Kaldor on the Irrelevance of Equilibrium Economics

Walrasian general equilibrium theory is the greatest obstacle to the development of economics as a science.

That is the bold contention of Nicholas Kaldor in his article “The Irrelevance of Equilibrium Economics” (Economic Journal 82 [1972]: 1237–1252), and it is undoubtedly true.

One can summarise Kaldor’s argument as follows:

(1) General equilibrium (GE) theory was invented by Walras, but found one of its major 20th century developers in the French economist Gerard Debreu.

At the time Kaldor was writing, Debreu’s Theory of Value: An Axiomatic Analysis of Economic Equilibrium (1959) was a notable exposition of the mathematised Walrasian general equilibrium theory.

Kaldor notes how the book does not purport to be an empirical description of reality, as, for instance, in describing how prices are actually formed in the real world (Kaldor 1972: 1237).

GE theory is an example of the aprioristic or deductive method in economics: a formal system in which a set of theorems are logically deduced from certain assumptions (Kaldor 1972: 1237). But there is no real attempt to verify whether the assumptions are true, or whether its system of established equilibrium prices has any explanatory power or even relevance to actual market economies (Kaldor 1972: 1238).

Amongst the unverified and plainly unrealistic assumptions of neoclassical theory are:

(1) that producers maximise profits;
(2) the existence of perfect competition;
(3) linear-homogenous and continuously differentiable production functions;
(4) impersonal market relations;
(5) information communicated by market clearing prices; and
(6) perfect knowledge of all relevant prices and perfect foresight. (Kaldor 1972: 1238).

Another delusional assumption is that real economies can approach, or are close to, a state of equilibrium (Kaldor 1972: 1239).

Kaldor rightly rejects all these neoclassical assumptions as untrue, and concludes that the main theorems of neoclassical theory “cannot possibly hold in reality” (Kaldor 1972: 1240).

(2) Kaldor argued that where modern economics went wrong – both in Classical political economy and neoclassical economics – was a fixation with the theory of value, or a deeply mistaken theory of prices, in which the question of how value and price are determined for factor inputs and products takes central stage (Kaldor 1972: 1241). The major flaw in this enterprise has been the assumption of constant returns to scale (Kaldor 1972: 1241).

But modern capitalism based on technology, innovation and mass production has increasing returns to scale as its fundamental trait in many industries (above all, manufacturing) (Kaldor 1972: 1242). Division of labour is not only applicable to working human beings, but also to labour-saving machinery and technology. When mass production occurs in industry and output is large, it pays to invest in or implement labour-saving machinery. The capital–labour ratio in production is therefore more a function of market scale than the prices of relative factor inputs (e.g., the price of labour versus machinery) (Kaldor 1972: 1242).

Kaldor sees these insights as revolutionary in their ability to overthrow neoclassical theory: once we assume that the production of most commodities is subject to increasing returns to scale, the whole notion of general equilibrium theory itself must be thrown side (Kaldor 1972: 1244). Why? Because a major assumption of neoclassical theory is that a convergence to an equilibrium state is governed by exogenous forces such as unchanging production patterns over time (Kaldor 1972: 1244).

But once increasing returns to scale are assumed, the dynamic system has endogenous forces that drive it in ways away from equilibrium.

(3) Kaldor moves on to another issue by the end of his paper, which is the nature of buffer stocks in modern economies.

In primary product markets, which tend to be a rough equivalent of competitive flexprice markets, stocks are carried by merchants who are independent of producers and consumers. These dealers carry stocks that act as buffers.

But in other markets where increasing returns to scale exist often producers carry their own stocks and adjust their output in response to demand (Kaldor 1972: 1250).

The ability to increase production in response to demand is achieved in modern capitalism by an endogenous money supply: a banking and monetary system where capital investment can be financed by new money.

Kaldor notes that

“This is the real significance of the invention of paper money and of credit creation through the banking system. It provided the pre-condition of self-sustained growth. With a purely metallic currency, where the supply of money is given irrespective of the demand for credit, the ability of the system to expand in response to profit opportunities is far more narrowly confined.” (Kaldor 1972: 1250).

BIBLIOGRAPHY
Debreu, Gerard. 1959. Theory of Value: An Axiomatic Analysis of Economic Equilibrium. Wiley, New York and London.

Kaldor, N. 1972. “The Irrelevance of Equilibrium Economics,” Economic Journal 82: 1237–1252.