – that is, are generally less desirable – the market will reward them with higher wages than otherwise.

So more pleasant and interesting jobs will offer lower wages than other jobs with less favourable characteristics.

Workers are then seen to shop around for different ‘utilities’ (levels of satisfaction) rather different wages per se when choosing employment.

The segmented labour market theory provides a devastating critique of the mainstream approach to wages. There are good jobs and bad jobs and they pay accordingly.

The bad jobs are typically dangerous, boring, unstable, and pay low wages.

The opposite is the case for good jobs. The resulting wage outcomes cannot be explained using the mainstream theories.

There was another theoretical development that also destroyed the mainstream approach to income distribution and concentrated on the return to capital – profits.

Can we really conclude that profits reflect the marginal product of capital?

To relate this question to the Tweets by Paul Krugman , note that in his own textbook – Microeconomics – I have the Second Edition (2009) – Part 9, Chapter 20 considers “Factor Markets and the Distribution of Income”.

From Page 518, Krugman and his co-author discuss “The Marginal Productivity Theory of Income Distribution” and state:

We’ve now seen that each perfectly competitive producer in a perfectly competitive factor market maximizes profit by hiring labor up to the point at which its value of the marginal product is equal to its price – in the case of labor, to the point where VMPL = W. What does this tell us about labor’s share in the factor distribution of income? To answer that question, we need to examine equilibrium in the labor market. From that vantage point we will go on to learn about the markets for land and capital, and how they also influence the factor distribution of income … the result that we derived for the labor market also applies to other factors of production …

The same is true for capital. The explicit or implicit cost of using a unit of land or capital for a set period of time is called its rental rate. In general, a unit of land or capital is employed up to the point at which that unit’s value of the marginal prod- uct is equal to its rental rate over that time period …

Using the present value method … we can convert the value of the marginal product stream that the parcel of land or machine generates today and in the future into its present value. Thus, a producer will purchase parcels of land or pieces of machinery up to the point at which the present value of its current and future stream of the value of the marginal product is equal to its factor price.

This is very clear.

There is a symmetry in neoclassical theory across all productive inputs in terms of the relationship between their ‘price’ and the quantity demanded.

And the return a ‘factor’ receives is in line with its marginal contribution to production.

But note also, which will become important soon, the reference to the “present value method”, which is about the use of – Discounted cash flow – analysis, where monetary streams across different periods are compared by discounting them back to the present.

That is, allowing monetary values that have different future values because of interest rate compounding effects to be compared in a common unit – dollars now!

This arises because a ‘dollar today is worth more than a dollar tomorrow’.

To understand this point you need to appreciate the – Time value of money.

When we decide on whether to spend now or later, we are making a decision about what the benefits we get today versus the benefits we get later by deferring our consumption.

The reason interest is paid is because we will only sacrifice consumption today in order to get more later.

So $10 now might deliver $11 in a year’s time, if we can invest it at 10 per cent (ignoring inflation).

So we in appraising income flows, we can convert $11 that we might anticipate receiving in a year’s time to be equivalent to $10 now, if the interest rate is 10 per cent.

If the interest rate was higher than that then $11 next year is worth less than $10 now.

Now the relevance of all that to this blog series is that we cannot calculate a present value without reference to a discount rate.

Which means we cannot define a marginal product for capital independently of the profit rate.

Which means (and I will explain below) that we cannot claim the marginal product generates the return.

Which means there is no aggregate distribution theory provided by marginal productivity theory.

The Cambridge Controversies

The Cambridge Capital Controversies of the 1960s demolished the foundations of marginal productivity theory.

There were several elements to the debates:

1. The capital debate – what is capital and how do you calculate a return.

2. The reswitching debate – there is no unique ordering of capital to labour relative to the relative prices of each.

Conclusion

I hope Part 1 has helped you understand the importance of this debate.

In Part 2, I will try to elucidate you of some of the key points, which Paul Krugman is keen to ignore, assuming he understood them.

That is enough for today!

(c) Copyright 2021 William Mitchell. All Rights Reserved.

Bill Mitchell
Bill Mitchell is a Professor in Economics and Director of the Centre of Full Employment and Equity (CofFEE), at the University of Newcastle, NSW, Australia. He is also a professional musician and plays guitar with the Melbourne Reggae-Dub band – Pressure Drop. The band was popular around the live music scene in Melbourne in the late 1970s and early 1980s. The band reformed in late 2010.

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