The Distribution of Income Between Labour and Capital: Inflation and Growth
One of the key themes of the Cambridge School was the emphasis which it placed on the distribution of income between labour and capital, and its importance for the macro economy. This was the topic of one of Rowthorn’s earlier and most influential papers, ‘Conflict, Inflation and Money’, published in the Cambridge Journal of Economics in 1977. He expanded the article into a book, Capitalism, Conflict and Inflation, which was awarded the Isaac Deutscher Memorial Prize in 1981. The Cambridge view of the role of income distribution in macroeconomics is in sharp contrast to that of mainstream, neoclassical economics. General equilibrium, for example, is consistent with any distribution of income.
The Cambridge view was inspired by the works of David Ricardo. Although his work was almost entirely theoretical, Ricardo wrote as a political economist, seeking to understand the key issues of his day. A crucial one, of course, was the entirely new phenomenon of industrial capitalism. This was clearly something completely different to anything which had ever existed before. But in the early nineteenth century, when Ricardo was writing, it was not at all clear that the system was sustainable. It might disappear just as quickly as it had emerged. Ricardo placed great emphasis on the distribution of income between capital and labour. An appropriate balance between the two had to be struck in order for long-run economic growth to continue.
Marx also placed great emphasis on the role of factor shares in the evolution of capitalism. It was only later in the nineteenth century, following the work of Jevons and Walras, that economics lost this focus. Economic theory became concerned instead with the problem of refining and making more precise the conditions under which prices which cleared all markets could be found. In many ways, it was a very strange problem for economics to focus on. The theory refers to the most efficient allocation of resources in a purely static world. Given a fixed amount of resources of all kinds, including labour, could a set of prices be found which would clear all markets? It was strange because by the late nineteenth century, the Industrial Revolution was a century old. For the first time in human history, a social and economic system had emerged in which the total amount of resources available was being continually expanded. There may be, indeed there were, short-term fluctuations in total output, but the underlying trend in total output was unequivocally upwards.
The luminaries of the Cambridge School, such as Kaldor, Robinson, and Sraffa, tried to revive the view that income distribution plays a central role in capitalism. This is the background to Rowthorn’s 1977 paper. A key policy question of the time was inflation. During the 1950s and 1960s, inflation had been positive but low throughout the West, at generally similar rates across the main economies. During the 1970s, for a variety of reasons, not least the quadrupling of the oil price in 1973-1974, inflation surged into double figures in many countries. Some, such as Germany, succeeded in bringing price rises back under control. In others, such as Italy and the UK, it rose to an annual rate of more than 20%. The various attempts to squeeze inflation down to permanently lower levels were the central theme of economic policy in the West for at least the next two decades.
Rowthorn addressed this crucial issue of political economy from a Cambridge perspective. In his model, labour and capital aspire to particular shares of national income. Workers try and meet their target by securing increases in the nominal wage, and capitalists in turn use price increases in an attempt to secure theirs. If the two shares are compatible and sum to total income, inflation remains constant. But if the sum of the desired shares exceeds national income, the result is accelerating inflation. One problem which capitalists face is that there is resistance on the part of the workers to reductions in the real wage. This is overcome by the use of monetary policy, which affects not inflation directly, but output and hence unemployment. The Marxist concept of the ‘reserve army of labour’ is invoked, with unemployment being used deliberately as a means of controlling inflation.
This brilliant article explained both the contemporary experience in the West in the 1970s and more general aspects of the inflationary process in the capitalist economies. The paper has received almost 500 citations, but it surely has the potential to become what I might term a ‘sleeping giant’. Two such papers spring immediately to mind. Armen Alchian’s 1950 paper (Alchian 1950) on evolution and economic theory was decades ahead of its time, anticipating many of the developments in the mathematical theory of evolution in the 1990s and beyond, and dealing ruthlessly with the argument that it is ‘as if’ firms adopt profit-maximising strategies because only the fittest, following such a rule, can survive. Herbert Simon’s 1955 paper (Simon 1955) on behavioural economics is the other, in which he introduces the concept of satisficing, a term which has subsequently been transformed in meaning by mainstream economists and safely neutered. For many years, both papers suffered from relative neglect, but they now have around 5,000 and 11,000 citations, respectively. The theoretical analysis of inflation set out by Rowthorn in his model is, to my mind, of similar intellectual stature.
The oil price shock of 1973-1974 had an obvious and immediate impact on inflation in the developed economies by increasing the cost of inputs. But it was the distributional consequences which explained the subsequent huge divergence in inflation rates between countries. In the short term, until the OPEC countries worked out how to spend their new-found surpluses, the oil price rise was an effective tax on the West. It transferred real national income from the oil-consuming to the oil-producing economies. The willingness of labour to both recognise and respond to this was a crucial determinant of inflation in 1975 and 1976. Rowthorn’s concept of real wage resistance was the key factor. In Germany, workers were willing to accept real wage cuts, and by 1976 inflation was only 6%. In contrast, in the UK it was still around 15%. The attitudes of the British labour force were undoubtedly militant, exemplified by the miners’ dispute in early 1974 which led to the defeat of the Conservative government in an election called explicitly on the question ‘Who Governs Britain?’ But the institutional structure of wage setting itself was a major barrier to real wage reductions. In late 1973, the government had agreed a system under which wage increases were brought in almost instantaneously after a particular rate of inflation had been reached. Real wage resistance was effectively institutionalised.
Inflation did moderate from its 1975 peak, in part due to the effects of higher unemployment and in part due to the income policies negotiated with the trade unions by the then Labour government. But even by 1981 it was still in double figures. The Thatcher government, elected in 1979, used tight monetary policies to try to control inflation. But the immediate effect was to generate a sharp recession, comparable in size to that of the 2008-2009 financial crisis drop in output. The unemployment rate, already very high by postwar standards, doubled. Exactly as Rowthorn’s model predicted, monetary policy was used to discipline labour and control inflation, which fell sharply.
The breakdown of the Phillips curve meant that economics needed a new theory of inflation. Rather it needed a theory, because the curve was simply an empirically observed relationship, with no formal theoretical basis other than a sort of handwaving around supply and demand. Milton Friedman and Edmund Phelps rose to the challenge and developed the so-called natural rate of unemployment in the 1960s. As Friedman stated in his famous Presidential Address to the American Economic Association in 1968:
[T]he [natural rate] is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labour and commodity markets, including market imperfections, stochastic variability in demands and supplies, the costs of gathering information about job vacancies, and labor availabilities, the costs of mobility, and so on (Friedman 1968: 8).
The natural rate fairly quickly morphed into the non-accelerating inflation rate of unemployment (NAIRU). The NAIRU is not necessarily time- invariant and can change over time, as the various factors set out by Friedman above evolve. But we might reasonably think that such changes would generally proceed only slowly. More generally, at any point in time, it is implied that there is a unique rate of unemployment consistent with constant inflation. Rowthorn’s model has many similarities with this mainstream approach.
A key difference, however, is that for any given set of institutional structures and any imperfections which they might introduce into the workings of the labour market, non-accelerating inflation is compatible with a wide range of unemployment rates. The key determinant is the consistency of the demands for factor shares by labour and capital.
This prediction of the model appears to be supported by the evidence. Over the 1871-2014 period, for example, the statistical technique of fuzzy clustering identifies three distinct regimes[1] in inflation/unemployment space for each of the three main Western economies over this period, the USA, Germany, and the UK.2 The most frequently observed is the cluster with both low unemployment and low inflation. High growth, and consequently low unemployment, may make it easier for the demands of labour to be met and is therefore consistent with low unemployment. This cluster, for example, characterises the post-war period until the early 1970s. The second cluster contains years with a similar level of inflation to the first, but with an average unemployment rate which is more than doubled. Typical observations in this cluster are from the early 1980s to the late 1990s, when, as mentioned above, monetary policy was used as an instrument to regulate real output. The final cluster, the least frequent in occurrence, has unemployment similar to the first cluster, but very much higher average inflation, well into double figures. Characteristic years here are the First World War, a time of acute struggle between capital and labour and a time when the government feared insurrection on Soviet lines, and the enormously disruptive period embracing most of the 1970s. These are times when historical evidence makes it very clear that not only was consensus over the distribution of factor shares lacking but labour was sufficiently powerful to try to enforce its claims. The episode of the 1970s ended as described above, and the experience of almost a century ago was terminated abruptly by the recession of 1921, by far the most serious drop in output in a single year ever experienced in the UK.
Rowthorn’s appreciation of the importance of the distribution of income between labour and capital has been a consistent theme in his writings. Indeed, one of his most recent papers uses his understanding to mount a devastating theoretical and empirical critique of Piketty’s best-selling book Capital in the Twenty-First Century. Published in 2014 in the Cambridge Journal of Economics, a journal much favoured by Rowthorn over the years, the article
cluster.
2 See Ormerod et al. (2013).
embodies the hallmarks of his work. A complete grasp of economic theory is combined with careful and meticulous understanding and analysis of the data. It also, as an aside, illustrates Rowthorn’s very generous nature. Although his criticisms are powerful, he nevertheless tries to see good in everything and describes Piketty’s book as ‘brilliant’ (Rowthorn 2014a: 1,275).
Rowthorn’s summary of the book could not be bettered:
[I]t shows how the share of income accruing to wealth-owners has increased dramatically in recent decades. It also provides a simple explanation of this development based on the standard neoclassical theory of factor shares. This theory establishes a link between the capital intensity of production and the share of profits in total output. The nature of this link depends on the elasticity of substitution between capital and labour. When this elasticity is greater than unity, an increase in the capital-output ratio leads to an increase in the share of profits. This, in essence, is Piketty’s explanation for the increased share of wealth-owners in national income. Thus, the shift in income distribution is due to the over-accumulation of capital: there has been too much real investment (ibid.).
As Rowthorn points out very clearly, the evidence suggests just the contrary. Many studies, in an area in which Bob has been actively involved over the years, show that the elasticity of substitution between capital and labour is in fact less than one. The capital-output ratio, as conventionally measured, has either fallen or been constant in recent decades. The apparent increase in the capital-output ratio identified by Piketty is a valuation effect reflecting a disproportionate increase in the market value of certain assets, a point which Rowthorn uses Piketty’s own data to demonstrate. A more plausible explanation for the increased income share of wealth owners is an unduly low rate of investment in real capital. Projecting ahead into the rest of the twenty-first century, Piketty assumes that capitalism will only deliver low rates of growth. One does not have to believe in the perfect functioning of markets to imagine that, if this were to be the case, at some point there would be a large downward revision of asset values, and that so much of the inequality generated in recent decades would disappear.
Economics is inevitably a discipline in which political values are invariably present, no matter how hard mainstream economists have tried to establish claims that it is value-free. Rowthorn certainly has his political views, but his writings are marked by their scientific candour and honesty. In the face of Piketty’s book, many Cambridge-trained (or inspired) economists tend to be blinded by their political sympathies. Rowthorn approached the book as objectively as possible and found it flawed. He applied his deep knowledge of both neoclassical and Marxist theory to arrive at his conclusion.
Rowthorn’s passion for scientific truth is shown clearly in a 1975 article, a thorough empirical demolition of what was then a fashionable and influential concept known as Kaldor’s Law. Kaldor was then one of the dominant figures if not the dominant figure in Cambridge economics. In addition, he had exercised substantial, direct influence over the 1964-1970 Labour government. One of its most controversial measures, the Selective Employment Tax, was almost entirely due to the content of his Inaugural Professorial Lecture in Cambridge, in which he set out his so-called law. Rowthorn was by then reasonably well established in Cambridge, although still very much junior to Kaldor in terms of status and influence. To add piquancy to the setting, both were Fellows of King’s.
Kaldor claimed that a strong positive relationship existed between productivity growth and output growth in the manufacturing sector. From this, he drew the conclusion that the UK’s poor manufacturing performance by international standards required labour to be shifted from the services sector to manufacturing, hence his tax on employment in the services sector. Kaldor’s empirical findings were criticised, and two young members of the Department of Applied Economics, Francis Cripps, one of the anointed princes of Cambridge economics, and Roger Tarling defended him.
Rowthorn’s short paper on this, published in the Economic Journal, another favourite Rowthorn outlet, is a model of careful applied econometric analysis. One key point, in an object lesson to many young econometricians today, is that he takes the trouble to understand the data. The econometric technique he uses is simple, but the paper is nonetheless devastating. Essentially, Rowthorn showed that, in the international data sets used in the analysis, Japan was clearly an outlier. Not just that, but this single country exercised a decisive influence on the results which were obtained by Kaldor to support his thesis. Nowadays, of course, measures based upon the hat matrix of a regression can be used to formalise this, but Rowthorn’s results speak for themselves.
Entirely typically, when Rowthorn revisited this area, in a 1979 paper also in the Economic Journal, in his final generous remark, he notes, ‘My own views on this matter have changed since I criticised Kaldor for his emphasis on dynamic economies, and I now think they are of great practical importance’ (ibid.: 133, fn. 1). This article is not empirical but theoretical and offers a strong critique of Verdoorns Law, derived from a mathematical model developed by Verdoorn in 1949 and which underpinned much of the kind of empirical analysis carried out by, for example, Kaldor. The gem of Rowthorn’s paper is its opening paragraph, which contains the marvellous sentence, ‘[Verdoorn’s] article is frequently cited in British and American literature, yet, as far as I am aware, has never been published in English, and does not seem to have been read very carefully by those who cite it’ (ibid.: 131). Again, this is entirely typical of Rowthorn. He took the trouble to read the paper in its original Italian. Rowthorn, it should be said, has a talent for languages and can read several European ones with fluency. For example, he has recently established a small study group which reads Wittgenstein. Rather than rely upon English translations, Rowthorn reads the original German edition of Tractatus Logico-Philosophicus, published in 1921.
- [1] With the exception of the hyperinflation in Germany from 1921 to 1924, which is a unique fourth
