Economic Theory

As early as 1966, in his comments on the defence of the marginal productivity theory of distribution by Paul Samuelson and Franco Modigliani, Kaldor had criticised neoclassical economic theory for its intellectual sterility. Quite apart from their highly questionable assumption of a well-behaved, linear homogeneous aggregate production function, neoclassical economists were unable to deal with increasing returns to scale, learning by doing, oligopolistic competition or uncertainty, all important features of the real world, which Kaldor described as being ‘non-Euclidean’ in nature. He developed these themes in subsequent critical work, including his 1972 Presidential Address to the Royal Economic Society, the Prefaces that he wrote in the late 1970s and early 1980s to the various volumes of his collected essays and in the Raffaele Mattioli Lectures that he gave in Milan in 1984, two years before his death. Kaldor emphasised several themes: the methodological problems that were raised by the use of equilibrium theorising, in particular for the theory of economic growth; the macroeconomic implications of a non-perfectly competitive economy; international issues, including the theory of trade and the prospects for global economic development; and the analytical and policy issues posed by the theory of endogenous money.

Kaldor regarded the habits of thought engendered by equilibrium theorising as a major obstacle to the development of economics as a science.

They required assumptions that were either unverifiable or directly contradicted by the evidence and distorted the focus of economic analysis, moving it away from the dynamic, creative functions of markets to a concentration on their static allocative functions. These errors were closely related to the assumption of constant rather than increasing returns to scale, which had led economists to ignore the forces of cumulative causation emphasised by his former UNECE colleague Gunnar Myrdal. Thus they had led them also to neglect history.

Once increasing returns to scale were allowed for, Kaldor maintained, the forces making for continuous change must be viewed as endogenous, and equilibrium states must be seen as path-dependent so that the end-state itself was no longer independent of the route taken towards it. This cast doubt on the entire Walrasian project, which had also gone astray by exaggerating the role of substitution and playing down the essential complementarity between different factors of production and different types of economic activity. Complexity theory and agent-based modelling were still in their infancy when Kaldor died, but he would probably have been intrigued by both projects.

There were significant implications also for macroeconomic analysis, not least for the theory of growth. The phenomena of increasing returns, cumulative causation, and path dependency reinforced Kaldor’s insistence on the endogenous nature not only of technical change but also of the supply of labour and capital. This endogeneity was inconsistent with Harrod’s notion of a ‘natural’ rate of growth that was given by the supposedly exogenous growth rates of the labour force and of technical progress. Here, Kaldor was on firm ground. His interpretation of the short-period macroeconomic consequences of increasing returns is less easy to justify. Unduly influenced by the Harvard theorist Martin Weitzman, he came to believe that the Keynesian principle of effective demand required imperfect competition and so was inconsistent with Keynes’s own assumption of perfectly competitive product markets. In effect, this was an endorsement of New Keynesian microfoundations for macroeconomic theory, though Kaldor himself never used the term. He would certainly have objected to the dynamic stochastic general equilibrium (DSGE) models with sticky prices that have come to dominate the New Keynesian variant of the New Neoclassical Synthesis in the three decades since his death.

Kaldor’s hostility to equilibrium theorising also made him increasingly critical of the orthodox theory of international trade, with its presumption that protection was always welfare-reducing. This was true under constant returns to scale, he conceded, when free trade would benefit all participants. It was a different matter under increasing returns, when trade would tend to enlarge differences in comparative costs instead of reducing them. Thus free trade might be disadvantageous to poor countries, and to poor regions within rich countries, leading to an increasing gap between prosperous and depressed areas. Applied to the world as a whole, this led him to reassert his earlier views on global economic development in the form of a North- South model in which primary producers, who enjoyed neither increasing returns nor oligopolistic product market power, tended to fall further and further behind the industrialised countries, which benefited from both.

Kaldor’s initial attack on the new monetarism came in a public lecture in March 1970, which was published four months later in the widely circulated Lloyds Bank Review. He raised strong objections to Milton Friedman’s econometrics and his interpretation of US economic history but now emphasised a fundamental theoretical question: the endogeneity of the stock of money. The rate of change of the money supply, Kaldor argued, was not under the direct control of the monetary authorities, as the monetarists maintained. On the contrary, changes in the money supply were determined by the rate of change of money incomes, and thus depended on the factors that influenced this magnitude: on changes in the pressure of demand (including domestic investment, exports, and fiscal policy) and on the rate of wage inflation. Even more clearly than in his evidence to the Radcliffe Committee, Kaldor now insisted that the direction of causation in the quantity equation (MV = PT) ran from right to left, not from left to right: changes in the price level (P) and the level of output (proxied by T, the volume of transactions) caused changes in the stock of money (M) and in the velocity of circulation (V).

Ten years later, with the Thatcher government in power and what Kaldor described as ‘the scourge of monetarism’ now being wielded against the British working class, he drew one of the most influential diagrams of the era. Monetarism assumed a vertical money supply curve, with the stock of money as a fixed multiple of the quantity of reserves. Kaldor’s theory of endogenous money entailed a horizontal curve, with the supply of money being perfectly elastic at the prevailing interest rate set by the monetary authorities. This was a remarkably original contribution to the debate on monetarism. Not even severe critics of Friedman’s approach, like the American Post Keynesians Paul Davidson and Basil Moore, had gone this far.

With the benefit of hindsight it can be seen that Kaldor won the battle but lost the war. British and American experience in the 1980s proved that the stock of money could not be controlled by the authorities, for precisely the reasons that Kaldor had given: it was an endogenous, not an exogenous, variable. The Taylor rule established the rate of interest as the critical—indeed, the only—instrument of monetary policy, just as Kaldor had always insisted.

But the New Neoclassical Synthesis that emerged in the decade after his death would have been abhorrent to him for several reasons, including its abandonment of any explicit commitment to full employment, its rejection of fiscal policy, and the requirement that central banks be ‘independent’—indepen- dent of democratic control by parliament, he would have complained, but increasingly and dangerously dependent on financial markets.

Kaldor repeated many of these arguments in the Mattioli Lectures, which were the closest that he ever came to writing a theoretical treatise, along the lines of Keynes’s General Theory or Robinson’s Accumulation of Capital. As he himself admitted, his views were constantly changing and never sufficiently coherent or systematic to be put down in a single lengthy work. Still less did he ever contemplate writing an undergraduate textbook (in view of the commercial and intellectual failure of the 1973 Robinson-Eatwell An Introduction to Modern Economics, this was probably no bad thing). But his ideas on theoretical questions were always interesting and often original and provocative, as even a strong opponent like Frank Hahn conceded, after Kaldor’s death (Hahn 1989).