Macro-economic Thinking and the Market Economy

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Macro-economic Thinking and the Market Economy An essay on the neglect of the micro-foundations and its consequences L. M. LACHMANN Professor of Economics and Economic History, University of the Witwatersrand, Johannesburg, 1949-1972 Published by THE INSTITUTE OF ECONOMIC AFFAIRS 1973 First published August 1973 © THE INSTITUTE OF ECONOMIC AFFAIRS SBN 255 Printed in Great Britain by TONBRIDGE PRINTERS LTD, Peach Hall Works, Tonbridge, Kent Set in Monotype Baskerville PREFACE The Hobart Papers are intended to contribute a stream of authoritative, independent and lucid commentary to the understanding and application of economics.

Their charac- teristic concern is the optimum use of scarce resources and the extent to which it can be achieved by markets within an appropriate legal and institutional framework. The first 50 were published from i960 to 1970. The second 50 in the 1970s will continue the central study of markets and of the environ- ment created by government.

The interest in the working of markets explains the essentially micro-economic approach, i.e., the study of indi- viduals, families, firms or other small homogeneous groups as buyers and sellers. 1 Several Hobart Papers have been the work of distinguished economists who have used the technique of macro-economics, i.e., the study of ... more. less.

the behaviour of aggregates such as national income, expenditure and production. Econom- ics comprises micro and macro elements but their relationship is rarely clarified. Since the 1930s economists who have followed the some 40-year-old approach of J. M. Keynes have often appeared to say, or to think, that macro- has replaced, or is superior to, or is distinct from, micro-economics. And this confusion has for many years been translated into some text books and into 'popular' writing for laymen. Professors Armen A. Alchian and William R. Allen's University Economics? which should be better known in Britain, puts macro-economic analysis of fluctuations in employment, national income and output in its place as 'relying on the basic theorems of micro theory'. In Hobart Paper Mo. 55 s Mr Douglas Rimmer illustrated the misleading results of the unthinking application of macro- economic concepts to the developing countries. In this Hobart Paper the methods of thought and analysis of macro-economics and leading macro-economists are further examined by Professor L. M. Lachmann to see how far they yield valid hypotheses about human activity and prescriptions for 1 Economic analysis can also be applied to giving and receiving: The Economics of Charity, IE A Readings No. 12, forthcoming. 2 Wadsworth Publishing, Belmont, California, 3rd edn., 1972; in the UK, Prentice-Hall International, Hemel Hempstead, Herts. 3 Macromancy: The ideology of'development economies', IEA, April 1973. [3] policy. He divides macro-economics into two main schools: the first, the neo-Ricardians, led in Cambridge (England) by Professors Joan Robinson, Piero SrafFa, and Nicholas Kaldor, and the second, the neo-classical school, represented mainly by Professors Paul Samuelson, Robert Solow and Sir John Hicks. In a recent article 1 Professor James Tobin is highly critical of the Cambridge School in England and defensive of Cambridge in the USA; in this Paper Professor Lachmann is severely critical of both. He finds the analyses of both schools defective on the ground that they have lost sight of the micro-economic foundations of economic behaviour. Although those economists who seem to be critics of the Cambridge School claim to have inherited the micro-economic approach of the neo-classical economists such as Leon Walras and Vilfredo Pareto, Professor Lachmann argues that they have not fully incorporated the essentials of neo-classical economics and that their thinking is no less defective than that of the Cambridge School. To go to the roots of these fundamental differences in the thinking of economists, Professor Lachmann has had to conduct a highly theoretical discussion that will be easier for economists than for beginners or for non-economists. The more fundamen- tal the differences, and the arguable errors, in economic thinking, the more abstract the reasoning must be. If macro- economists have been using poor reasoning and emerging with bad recommendations, it is essential to re-examine the funda- mentals of their methods. There is no easy way to grasp their conclusions without an effort to understand how and why they think as they do. This Hobart Paper is therefore more theoretical than most have been, but newcomers to economics and laymen will find it rewarding if they persevere in their effort to under- stand it, perhaps in a second or third reading, because the implications for policy could be radical. If Professor Lachmann is right, much of the thinking of economists for the last 40 years has misled a generation or two of students, teachers, popularisers of economics in the press and broadcasting, businessmen and politicians. For the inference would be that macro-economics has a useful role to play in economic thinking and policy only if its underlying micro- economics are understood. It is safely used by economists who are constantly aware of the substructure of individual decisions 1 'Cambridge (U.K.) v Cambridge (Mass.)', The Public Interest, Spring 1973. M in buying and selling; it is unsafe in the hands of economists who think it replaces the substructure, or that it is sufficient to assume that individuals, or individual entities like families and firms, will act in the way that conforms to macro-economic laws, rules, tendencies or generalisations typically made about the behaviour of large groups such as a country, an economy, or a society as a whole. The reader who masters Professor Lachmann's analysis will find that the implications for policy are indeed far-reaching. Professor Lachmann briefly indicates the erroneous conclusions that have been drawn from macro-economics for current policies in the Western countries: the control of incomes and wages as a means of mastering inflation, the management of economic growth, ensuring technical progress, and the monetary policy required for a progressive, open society. Professor Lachmann's analysis is scholarly but the implica- tions of his approach are revolutionary: for the teaching of economics, for the authority ,with which economists offer advice, for the respect in which they are held by industry, government and society in general. The Institute would like to thank Professor Armen A. Alchian and other economists for reading an early draft and offering comments and suggestions which the author has taken into account in his final revisions. Its constitution requires it to dissociate its Trustees, Directors, and Advisers from the analysis and conclusions of its authors; but it offers Professor Lachmann's study to economists of all schools, and to non- economists who benefit or suffer from their thinking and advice, as a reasoned re-assessment of a school of thought which has dominated economics for decades. June 1973 EDITOR [5] THE AUTHOR L. M. LACHMANN was born in Berlin in 1906 and studied in Berlin and Zurich. In 1930 he obtained the degree of Doctor rerum politicarum from the University of Berlin. In 1933 he came to England where he did research work in economic theory at the London School of Economics and held the Leon Research Fellowship in the University of London from 1938 to 1940. He was Acting Head of the Department of Economics of the (then) University College of Hull from 1943 to 1948. In 1949 he went to South Africa as Professor of Economics and Eco- nomic History in the University of the Witwatersrand, Johannesburg. He retired at the end of 1972. He was President of the Economic Society of South Africa from 1961 to 1963 and has been a member of its Council since 1950. Professor Lachmann's publications include Capital and its Structure (Bell, 1956); The Legacy of Max Weber (Heinemann, 1970); articles in the learned journals, particularly 'Economics as a Social Science' (Inaugural Lecture), 1950, 'The Science of Human Action' (Economica, November 1951), 'Mrs Robinson on the Accumulation of Capital' (South African Journal of Economics, June 1958), 'Sir John Hicks on Capital and Growth' (South African Journal of Economics, June 1966); and contributions to festschriften for eminent economists, especially 'Methodological Individualism and the Market Economy' in Erich Streissler et al. (eds.), Roads to Freedom: Essays in honour ofFriedrich A. von Hayek (Routledge & Kegan Paul, London, 1969), and 'Ludwig von Mises and the Market Process' in Toward Liberty (Institute for Humane Studies, Menlo Park, California, Vol. II, 1971). Most of these writings are concerned with the analytical foundations of the market economy and the question of how far modern economics provides an adequate picture of it. [6] CONTENTS Page PREFACE 3 THE AUTHOR 6 GLOSSARY 9 I INTRODUCTION I I 'A multitude of perspectives' 11 II THE GRAND DEBATE 11 The 'Cambridge' and 'neo-classical' schools 12 Assumption of macro-equilibrium 14 III MACRO-ECONOMIC FORMALISM AS A STYLE OF THOUGHT 16 A. The 'Neo-Ricardian' Counter-Revolution 17 Lip-service to micro-foundations 19 Salvation by econometrics? 20 Macro-formalism adopted by both schools 20 The Ricardian shadow 22 B. A Brief History of the Controversy 23 Stage 1 23 Stage 2 23 Stage 3 24 IV THE NATURE OF PROFITS AND 'THE' RATE OF PROFIT 25 Competition implies varying rates of profit 26 Long-run equilibrium is unattainable 27 Inter-temporal exchange rate 28 Solow's 'social rate of return' 29 'Planner's approach' to investment 30 Profits are a phenomenon of disequilibrium 31 Micro-foundation of profits 32 Rate of profit/rate of interest controversy 33 (a) One equilibrium rate (neo-classical school) 33 (b) Distinction between the two rates (Cambridge School) 33 Absurdity of the 'normal rate of profit' concept 35 [7] V STEADY-STATE GROWTH? 36 Politicians and the growth rate 37 Gassel's idea of the 'uniformly progressive economy' 38 Growth and macro-formalism 38 Not all plans can succeed 39 No room for individual expectations in macro- economics 39 The Cambridge 'golden age' 40 Malinvestment inevitable in economic growth 42 Equilibrium growth is a misconception 43 VI THE DISEQUILIBRATING FORGE OF TECHNICAL PROGRESS 44 Dangerous thoughts 44 Technical progress in macro-economics 45 'Learning by doing' 46 Technical progress is unpredictable 46 Markets are 'the final arbiter' 47 VII CONCLUSIONS FOR ECONOMIC POLICY AND THE FUNCTIONING OF THE MARKET ECONOMY 48 1. Incomes policy 48 2. Economic growth 49 3. Technical progress 49 4. Main conclusions 49 (i) Macro-aggregates 49 (ii) Monetary policy 50 (iii) Cambridge School 51 (iv) Neo-classical School 52 (v) Labour, capital, and expectations 52 SUGGESTED QUESTIONS FOR DISCUSSION 54 FURTHER READING 55 [8] GLOSSARY ARBITRAGE 4action by which different prices for the same good in different markets are brought to uniformity, e.g. by London stockbrokers buying a share in Paris and selling it in London whenever the Paris price is lower than the London price. Ex ANTE 4Ex POST (before 4afterwards) 4economic actions look different when they have happened from what they did when planned. EXCHANGE ECONOMY 4an economy in which existing goods are exchanged but no production takes place. FORMALISM 4a style of thought according to which abstract entities are treated as though they were real. Contrast with SUBJECTIVISM (page 10). HOMOGENEITY 4HETEROGENEITY ('MALLEABILITY') 4an aggre- gate, such as a capital stock, may consist of elements that are all alike like drops of water in a lake. If so, it is homogeneous, otherwise heterogeneous. INVESTMENT DECISION, SPECIFYING 4a decision to build a house or ship involves turning an amount of money into a concrete and specific object. This decision cannot be reversed. KALEIDO-STATICS 4'The economy is in the particular posture which prevails, because particular expectations, or rather, particular agreed formulas about the future, are for the moment widely accepted. These can change as swiftly, as completely, and on as slight a provocation as the loose, ephemeral mosaic of the kaleidoscope. A twist of the hand, a piece of'news', can shatter one picture and replace it with a different one.' (G. L. S. Shackle, A Scheme of Economic Theory, Cambridge, 1965, p. 48.) LEARNING BY DOING 4learning from practical experience rather than from books or lectures. Technical knowledge acquired in the workshop. It takes time. MALINVESTMENT 4investment which turns out to be a failure, yields less profit than was expected. See also Ex ANTE 4Ex POST. MARGINAL EFFICIENCY OF CAPITAL 4'The relation between the prospective yield of a capital-asset and its supply price or replacement cost, i.e., the relation between the prospective yield of one more unit of that type of capital and the cost of [9] producing that unit, furnishes us with the marginal efficiency of capital of that type.' (J. M. Keynes, General Theory, p. 135.) NEO-CLASSICAL PRODUCTION FUNCTION 4a neo-classical theorem in which total output is regarded as a function of total input of capital and labour, one that yields constant returns to a pro- portionate increase in all the inputs. One version is the COBB-DOUGLAS FUNCTION 4a linear homogeneous production function, in which the elasticity of substitution between capital and labour is always one. PRODUCTION ECONOMY 4an economy in which, as distinct from an exchange economy, goods have to be produced as well as exchanged. SUBJECTIVISM 4The postulate that all economic and social phenomena have to be made intelligible by explaining them in terms of human choices and decisions. Contrast to FORMALISM (above). TECHNICAL PROGRESS 4is said to be embodied when each new invention requires a new c machine' to give it expression. It is disembodied when its results can be incorporated into all old machines so that the age of a machine has no effect on its efficiency. TECHNICAL PROGRESS FUNCTION, KALDOR'S 4a macro-function that makes the results of technical progress dependent on the rate of gross investment (below, p. 45). TECHNOCRATIC APPROACH TO CAPITAL THEORY, SOLOW'S 4 'Solow classifies capital theories as either technocratic or descriptive. They are technocratic when planning and alloca- tion questions (and so socialism) are discussed, descriptive when used in an explanation of the workings of capitalism.' (G. C. Harcourt, Some Cambridge Controversies in the Theory of Capital, Cambridge University Press, 1972, p. 93.) WELFARE ECONOMICS 4'Welfare economics is the study of the well-being of the members of a society as a group, in so far as it is affected by the decisions and actions of its members and agencies concerning economic variables.' (D. M. Winch, Analytical Welfare Economics, Penguin Modern Economic Texts, i97 r > P- 13O [10] I. INTRODUCTION In our day the market economy is under relentless and heavy criticism. Some of these criticisms are due to ignorance. Some show a remarkably high degree of skill and sophistication. This Paper is devoted to a critical evaluation of some of the more sophisticated ideas deployed in this debate. ' A multitude of perspectives' Nobody can claim, of course, that the market economy can be viewed only in one kind of perspective superior to all others, that it requires for its full understanding an analytical scheme of its own, or that any particular body of thought can be said to 'represent' it. In the study of the social world there is a good deal to be said for a multitude of perspectives and styles of thought, each of them illuminating one aspect of the problem under investigation. It remains true none the less that some of these perspectives are apt to blur essential features of the object of study and to distort our vision. In such cases we are entitled to state that some styles of thought are inadequate to their subject matter. In what follows we shall endeavour to show that such inadequate styles of thought are prominent in a contemporary debate among economists in which the nature of the market economy, the way it works and the results it achieves, are at issue. II. THE GRAND DEBATE For almost two decades now a controversy has raged on the higher levels of economic theory, particularly in capital and growth theory, which concerns some essential features of the market economy, but in which those human actions which give rise and lend meaning to these features are ignored. From time to time the contestants will address to one another requests to 'state your assumptions clearly', but these injunctions always seem to apply to macro-economic variables, such as incomes, output or investment, used here as instruments of combat; they never extend to the types of action, the plans of millions of consumers and producers, the mostly unintended results of which these variables are meant to symbolise. 1 The 'Cambridge 9 and 'neo-classical* schools This is by no means the only curious feature of the situation in which the controversy takes place. One of the contestants, the 'Cambridge School', as we shall call it, is strongly critical of the market economy. In their view, the mode of distribution of the national income between wages and profits is indeterminate, which means that profits are not an 'economically necessary' type of income and, in practice, might almost indefinitely be squeezed with impunity by taxation. To be sure, retained profits are necessary for economic growth, but the payment of dividends, and indeed any consumption by non-workers, are regarded as unnecessary! 2 We might call this school of thought 'post-Marxist', were it not that to Marx and Engels the very idea that the mode of income distribution under capitalism is indeterminate would have been abhorrent. Strictures on the market economy are, of course, nothing new. During the centuries of its existence they have come from many sides and been made on many occasions. But so far the market economy also has always found ready exponents on many sides and many levels, in particular among the most eminent econ- omic thinkers of each age. When around the turn of the century what came to be known as the 'Neo-classical' school of econ- omic thought gained prominence, two of its outstanding thinkers, Pareto and Gustav Gassel, devoted a good deal of their efforts to espousing the market economy and launched some vigorous critiques of collectivist ideas. Eugen von Bohm-Bawerk whom, as an 'Austrian', we should perhaps not include in this school, stood on the same side. 1 A book of readings containing excerpts from most of the important contributions to the debate has recently been published in the Penguin Modern Economics Readings. It provides an excellent introduction to it: G. G. Harcourt and N. F. Laing (eds.), Capital and Growth, Selected Readings, Penguin Books, 1971. Joan Robinson, Economic Heresies. Some old-fashioned questions in Economic Theory, Macmillan, 1971, is virtually in its entirety a contribution to the debate; also J. A. Kregel, Rate of Profit, Distribution and Growth: Two Views, Macmillan, I 97 I - An almost point-by-point commentary on the various issues at stake in the debate is in G. G. Harcourt, Some Cambridge controversies in the theory of capital, Cambridge, 1972. To the serious student it is indispensable. The author hides neither his sympathy for the Cambridge side nor his lack of sympathy for the market economy. 2 Gf. the note on David Ricardo, below, p. 17, footnote 4. [18] What is odd about the present situation is that while the Cambridge School assails essential features of the market economy, their opponents, who have borrowed the name 'neo- classical', have shown no strong desire to accept this part of their inheritance, viz. to espouse the market economy. To be sure, their claim to the neo-classical inheritance is not uncontested. Professor Joan Robinson always refers to them as the 'neo-neo- classical' school. But it is clear that such eminent contemporaries as Professors Paul Samuelson and Robert Solow, while certainly regarding themselves as the heirs of Leon Walras and Vilfredo Pareto, do not wish to incur these liabilities of their inheritance. Perhaps to their way of thinking such liabilities do not exist. The reasons for this attitude are not to be found in scholarly reticence towards the affairs of one's own day and age. Professor Solow felt no compunction recently in denouncing the pre- tensions of a good deal of what goes by the name of 'radical economics'. 1 Professor Samuelson has never been known for undue reticence when it comes to letting the world know his views about this or that topical question. In successive editions of his famous textbook he has, indeed, given such matters increasing space and attention. The reasons are partly to be found in the degree of remoteness of the 'model' which forms the shell of their thought from the everyday processes of the market, a remoteness of which they cannot but be well aware, but partly in a strange weakness, an unwillingness to challenge the basis of their opponents' thought. 2 In the first place, the neo-classical model assumes perfect competition, which in our world hardly exists, though in the industrial economy of the 19th century the predominance of the wholesale merchant in most markets produced results not altogether dissimilar from it. Furthermore, within the body of thought that came to be known as welfare economics 3 and in which some members of the neo-classical school have come to take an interest, a prominent place is occupied by the notion of a 'Pareto Optimum', an 'ideal' general equilibrium position based on perfect competition, free access to all markets and equal knowledge shared by all participants. Anybody feeling committed to this 'ideal' would naturally compare the 1 American Economic Review, Papers and Proceedings, May 1971, pp. 63-65. 2 G. E. Ferguson gives a concise and polished statement of neo-classical views in The Neo-classical Theory of Production and Distribution, Cambridge, 1969. 3 'Glossary', p. 10. [13] market situations of the real world with it and find them wanting. In this way our judgement on the world as it is comes to depend not merely on the world as we would wish it to be, which is quite proper and, in a sense, inevitable. It comes to depend on a comparison with a fictitious state of equilibrium of which nobody has as yet explained how it could come about in reality. After a few strenuous exercises in the manipulation of the macro-variables of our model, such as incomes, output or investment, the question of which human actions keep them in being vanishes from sight, and we may permit ourselves to establish the fictitious world of our model as a criterion by which to judge the world as it really is. Clearly, however, this enchantment with welfare economics cannot be regarded as a complete explanation of the attitude of the neo-classical school to the market economy. The controversy takes place in a strange mental atmosphere. The strangeness is not entirely due to the level of abstraction, high as it is, on which the two rival schools move. It is often said that what is a permissible level of abstraction depends on the problem at hand, and that every thinker must be allowed to exercise his discretion in such matters. This may be so, but until recently two rules have generally been observed in this context. The first, which Gassel in particular used to emphasise, is that from the initial level of abstraction, however high, it must be possible gradually to approach reality by a sequence of approximations involving the modification of the initial assumptions. At the very start of an argument it has to be decided which assumptions will be modified later on and which will not. The second rule concerns what may be abstracted from and what not. Essentials fall into the latter category. In discussing a system of action, for example, we are not entitled to abstract from the springs of human action, the purposes sought by individuals and the plans in which they find their expression, by assuming their modus operandi to be known and therefore predictable. The strange character of the atmosphere in which our controversy takes place owes not a little to the fact that these two rules are more often honoured in the breach than in the observance. Assumption of macro-equilibrium The two rival schools of thought conduct their argument within the context of macro-economic equilibrium. This [14] means that the economic forces the mode of interaction of which is at issue are long-term economic forces reflecting the movement of certain economic aggregates, like investment or exports, of apparently unchanging composition. The field of motion of these forces is the 'economic system' as a whole. The TmVro-economic origins of these forces are not under discussion by our two rival schools. The relevance of these assumptions to the working of the market economy whose operations they are, after all, supposed to reflect calls for some immediate comment. In the real world there is no equilibrium, although there certainly are equilibrating forces of various degrees of strength and speed of operation. They operate with varying degrees of ease in different spheres. They encounter obstacles of various kinds. In general we may say that the more swiftly the co- ordinating forces can do their work the stronger the chance that a state of equilibrium will be reached. Thus, in the large international financial markets in which arbitrage 1 is worth while, and as long as capital movements are unhampered, equilibrium may be established within a matter of hours. On the other hand, where durable and specific capital goods play a prominent part in markets, the attainment of equilibrium becomes precarious because it may take a long time before they fall due for replacement, and meanwhile new changes will probably affect other elements of the situation. Needless to say, but as we shall have to emphasise repeatedly, macro-economic equilibrium, i.e., equilibrium of the economic system as a whole, is a more problematical concept than market equilibrium. Equilibrium of the individual, household or firm, is a much simpler notion than either and is virtually synony- mous with rational action. Everybody knows from experience that he cannot hope to succeed in a course of action unless he is able to co-ordinate the various acts of which it consists. Con- sistency of plan is always a necessary condition of success. The smaller the micro-unit the more firmly based is the concept of equilibrium. We must not forget that whenever we pass from the sphere of action controlled by one mind, in household or firm, to the sphere of action in which diverse minds have to take their orientation from one another while each is pursuing its own interests, as in a market, we face a formidable array of problems of the existence of which all too many economists 1 'Glossary', p. 9 [15] seem blissfully unaware. To discuss a problem within a general equilibrium context must mean to pin one's faith on the over- riding strength of the equilibrating forces operating in the situation under discussion. By the same token, one must regard what obstacles there may be in the path to equilibrium as surmountable, and disequilibrating forces as too weak to disrupt the result. But how do we know that in every such encounter the equilibrating forces will, in the end at least, al- ways gain the upper hand ? The neglect of the micro-economic foundations of aggregate magnitudes, on the other hand, means that the game is being played with a set of macro-variables as chips into whose origins, i.e., individual actions, we must not inquire. What is more important, we have to take the constant molecular composition of the chips, the unvarying numerical magnitude of the aggre- gates, for granted. The macro-variables, to be sure, will be affected by the operation of one upon another, within the field of equilibrium forces, but never, it seems, by forces operating within each one of them. It is easy to imagine what will happen if theories based on such assumptions are applied in circumstances of rapid unexpected change, in which the continuous constant composition of the aggregates, e.g., outputs produced by various industries, can by no means be taken for granted. We shall call the style of thought which finds its expression in assumptions such as these and which is common to both our contending factions macro-economic formalism. 1 We may speak of formalism whenever a form of thought devised in a certain context, in order to deal with a problem existing there and then, is later used in other contexts without due regard for its natural limitations. We shall try to show that this is precisely what has happened to the concept of equilibrium in the economic thought of our age. III. MACRO-ECONOMIC FORMALISM AS A STYLE OF THOUGHT Though the style of macro-economic formalism finds its expression in the writings of both our rival schools, they have come to acquire it in different ways and evidently do not 1 'Glossary', p. 9. [16] equally feel at home in it. We cannot fail to notice that members of the Cambridge School wield these weapons not only with much more confidence but also with more competence and verve. We may suspect that one reason at least for the dexterity with which we see them handle the instruments of macro- economic formalism has to be sought in the circumstance that these enable them to dispense with individuals, the differences between their minds, and the inequality of men in general. Their opponents, the neo-classical Samuelson-Solow school, prompted by no such desire, may have embraced this style of thought for other reasons and probably in a mood of innocence, but cannot escape the consequences of their choice. Having embarked upon it they helplessly drift further and further away from the micro-economic shore. The Cambridge School has repudiated the marginal revolution of the 1870s and regards subjectivism, 1 the style of thought to which we owe marginal utility and expectations, as at best an aberration. Professor Joan Robinson on the first page of the Preface to The Accumulation of Capital says that '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 4a Theory of Value'. 2 Mr Piero Sraffa, the Cambridge School's most original thinker, who has provided the inspiration for the work of most of the others, gave his book the characteristic sub-title Prelude to a Critique of Economic Theory. 3 A. THE 'NEO-RICARDIAN' COUNTER-REVOLUTION The members of the Cambridge School are best described as latter-day Ricardians. 4 For the reason given above we cannot call them post-Marxists. They prefer the label of neo-Keyne- 1 'Glossary', p. 10. 2 The Accumulation of Capital, Macmillian, 1956, p.v. 3 Piero Sraffa, Production of Commodities by Means of Commodities. Prelude to a Critique of Economic Theory, Cambridge University Press, i960. 4 David Ricardo (1772-1823) endeavoured to find an invariable measure of value, i.e. a common denominator to which all economic phenomena could be reduced, in the same way as in daily life we use pounds and pence, but that would not be distorted by inflation and deflation. He thought it could be found in labour, because all goods and services require hours of work to come into existence. This labour theory of value was never quite satisfactory, even Continued on page 18 [17] sians, but we may have misgivings about that. Keynes, for all his interest in macro-economics, owed little to Ricardo and all his life remained a subjectivist 1 who refused to cast the induce- ment to invest in the mould of a macro-variable such as the acceleration principle. He disclaimed any interest in long-run equilibrium and substantiated this disclaimer by pointing out that in the long run we are all dead. The main aim of the present-day Cambridge School appears to be an attempt to undo the results of the marginal revolution and to bring about a Ricardian counter-revolution. For a hundred years economists have taken it for granted that what happens in a market economy ultimately depends on the subjective preferences and expectations of millions of indivi- duals finding expression in the supply and demand for goods, services and financial assets. If we accept this approach we are compelled to pay close attention to the differences between human preferences and the divergence of expectations. If not, we are presumably free to turn our attention to facts supposedly 'socially objective'. In a world in which differences of pre- ferences and divergence of expectations do not matter there is, of course, no room for entrepreneurs. To neo-Ricardians the distribution of incomes, admittedly a Ricardian term, appears to have no meaning except within the narrow terms of'classes of the community'. How incomes are, for example, distributed among capital owners does not seem to interest them. That people belonging to the same 'class' may act in many different ways in the same 'objective situation', that there can be no competition without some competitors being unsuccessful while others are successful 4all these are facts not congenial to neo-Ricardian thinking. For them econ- 1 'Surmise and assumption about what is happening or about to happen are themselves the source of these happenings, men make history in seeking to apprehend it. This is the message of the General Theory.' (G. L. S. Shackle, The Tears of High Theory, Cambridge, 1967, p. 130.) Continued from page ij to Ricardo himself, but Karl Marx took it up with some ardour. He asked how, if labour is the only source of value, there can be profits, i.e. an income going to non-workers. In the 1870s economists came to see that not labour but utility is the source of value, that how many hours of work a good required has little to do with its value, and that value is not an objective quality inherent in goods and services but a subjective quality bestowed upon them by the appraising mind of the buyer. [18] omic action always means the response of a 'typical agent' to a 'given' situation. Men act exclusively in their capacity as 'workers', 'capitalists', or 'landlords'. Spontaneous action does not exist. Men do not really act in the Ricardian world, they merely re-act to the circumstances in which they happen to find themselves. It is thus hardly surprising that the neo- Ricardian understanding of the ways in which a market economy functions is somewhat limited, and subjectivism is seen as nothing but an aberration from the true path of econ- omic thought. Ricardo can be said to have thought essentially in long-run equilibrium terms. So it is not surprising to find that macro-economic formalism is a style of thought congenial to his latter-day disciples. Lip-service to micro-foundations From time to time, though, we find that lip-service is paid to the micro-foundations of economic phenomena. The return to the classical style of thought requires a strenuous effort, and a century of subjectivism has understandably left deep traces in the minds of our would-be Ricardians which they appear unable to erase completely. We even find the truth occasionally acknowledged that macro-equilibria require causal explanation in terms of human choice and decision. 1 But these admissions are never permitted to affect their analytical practice. When it comes to explaining economic processes we are usually told, for example, that 'entrepreneurs' make investment decisions, 'rentiers' place their wealth in one form or another, while consumers consume what is left of the GNP. Stereotypes play the part of economic agents. Economic events are the result of some kind of collective process of decision-making the modus operandi of which is never explained. Imaginary beings take the place of real people. 1 'To build up a causal model, we must start not from equilibrium relations but from the rules and motives governing human behaviour. We therefore have to specify to what kind of economy the model applies, for various kinds of econ- omies have different sets of rules. (The General Theory was rooted in the situation of Great Britain in the 1930s; Keynes was rash in applying its conclusions equally to medieval England and ancient Egypt.) Our present purpose is to find the simplest kind of model that will reflect conditions in the modern capitalist world.' (Joan Robinson, Essays in the Theory of Economic Growth, Macmillan, 1962, p. 34.) The reader will not fail to notice, even here, the somewhat ambiguous characterisation of the springs of action as 'rules and motives'. Which are the more important ? ['91 Salvation by econometrics? The attitude of their neo-classical opponents to macro- economic formalism is much more difficult to describe. As Walrasians they can hardly be oblivious of the micro-founda- tions of macro-theory. Was not one of Walras's achievements precisely this, namely, to have fused economic events on the level of individual, market, and system within one body of thought, and to have found in the notion of equilibrium the unifying concept, the instrument which permits us to view micro- as well as macro-economic phenomena as elements of an organic whole? But the strength of prevalent intellectual fashions is not easily resisted, their admiration for Keynes and his work is strong (most of them like to think of themselves as Keynesians), and the ease with which Keynesian macro- variables, such as employment or investment, appear to lend themselves to statistical measurement have induced them to look to econometric investigations as a means of verifying their theories. Indeed, the more hard pressed by their opponents, the more they have become inclined to look to the econo- metricians for their ultimate vindication. The attempt, on the one hand to cling firmly to acts of choice and decision as the foundation of economic phenomena, while at the same time presenting one's theories in an 'operationally meaningful', i.e., statistically measurable, form has naturally turned out to be a source of weakness which their opponent neo-Ricardians have not failed to exploit. Macro-formalism adopted by both schools Hence the two rival schools have come to embrace macro- economic formalism as their common style of thought for different reasons, the Cambridge School from inner conviction, the neo-classicals dazzled by the brightness of Keynesian success. From this difference there has followed a difference in attitude towards mode of verification and realism of assump- tions. The neo-classical formalists are inclined to regard realism of assumptions as less important so long as they permit us to make 'testable predictions'. For a long time they evidently regarded the conformity of statistical series in the USA and elsewhere to the Cobb-Douglasfunction 1 as empirical evidence for 1 'Glossary', p. 10. [20] the neo-classical theory of distribution. 1 Professor Solow in his De Vries Lectures 2 of 1963 drew on statistical series for such corroboration, and in his Growth Theory 3 (1970) does the same to support the notion of 'steady growth'. Naturally their opponents have of late turned their fire on these weak positions. Thus Professor Joan Robinson has shown that, precisely in so far as neo-classical theory is firmly based on micro-foundations, is grounded in. and meant to lend expression to. individual acts of choice and decision, it defies 'Statisticians can find out in a rough general way, for a particular situation, the capital-output ratio in dollar values and the share of profit in the dollar value of net output, so that they can estimate the overall ex post rate of profit on capital. They cannot describe what was in the minds of directors of firms or on the drawing boards of engineers when the choices were made which led to the creation of the existing stock of capital equipment. Still less can they say what choices would 4 " have been made if the rate of profit had been different from what it is.' 5 Her criticism here is directed, it is true, against only one of the neo-classical positions, namely, the so-called 'neo-classical production function'. 6 But it clearly must extend to any theory based on individual choice between alternatives. The more firmly a macro-economic argument is linked to its micro- foundation in choice and decision, the less it lends itself to statistical verification. Since the range of choice present to the minds of decision-makers defies statistical measurement, no theory linking observable events, like output quantities or 1 A rather precarious position to take. 'The conclusion must be that the fitting of the Gobb-Douglas function to time series has not yielded, and cannot yield, the statistical realisation of the production function. It can describe the relations between the historical rates of growth of labour, capital, and the product, but the coefficients that do this do not measure marginal productivity.' (E. H. Phelps- Brown, 'The Meaning of the Fitted Cobb-Douglas Function', Quarterly Journal of Economics, November 1957, p. 551.) 2 Robert M. Solow, Capital Theory and the Rate of Return, North Holland Publishing, Amsterdam, 1963, especially pp. 72-93. 3 R. M. Solow, Growth Theory. An Exposition, Clarendon Press, Oxford, 1970. 4 Italics in original. 5 Economic Journal, June 1970, p. 336. The reader will not fail to notice, we trust, what an effective use, in the heat of combat, our eminent neo-Ricardian is making of an argument which spells pure subjectivism! A century of it has left its mark even in the minds of our Ricardian counter-revolutionaries. 6 'Glossary', p. 10. [21] prices, to choice and decision is, in this sense, 'testable'. The circumstances influencing decisions find their mental reflection in plans. All economic action is, in the first place, the making and carrying out of economic plans. So long as there are no statistics of plans there is nothing to which the econometricians can correlate their measurements. A theory couched in equilibrium terms cannot be tested by measurements taken in a world of continuous disequilibrium. Any hope that the disequilibrating forces, from which in our theory we have abstracted, would in the real world operate in such a fashion as to offset one another and produce a net result of zero and so yield equilibrium, is evidently quite unfounded in reason or experience. In the real world in which statisticians have to work, some markets will be in equilibrium at any moment, others in disequilibrium. Thus the 'economic system as a whole* is never in equilibrium. How can statistical measurements taken in such circumstances either verify or falsify equilibrium theories of the neo-classical type ? The Ricardian shadow The Cambridge School, in pointing out the weaknesses of the methodological position of their neo-classical opponents, have done nothing to strengthen the foundations of their own. Of course they are unable to jump over their Ricardian shadow. Expectations do not fit into their analytical scheme and have to be kept at arm's length. The variability of human prefer- ences, shaped by experience and guided by the diffusion of knowledge from one individual to another, from market to market, from country to country, is best ignored, though, to be sure, its consequences cannot always be. For Ricardians the consumer does not exist at all. Theirs is a world of production and distribution. Consumption is not an economic activity. Consumers' demand has no effect on prices. For the neo- classical formalists he does exist, but his is a rather shadowy existence. Only his preferences, permanent by assumption, not the course of his actions, are considered to be of any interest to economists. Once his preference scales have been fully recorded he is dismissed into the realm of shadows and told never to come back. It is characteristic of the formalistic style of thought that those who have imbibed it become incapable of conceiving of spontaneous human action, as distinct from reaction to outside events. [22] We shall attempt to show that in this controversy both the Cambridge and the neo-classical schools are prevented by their equilibrium preconceptions from understanding the nature of the market processes of reality. They are tempted to regard as 'macro-variables' what are in reality the cumulative results of millions of individual actions. Since these micro-economic actions are not necessarily repeated from day to day, even less from year to year, we have no reason at all to believe in the aggregative constancy of the macro-variables over time. B. A BRIEF HISTORY OF THE CONTROVERSY Stage i The controversy began in 1953 with a frontal attack by Mrs Robinson on the 'neo-classical production function' as a macro-variable designed to show output as a function of labour and capital input. 1 She showed that there is no such thing as a quantity of capital, hence no measurable input of it. In 1956, she presented a model of a theory of growth (with and without technical progress) without measurable capital. 2 Some awkward corners were encountered there which the eminent author managed to turn with elegance and ease. Expectations were effectively disposed of by assuming that everybody always expected the future to be like the past. The effects of changes in consumers' demand were obviated by the assumption that the stock of capital always had (but how?) exactly that com- position required by the composition of the 'bundle' of con- sumption goods consumers demanded. Though the possibility of malinvestment, thus considerably restricted in any case, was candidly admitted to exist all the same, we were given to to understand that, by and large, the current capital stock represented the cumulative result of all the investment decis- ions taken down the centuries. Capital was heterogeneous, and thus not measurable, but this heterogeneity had no effect on the process of accumulation. Stage 2 The next stage was reached in i960 with the publication of Mr Sraffa's book. 3 The atmosphere of Ricardian long-run equilibrium is here all-pervasive. From the first page to the 1 Joan Robinson, Collected Economic Papers, Blackwell, i960, Vol. II, pp. 114-131. 2 The Accumulation of Capital, op. cit. 3 Production of Commodities by Means of Commodities, op. cit. [23] last we find ourselves in a world in which every market is always in equilibrium. No word is wasted on telling us how such equilibria might in reality be attained or what would happen if they were disturbed. His most important conclusion is the indeterminate character of the distribution of incomes between wages and profits in such a model. The instruments of marginal analysis were blunted. From this conclusion it further followed { that there is no such thing as a "quantity of capital" which exists independently of the rate of profit*. 1 In Chapter XII of his book, 'Switch in Methods of Produc- tion', Mr Sraffa discussed the possibility of using the same method of production at more than one rate of profit. This gave rise to what came to be known as the 'Reswitching Contro- versy', which the neo-classical side for a time regarded as the heart of the matter but which we can now see to have been a mere episode. We shall therefore deal with it very briefly. Here the Cambridge School won a clear victory. They were able to establish that, as Mr Sraffa had said, techniques of production are not uniquely related to 'relative factor prices'. The same technique of production may be the most profitable to use at a lower as well as a higher rate of profit, while others may be more profitable at an intermediate range. We are therefore not entitled to assume a continuous variation in techniques of production consequent upon changes in the rate of profit, e.g., in such a way that as the rate of profit falls more and more 'capital intensive' techniques will be chosen. In principle a return to a technique formerly used at a higher rate of profit is always possible. Whether it will really occur depends on the technology available. Thus the same water pump which was the most profitable to use when the rate of interest was 9 per cent may again be the most profitable at 5 per cent while others are more eligible between 5J and 8J per cent. The neo-classical side had originally denied this possibility. Stage 3 Of late the controversy has taken a new turn. The turning point is clearly visible in Dr Luigi Pasinetti's famous article of 1969. 2 The opening passage unambiguously indicates the real aim of his attack. 1 Joan. Robinson, Collected Economic Papers, Blackwell, 1965, Vol. Ill, p. 13. 2 L. L. Pasinetti, 'Switches of Technique and the "Rate of Return" in Capital Theory', Economic Journal, September 1969. The opening passage is on p. 508. [24] 'Whenever a new result emerges, in any theoretical field, it is natural to look back on traditional theory to verify whether, or to what extent, received notions may still be used or have to be abandoned. The outcome of the recent discussion on the problem of switches of technique seems to have started a process of this kind for the analytical tools used in the theory of capital.' The Cambridge School, throughout the period on the offen- sive, now attempts to show that the rate of interest (or profit) is as indeterminate within the neo-classical system as it is within Sraffa's neo-Ricardian model. They assert that, contrary to Professor Solow's view, no such rate can be found as a dependent variable within a system of equilibrium prices; that, if to be used in such a system, it has to be determined from outside it. For the market economy of reality it means that, since there is no marginal productivity of capital to govern the rate of profit, the distribution of incomes between profits and wages is economically indeterminate. Profits may be squeezed by trade union or government action with no untoward result, except possibly on the growth rate. It is at this point that we must enter the fray. Profits are an essential feature of the market economy. Does the controversy cast any light on the necessity of profit? Perhaps we shall be able to illuminate some very odd aspects of the position shared by both contending schools if we attempt to elucidate the nature of profits, their function in the market economy, the circumstances which give rise to them and those which modify their magnitude. IV. THE NATURE OF PROFITS AND 'THE' RATE OF PROFIT There must be more than a few economists who, when reading the works of Ricardo or Marx or their latter-day disciples, have found themselves wondering where exactly we are to look, in real life, for a counterpart of the rate of profit. Workers earn wages, we are told, and capital owners receive profits. We all know where to look for the real counterpart of wages. Though wage earners earn wage-rates which may differ very much, in ordinary circumstances a wage earner of a given category may expect to earn a wage-rate of more or less given [25] magnitude which may vary between certain, but finite, limits. With profits we have no such indication of its future magnitude at all. Profit is the difference between the price at which a com- modity is sold and its cost to the seller. Such differences may assume any magnitude, including a negative one. Losses are by no means uncommon in business, though no firm could sustain them in the long run. Competition implies varying rates of profit Profits are an essential feature of the market economy. Each firm attempts to maximise its profits over some period of action which may be short or long. This period may vary as circumstances change. But however the target is defined, each action must contribute towards its attainment. The firm must strive to make a profit on each transaction it enters upon. A capital owner invests his capital where he hopes to obtain the highest rate of net return. But motivation of action and success of the action thus motivated are by no means the same thing. It is possible to describe the working of a market economy in terms of the universal orientation of its active entrepreneurial minds to maximum profits; it is absurd to do so in terms of universal success. The very nature of competition, another essential feature of the market economy, renders the success of all plans impossible. Hence we find unsuccessful firms side by side with the successful, even within the same industry or region. We find malinvestment side by side with capital investments that have succeeded beyond the boldest expectations of those who made them. There is no such thing therefore as a rate of of profit, there are only rates of profit which may differ widely. This situation has, of course, something to do with the heterogeneity of capital, a property of the capital stock that plays a part in the controversy with which we are concerned, but its true significance lies beyond that of mere physical heterogeneity. If we assume all capital to be homogeneous v an assumption Keynes shared with Ricardo and Bohm- Bawerk as well as most of the older neo-classical economists) there can be only one rate of profit. But while physical hetero- geneity of capital is a cause of the variety of profits we find in reality, it is not the only cause. Two completely identical machines, used in two different factories, may not be at all equally profitable to their owners. Thus even physical homo- [s6] geneity does not entail a uniform rate of profit. For profit accrues in the first instance to a capital combination, the stock of variable composition held by a firm, and its imputation to each single component of it is often a matter of some intricacy. 1 This fact nevertheless serves further to impair the notion of a uniform rate of profit. Long-run equilibrium is unattainable For Ricardo, of course, the originator of the idea, the uniform rate of profit was simply a corollary of free access to all markets. If rates were different all capital would flow out of the least profitable branches of industry and accumulate in those most profitable, thus bringing about a uniform level of profitability. This is a property of long-run equilibrium. But in our world in which so much capital is durable and specific, these equilibrat- ing forces, on the final triumph of which Ricardo relied, can operate only slowly, though of course at varying rates in different sectors of the system. When they can only operate slowly, however, it is very likely that they will be overtaken by the disequilibrating forces of unexpected change, and the long-run equilibrium position will never be reached. The faster the equilibrating forces can do their work, the more we can rely on them and vice versa. All this goes to show, first, how fraught with danger are all equilibrium theories when applied to a world in which the triumph of our equilibrating forces, even their final triumph, may by no means be taken for granted. Secondly, our argument shows that the structure of the capital stock in terms of durability and specificity cannot, any more than its composition in terms of the combinations mentioned above (a micro-economic category by any description!), be ignored with impunity, even in a macro-economic argument likejhat concerned with the tendency to uniformity of all rates of profit. There are of course markets in which the Ricardian mechanism operates with great speed and success, and in which equilibrium is as a rule established swiftly and efficiently. This is naturally possible only within the general framework of the market economy. We may mention here the whole gamut of financial 1 Discussed in some detail in L. M. Lachmann, Capital and its Structure, Bell, 1956, pp. 3-12. [27] markets. In the loan markets arbitrage will swiftly bring about a structure of interest rates. There is the Stock Exchange, a market for securities embodying titles to shares in capital combinations, and thus for expected future income streams, in which an equilibrium of asset prices entailing a yield equilibrium for classes of assets of the same degree of riskiness is established every day. Such yield equilibrium, however, has nothing whatever to do with what Ricardians, young and old, mean by the rate of profit. It is not identical either with Fisher's rate of return over costs, 1 the neo-classical version of the Ricardian concept. On the contrary, what happens in a market economy is that the market brings about a state of aftairs in which differences in the rates of return to different types of capital (buildings, machines, stocks of goods) invested in different enterprises are offset by capital gains and losses, in such a way as to make these assets of different profitability on capital originally invested in them equally attractive to present wealth holders. The market is thus an ingenious device for letting bygones be bygones and compelling us to direct all our mental strength towards unravelling the secrets of the future. The rate of (dividend and earnings) yield on all shares to which the market ascribes an equal degree of risk has, of course, to be equal, but this says nothing about the rate of return on capital originally invested in them. Inter-temporal exchange rate We may also imagine a system of inter-temporal markets such as Keynes envisaged, 2 in which present goods can be exchanged for future goods as well as against one another. An 'own rate of interest' would come to exist in each market, but a general rate would prevail in the end in such a way that it is no more profitable to carry a stock of timber than one of coal. This general rate of interest would of course reflect the 'time preference' of the market as a whole in the same way as Stock Exchange prices reflect the degree of risk aversion or preference of the market as a whole. Again, however, this equilibrium rate of inter-temporal exchange has nothing to do with the Ricar- dian rate of profit. Contemporary Ricardians will hardly find 1 Irving Fisher, The Theory of Interest, The Macmillan Co., New York, 1930. 2 J. M. Keynes, General Theory of Employment, Interest and Money, Macmillan, 1936, Ch. 17. [28] it to their taste. Considering their hostile attitude towards subjectivism (they loathe utility and neglect expectations whenever possible), they are unlikely to grant high status to an economic magnitude reflecting time preference, another subjective attitude. The concept must be suspect to them precisely because it rests on a firm micro-economic foundation. We may surmise, on the other hand, that this equilibrium rate of inter-temporal exchange is more or less what the neo- classical school of Samuelson, Solow, and others mean by the rate of interest. If so, two points have to be raised. First, this concept has a clear and unambiguous meaning only within the context of an inter-temporal exchange economy, but not necessarily in an economy in which time-consuming processes of production take place and durable equipment is used. In the former we may, indeed we have to, assume that stocks carried of each of our commodities are of equilibrium size. Without equilibrium stocks there can be no equilibrium price. But in an economy with durable and specific capital equipment this is hardly feasible. There must be in the stock some 'fossils' 4 capital goods produced long ago, in a situation quite different from today's, which would not be replaced in their present form were they to be destroyed by accident. In other words, in a production economy such as we know it the stock of capital never has its equilibrium composition. In a pure exchange economy there is no reason why it should not have it. Soloufs *'social rate of return* Secondly, if this is what the neo-classical school mean by the rate of interest, they have not as yet said so. Professor Solow's 'social rate of return', to be sure, is an inter-temporal rate, but in a one-commodity world. Our equilibrium rate requires inter-temporal price adjustments in order to be established. In the Solovian model there are no prices that could change. Also, his rate of return appears to apply to a production, not an exchange, economy without fossils. But in a production econ- omy in which stocks are not of equilibrium size there is no place for an equilibrium rate of inter-temporal exchange. In short, Professor Solow's model is irrelevant to the market economy. He is not unaware of it: 'It may be claimed that a capital theory erected on planning grounds has no relevance to the actual behaviour of any [29] real capitalist economy. That argument has often been made, with considerable success, against static competitive price theory. Capital theory is unlikely to be immune to the same complaint.' 1 It is hard to see how, then, he can on the very next page 'suppose that my point of view could be described as a modern amalgamation of Wicksell and Irving Fisher'. 2 These two thinkers were concerned with the market economy and tried to elucidate problems of investment arising within it. They never, to our knowledge, looked at them from 'the planning point of view'. They knew that in a market economy all economic changes, hence investment, in the first place find their expression in relative price-level changes. The one- commodity world as an auxiliary device, to be sure, was not unknown to them. But they knew better than to leave things there. But this is not all. In Fisher's system the rate of return over costs is closely linked to the rate of interest which in its turn reflects time preference. It is by comparing the two that the investor decides which projects to pursue. u 4 J * J^ ,r- v 'Planner's approach 9 to investment \(r In Fisher's theory of interest subjective and objective elements, ^ time preference and investment opportunities, are thus evenly matched. (Of course, even such opportunities, existing as expectations in the minds of investors, are strictly speaking subjective elements, but Fisher wrote before expectations entered modern economics in the 1930s.) Professor Solow deliberately ignores the subjective element of time preference and, choosing the 'planner's approach', concentrates on the supposedly objective investment opportunities to calculate his rate of return on investment. The case is instructive because it highlights some charac- teristics of the style of thought of neo-classical formalism. First, it bears out our contention that only lip-service is paid to the micro-economic foundations. These economists may well acknowledge, in a general way, the significance of human preferences and expectations in economic life. However, when serious problems are encountered (and for Professor Solow the 1 Capital Theory and the Rate of Return, op. cit., p. 16. 2 Ibid., p. 17. [30] 'rate of return' is the central problem of capital theory) 3 time preference is ignored and a 'technocratic' view taken. 1 Secondly, when confronting a serious problem in a market economy, the neo-classical mind seems unable to view it in the perspective of savers and investors, those who in reality have to solve it. It must be viewed instead in the perspective of a hypothetical planner. We conclude that economists who propound such recipes are not really interested in how the market economy functions, and that those who are have little to learn from them. In any case, the overall inter-temporal rate of exchange provides only a floor level. Evidently no lower rate of profit is possible. To this we may add that in a loan market in which financial institutions, fairly expensive to run, are important lenders, interest rates must be high enough to enable them to cover their costs. So much, following Sir John Hicks, an eminent neo-classical economist, we may take over from Keynes's liquidity preference 2 . This provides us with another, and prob- ably higher, floor level. But in any normal situation in a market economy profits are, of course, considerably in excess of this level, and capital lenders will adjust their demands to what they feel borrowers are able to pay. There must, of course, be equilibrium in the loan market. The demand is governed by profits expected to be earned on capital at present completely mobile (Tree capital', Gassel's 'capital disposal') when it is invested, and this in its turn depends on the constellation of price-cost differences, present and expe

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