Practice Exam Question. “Capitalism is unstable, but not that unstable.” Explain and discuss this statement with special reference to Harrod’s knife-edge problem and modern developments in growth theory. (Please take this exercise seriously and treat like a real exam. You will be glad you did come finals.)
Student Response. Roy Harrod’s famous ‘knife edge’ suggested a capitalist susceptibility to extreme instability in which, other than at the ‘warranted’ rate of growth, the economy would either shrink to zero or explode toward hyperinflationary infinity. Because capitalism, though unstable, is clearly not that unstable, economists scrambled to find a reason for the system’s track record of not being that unstable.
Such were the sharply defined incentives of the collegiate environment, and the urgency of the scramble, that within seventeen short years Robert Solow had devised an explanation satisfactory to many economists. If (i) the capital-to-output ratio is allowed to vary, instead of being taken as fixed, and (ii) the price mechanism can be relied upon to give ‘factor substitution’ full sway as well as to adjust demand automatically to a full-employment steady-state growth rate, then far from being unstable, capitalism can be seen to be very tranquil indeed.
Though instantly popular, this solution was not considered satisfactory by everyone. (Not absolutely everyone.) It ran afoul of dissenters who, before long, claimed that support for their skepticism could be found in the indecipherable mathematical squiggles of the Cambridge Capital Controversy. The skeptics felt, on the strength of these squiggles, that a capitalist economy could not really be so tranquil and looked for alternative explanations of why it might instead be rather unstable, just not that unstable.
One such explanation put forward was the existence in reality, though for reasons of simplicity not in Harrod’s original theoretical model, of expenditures that (i) are autonomous of the circular flow of income and (ii) do not add directly to the economy’s productive capacity. These can be described, unfortunately, as ‘non-private-sector-capacity-generating autonomous expenditures’. As freshmen, we knew them as ‘autonomous consumption’, ‘government spending’ and ‘exports’, but Harrod apparently felt the need to assume away Economics 101 to avoid unnecessary complications.
Now, proponents of demand-led growth, who seem to use a lot of long sentences, hold that if the modeling of this kind of expenditure is coupled with the realistic assumption (though don’t hold that against it) that most firms operate with planned margins of spare capacity to meet unanticipated fluctuations in demand, then there might be room for private investment induced by autonomous expenditure to have its immediate demand impacts before its lagged capacity effects without sending the entire economy into either a permanent stupor or utter tizz. Frankly, the economy would have more wiggle room.
Theories of demand-led growth, such as the one just outlined, are still with us today, but face an old enemy in new clothing whose most striking contributions have been to (i) deny the relevance of the indecipherable mathematical squiggles of the capital controversies and (ii) repackage certain ideas of Adam Smith and David Ricardo into the aptly named (well, why not?) New Growth Theory.
To this day, the opposing theorists of growth battle it out, albeit in different corners of the academy, rarely citing each other or admitting at parties to having read each others’ work, in efforts to establish once and for all why capitalism, whether very tranquil indeed or really quite unstable, is clearly not that unstable.