From the Academic Files – Anonymous Student’s Essay: “Demand-Led Growth Theory and its Enemies”

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. R.M.S.)

Student Response. Roy Harrod’s famous ‘knife edge’ (though he is said frequently to have denied it being a 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.


4 thoughts on “From the Academic Files – Anonymous Student’s Essay: “Demand-Led Growth Theory and its Enemies”

  1. I hew to the idea of reflexivity, i.e., a circular relationship between cause and effect. Most things in the economy are reflexive in nature.

    Take the example of the Great Depression. You have high unemployment, which in turn causes people to cut back on spending, which in turn compounds the unemployment problem. Unemployment causes unemployment. In the Great Depression, the economy was stuck in a reflexive trap.

    Or take the example of a Latin American economy experiencing hyperinflation. As people see the value of their money erode, they spend it as fast as they can, which in turn causes further inflation. Inflation causes inflation. This is another example of a reflexive trap.

    And you will find that this reflexive effect crosses over into other areas of the economy. For example, rising unemployment leads to a reduction of spending which means falling corporate profits which in turn means falling stock prices. The negative wealth effect on consumption kicks in and that in turn drives both unemployment higher and the stock market lower. A falling stock market leads to a falling stock market.

    In good times, the effect works in reverse, as rising corporate profits leads to rising stock prices which leads, again, through the wealth effect, to greater spending, which in turn increases employment. All in a virtuous cycle.

    All this reflexivity means that the economy, if left alone, is unstable and tends toward disequilibrium. Hence, the requirement for government to intervene, as the case may be, to keep the economy stable.

    The job of a government is to break the reflexive cycle and kill the fear that is causing it. The fear of job loss in the first case or the fear of money losing its value in the latter case.

  2. So, the fact that capitalism is not that unstable is attributable to actions of government? What happens if government fails to break the reflexive cycle? What mechanism then limits the instability?

  3. @ Richard McGee,

    There is no need for there ever to be a business cycle. An issuer of fiat currency, and having powers of taxation, can set always set aggregate demand at potential GDP, as the following quote from Abba Lerner shows (this is known as Functional Finance):

    “The central idea is that government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound and what is unsound … The principle of judging fiscal measures by the way they work or function in the economy we may call functional finance.The first responsibility of the government (since nobody else can undertake the responsibility) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce. If total spending is allowed to go above this there will be inflation, and if it is allowed to go below this there will be unemployment. The government can increase total spending by spending more itself or by reducing taxes so that taxpayers have more money left to spend. It can reduce total spending by spending less itself or by raising taxes so that taxpayers have less money left to spend. By these means total spending can be kept at the required level, where it will be enough to buy the goods that can be produced by all who want to work, and yet not enough to bring inflation by demanding (at current prices) more than can be produced.”
    —Abba Lerner

    The 2008 recession was a balance-sheet recession. People stopped spending in order to repair the holes in their balance sheets. The government should have helped them to do just that, i.e., a helicopter drop. The recession would have lasted all of about five minutes.

    Have the government issue cheques for $10k to every household in the country. Keep issuing cheques and watch the output gap close. When you reach full potential, stop issuing cheques. If inflation arises, start taxing.

    Monetary policy is useful for fine tuning an economy but it is fiscal policy that does the heavy lifting. The government’s power over the economy is absolute. There is never any need for anyone to suffer. All this is caused by economic ignorance.

  4. It was fascinating reading this. I was only reading some stuff on Bill Mitchells website which made me question why governments are so adverse to the idea of eliminating business cycles, JG programs, and so forth.

    Would we agree that if any government acted the way it should as per Abba Lerner, that the country itself would become extremely prosperous in relative terms (compared to other countries)?

    Could this be what is actually feared, on account of the fact that it would create envy from other countries, create huge surges in migration, and so forth. It seems to me that if any country wishes to employ this model it is really only going to work if everyone does it.


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