Keynes’s Marginal Efficiency of Capital: A Mistake?

It is very interesting to note what Joan Robinson thought of Keynes’s notion of the marginal efficiency of capital:

“[sc. Keynes] made a fatal mistake in offering a quasi-long-period definition of the inducement to invest as the ‘marginal efficiency of capital’, that is, the profit that will be realised on the increment to the stock of capital that results from current investment and, still worse, identified the profitability of capital with its social utility. This was an element in the old doctrine from which he failed to escape. He had an alternative concept of the inducement to invest as the expected future return on sums of finance to be devoted to investment. Minsky (1976) points out that he did not seem to recognise the difference between the two formulations. If he had stuck to his short-period brief, he would have used only the second.” (Robinson 1979: 179–180).

I have seen other criticisms of the marginal efficiency of capital idea, on the grounds that Keynes, in developing it, failed to free himself from the neoclassical marginal productivity of capital (King 2002: 209). Keynes was also influenced by Sraffa’s own rates of interest concept (Barens and Caspari 1997: 294). In fact, Knut Wicksell’s natural interest rate concept, by one of his definitions, appears rather similar to the marginal efficiency of capital:

“The rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yields on the newly created real capital, will then be the normal or natural rate. It is essentially variable. If the prospects of employment of capital become more promising, demand will increase and will at first exceed supply; interest rates will then rise as the demand from entrepreneurs contracts until a new equilibrium is reached at a slightly higher rate of interest. At the same time equilibrium must ipso facto obtain—broadly speaking, and if it is not disturbed by other causes—in the market for goods and services, so that wages and prices remain unchanged” (Wicksell 1934: 193).

The natural rate or “the expected yields on the newly created real capital” is the analogue of the marginal efficiency of capital (Uhr 1994: 94). But Keynes’s marginal efficiency of capital is arguably not a “real” concept: the marginal efficiency of capital is a rate expressed in terms of money.

BIBLIOGRAPHY

Barens, I. and V. Caspari, 1997. “Own-Rates of Interest and Their Relevance for the Existence of Underemployment Equilibrium Positions,” in G. C. Harcourt and P. A. Riach (eds.), A “Second Edition” of The General Theory (Vol. 1), Routledge, London. 283–303.

Harcourt, G. C. and P. A. Riach. 1997. A “Second Edition” of The General Theory (Vol. 1), Routledge, London.

King, J. E. 2002. A History of Post Keynesian Economics since 1936, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Lawlow, M. S. 1994. “The Own-Rates Framework as an Interpretation of the General Theory: A Suggestion for Complication the Keynesian Theory of Money,” in J. B. Davis (ed.). The State of Interpretation of Keynes, Kluwer Academic, Boston and London. 39–90.

Robinson, J. 1979. “Garegnani on Effective Demand,” Cambridge Journal of Economics 3: 179–180.

Uhr, C. G. 1994. “Knut Wicksell – A Centennial Evaluation,” in J. Cunningham (ed.), Knut Wicksell: Critical Assessments (vol. 3), Routledge, London. 72–103.

Wicksell, K. 1934. Lectures on Political Economy (trans. E. Classen), Routledge & Kegan Paul, London.

Krugman, Hayek versus Keynes and the Austrians

A bitter debate has broken out in the blogosphere about Hayek and what his legacy and influence was in modern economics.

The opening shot is fired by David Warsh, and then followed by Paul Krugman in a post that I am quite sympathetic to, as it happens:

David Warsh, “Ruizismus among the Austrians,” Economicprincipals.com, December 4, 2011.

Paul Krugman, “Things That Never Happened In The History Of Macroeconomics,” December 5.

Other relevant anti-Hayek views:

Robert Vienneau, “On Hayek’s Lack Of Impact On Macroeconomic,” Thoughts On Economics, December 9, 2011.

Pro-Hayek responses are here:

Steven Horwitz, “Rizzo on Hayek vs. Keynes,” Coordination Problem, December 7, 2011.

Alex Tabarrok, “Hayek and Modern Macroeconomics,” Marginal Revolution, December 6, 2011.

“Hey Paul Krugman, Leading Economists Have Been Talking About Hayek’s Macro Throughout the Boom & Bust,” Cafehayek.com, December 5th, 2011.

Mario Rizzo, “Yes, Paul: It is Hayek versus Keynes,” ThinkMarkets, December 7, 2011.

The comments on Rizzo’s post are well worth reading as well, and above all this comment by Roger Koppl.

I will have much more to say about this soon, but some quick points:

(1) It is astonishing how quickly Austrians move to defend Hayek’s business cycle theory, when that is probably an example of one of his worst failures. Why do they persist in defending a theory based so obviously on neoclassical equilibrium models, when the latter are supposedly contrary to Austrian theory?

(2) When Krugman says that “Hayek essentially made a fool of himself early in the Great Depression,” he is entirely correct. There are two reasons why. The first is that his business cycle theory - while it certainly got traction at the LSE - was greeted with derision by economists at Cambridge in the tradition of Marshall:

“Immediately before giving his early 1931 lectures at LSE, which were his introduction to the school, Hayek gave a one-lecture to the Keynes-dominated Marshall Society at Cambridge. Richard Kahn, one of Keynes’ followers and later his literary executor, described the scene. Hayek had “a large audience of students, and also of leading members of the faculty. (Keynes was in London.) The members of the audience—to a man—were completely bewildered. Usually a Marshall Society talk is followed by a lively and protracted barrage of discussions and questions. On this occasion there was complete silence. I felt I had to break the ice. So I got up and asked, ‘Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?’ ‘Yes,’ said Hayek. ‘But,’ pointing to his triangles on the board, ‘it would take a very long mathematical argument to explain why’” (Ebenstein 2003: 53).

Secondly, Hayek retreated from the stupidity of his liquidationism that he had held in the early 1930s:

“Although I do not regard deflation as the original cause of a decline in business activity, such a reaction has unquestionably the tendency to induce a process of deflation – to cause what more than 40 years ago I called a ‘secondary deflation’ – the effect of which may be worse, and in the 1930s certainly was worse, than what the original cause of the reaction made necessary, and which has no steering function to perform. I must confess that forty years ago I argued differently. I have since altered my opinion – not about the theoretical explanation of the events, but about the practical possibility of removing the obstacles to the functioning of the system in a particular way” (Hayek 1978: 206).

(3) The later Hayek is found endorsing monetary stabilisation and giving qualified support for fiscal policy, positions which are essentially Keynesian:

“Did Hayek Advocate Public Works in a Depression?,” September 25, 2011.

Funny how these, especially point (3), have gone down the memory hole.

There are many other things to be said, and I intend to update this post after some more reading.

UPDATE

Some additional literature worth reading that is mentioned in this comment by Roger Koppl on Rizzo’s ThinkMarkets post:

Butos, W. N. and R. Koppl, 1997. “The Varieties of Subjectivism: Keynes and Hayek on Expectations,” History of Political Economy 29.2: 327–359.

Koppl, R. and W. J. Luther, 2011. “Hayek, Keynes, and Modern Macroeconomics,” Review of Austrian Economics (July): 1-19.
This paper can also be downloaded through the Social Science Research Network (SSRN).

Prychitko, David L. 2010. “Competing Explanations of the Minsky Moment: The Financial Instability Hypothesis in Light of Austrian Theory,” Review of Austrian Economics 23: 199-221.

BIBLIOGRAPHY

Ebenstein, A. O. 2003. Friedrich Hayek: A Biography, University of Chicago Press, Chicago, Ill. and London.

Hayek, F. A. von. 1978. New Studies in Philosophy, Politics, Economics, and the History of Ideas, Routledge & Kegan Paul, London.