TRANSFORMATIONAL GROWTH AND

EFFECTIVE DEMAND
Also by Edward J. Nell
* BEYOND THE STEADY STATE: A Revival of Growth Theory (co-editor with Joseph
Halevi and David Laibman)
FREE MARKET CONSERVATISM: A Critique of Theory and Practice
GROWTH, PROFITS AND PROPERTY
• NICHOLAS KALDOR AND MAINSTREAM ECONOMICS (co-editor with Willi
Semmler)
RATIONAL ECONOMIC MAN (with Martin Hollis)
PROSPERITY AND PUBLIC SPENDING: Transformational Growth and the Role of
the State

• Also published by Macmillan

Transformational
Growth and Effective
Demand
Economics after the Capital Critique

Edward J. Nell
Professor of Economics
New School for Social Research, New York

M
MACMILLAN
© Edward J. Nell, 1992
Softcover reprint of the hardcover 18t edition 1992
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First published 1992

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British Library Cataloguing in Publication Data

Nell, Edward J. (Edward John)
Transformational growth and effective demand: economics
after the capital critique.
1. Economic development 2. Economic theory
I. Title
330.9

ISBN 978-1-349-21781-6 ISBN 978-1-349-21779-3 (eBook)

DOI 10.1007/978-1-349-21779-3
For my mother, Marcella, who always supported me
And for my father, Edward, who would have
Contents
Introduction ix
Preface: Joan Robinson - a Memoir xvii

PART I METHOD AND APPROACH

1 The Revival of Political Economy 3
2 Theories of Growth and Theories of Value 23
3 Value and Capital in Marxian Economics 35
4 Understanding the Marxian Notion of Exploitation: the
'Number One Issue' 59

PART II CAPITAL THEORY IN A GROWING ECONOMY

5 Accumulation and Capital Theory 91
6 Capital and the Firm in Neo-Classical Theory 125
7 Reswitching, Wicksell Effects, and the Neo-Classical
Production Function (with David Laibman) 139
8 The Black Box Rate of Return 157
9 The Theory of Income Distribution 177
10 On Long-run Equilibrium in Class Society 194

PART III TRANSFORMATIONAL GROWTH

11 Population Pressure and Methods of Cultivation: a Critique
of Classless Theory 219
12 Economic Relationships in the Decline of Feudalism: an
Examination of Economic Interdependence and Social
Change 231
13 The Transformation of Agrarian Society 269
14 The Price Revolution and Primitive Accumulation 302
15 Cyclical Growth: the Interdependent Dynamics of Industry
and Agriculture 319
16 Transformational Growth: From Say's Law to the
Multiplier 334

PART IV PRICES, INVESTMENT AND EFFECTIVE DEMAND

17 Demand, Pricing and Investment 381
18 Stability in Simple Keynesian Models 452
19 Wealth Effects and the Government Budget Constraint 477
20 The Simple Theory of Effective Demand 493

vii
viii Contents

21 Notes on Finance, Risk and Investment Spending 529

22 Does the Rate of Interest Determine the Rate of Profit? 560
23 Wages, Inflation and the Labor Market 565
24 Growth, Distribution and Inflation 590
25 Controversies in Macroeconomics: Patinkin, Friedman and
Marglin 599

PART V PROFITS AND JUSTICE

26 Economizing Love 645
27 On Deserving Profits 654
28 Justice under Socialism (with Onora O'Neill) 663

Concluding Remark 675

Index 677
Introduction
This collection of essays is not intended primarily to contribute to the
critique of neo-Classical theory, even though individually many of these
papers first appeared in the course of debates over the validity of certain
neo-Classical propositions. Rather, the reason for bringing them together
at this time is that, when they are read in conjunction with one another, it
can be seen that the critique presents the basis for an alternative approach
to understanding the economy, building on the Classics and Marx. For
more than a century the real foundations of this alternative have been
submerged: the message of the Classics - Smith and Ricardo especially -
has been systematically distorted and misinterpreted by the determined
neo-Classical attempt to read them only as precursors of the marginalists.
The publication of Production of Commodities by Means of Commodities,
the great work of Sraffa, and the subsequent Capital Theory Controversy,
together with the work of Joan Robinson, Nicholas Kaldor, Luigi Pa-
sinetti, Pierangelo Garegnani, Michio Morishima, John Hicks, Richard
Goodwin and many others, should have made it clear by now that what-
ever incipient marginalist elements may have lurked in the Classics,
another vision altogether dominated their writings - and is relevant today.
That way of thinking about economic analysis has been called 'the surplus
approach', since it takes its start from the fact that production, using labor
and produced means of production, normally results in a surplus. More is
produced than is needed to support the workers and replace the used-up
means of production; and this surplus is distributed through market pro-
cesses as wages to labor, rents to land and profits on the value of capital.
Prices indicate the exchanges that must be made to replace used-up means
of production so that another round of production can take place again, in
the same way, consistently with the distribution of the surplus between the
various claimants through the market mechanism. Notice that this implies
a difference in logical form and function between prices of commodities
and 'factor prices,' the rate of profit and the wage rate. When the price
equation is set up in matrix form, commodity prices are derived from the
characteristic vector in the solution, whereas the rate of profit and the wage
rate follow from the characteristic root.
The price equations have as their mirror image, so to speak, a set of
quantity equations, relating the rate of balanced growth and per capita
consumption. Just as the profit and wage rates are inversely related, so are
the growth and consumption rates; and just as the rate of profit is associ-
ated with a set of relative prices, the growth rate is similarly associated with
a set of relative industry sizes. When the wage rate (or the ra,te of profit) is
determined, the other distributional variable and the set of relative prices
ix
x Introduction

follows; when either consumption or growth is determined, the other

variable and relative sector sizes follow. Prices and quantities are thus
capable of being separately determined; savings behavior, and the influ-
ence of distribution on investment, will link the two through the working of
effective demand, at least under some conditions, but the straightforward
simultaneous determination, central to the neo-Classical vision, is not
present here.

1 TEMPORARY EQUILIBRIUM AND THE RATE OF PROFIT

The conventional picture holds that prices are indicators of relative scarci-
ties, and that prices adjust so as to bring about the most efficient allocation
of the resources available at any given time. The Capital Theory Debate
showed that neither capital nor labor were governed by a scarcity pricing
process; neither the rate of profits nor the wage rate behave in the required
fashion. Moreover, there is no escape through an appeal to 'general
equilibrium' theory, for if provision is made for the formation of a general
rate of profit, a model based on the normal neo-Classical assumptions,
namely given specific resources (produced means of production), a given
technology (set of methods of production), and given preferences will -
accidental cases aside - be overdetermined. If the rate of profit is neglected
then, of course, an analysis can be made of the relation between supply
based on given equipment, labor and natural resources, and demand based
on preferences constrained by the income generated by ownership of the
resources (including labor). But such a 'temporary equilibrium' is really no
equilibrium at all, whether considered ex post or ex ante. For example,
taking the ex post perspective, firms employing means of production in
ways that earn lower than normal profits will try to discard them and
acquire other more profitable equipment, or shift such resources into uses
that earn the greatest possible profit. Taking the ex ante viewpoint,
suppose that some firms expect that their equipment, put to normal use at
market-clearing prices, will earn profit at a lower rate on the value invested
in it either than other equipment which they could acquire, or than they
could earn by putting it to other uses. If expectations are formed rationally,
and firms make use of all information available to them at reasonable cost,
they will anticipate the market-clearing prices and realize that they will not
make as high a return on their invested capital as they could get elsewhere.
Surely such firms would be foolish to try to supply the available demand at
market-clearing prices; they should at once get out of low profit-rate
activities and into those that provide the best obtainable rate of earnings on
the value of their holdings. Hence, if earnings below the general rate of
profit are foreseen, as they must be if expectations are rational, the
'temporary equilibrium' will never happen; if they are not foreseen, then it
 Introduction xi

is not a genuine equilibrium, but a temporary position resulting from

imperfect knowledge, which will be corrected as soon as firms learn from
their experience, at which point they will rearrange their holdings of means
of production.
The relation between capital, exchange value and profit, then, has to be
approached differently. Prices are not indicators of relative scarcities, and
they are not determined by market-clearing processes. Rather they reflect
technological interdependence and the requirements of distribution, and
they interact with demand in a very different manner than that indicated by
conventional theory. Some of these differences can be captured pictorially.
(See pp. to, 12 and 18, et passim.)

2 CONTRASTING PICTURES

The neo-Classical way of thinking is often summed up in a simple and

familiar diagram, with boxes indicating Households and Firms, and circles
the Factor and Product Markets. Money flows in one direction, goods and
services in the other. Households maximize utility, Firms profit (NOT the
rate of profit); Households demand goods and supply factor, Firms de-
mand factors and supply goods. The diagram is simple - and telling,
especially in its combination of symmetry and abstraction. There is neither
production nor distribution in the Classical sense; production is subsumed
under supplying goods, and distribution becomes demanding factors.
Households and Firms behave in symmetrical ways; both react passively to
signals and essentially choose from among pre-determined options, con-
strained by similarly pre-determined givens.
By contrast the Classical scheme, of Smith and Ricardo as much as·
Marx, can be presented in an alternative diagram, based on a Social
Pyramid and an Industrial Park, as well as markets and flows of funds. The
Social Pyramid signifies the class structure, in particular that the upper
class receives profits as a result of ownership, while the lower class must
work for wages, and the unemployed constitute a reserve labor force. The
Industrial Park displays the exchanges between industries which maintain
the viability of the system of production. The surplus is distributed as
profit, which is channeled through the financial system. Government
performs two functions, regulating the flow of traffic - the stoplights - and
adding to or subtracting from it, to maintain an appropriate level of traffic.
The orthodox diagram is deliberately abstract and stylized; Households
and Firms are both contained in boxes of the same size, set opposite to one
another, implying or suggesting that Firms and Households play the same
kind of role in the economy, are of equal importance, but act in symmetri-
cally opposite ways - Firms supplying final goods and demanding factors,
Households supplying factors and demanding final goods. Factor markets
xii Introduction

and final goods markets are both contained in circles, also set diametically
opposite each other. By implication both are markets in the same sense-
that is, work on the same principles of supply and demand - and both
mediate exchanges between households and firms.
The Classical diagram is deliberately concrete. The factory buildings
have doors and windows, and the smokestacks are polluting the air. The
bank building has columns, and the Social Pyramid has steps - for social
climbing. The implication is that such details matter; the outcome of market
processes depends on them for they provide sources of power and points
for bargaining. Prices depend on the transactions within the Industrial
Park, given the level of wages that must be paid. Overall demand depends
on wages and salaries and the government, which together determine
Consumption, and on Investment and finally on Government Spending.
The alternative vision thus centers on the exchanges needed to bring
about reproduction and distribution, and the pattern of expenditure that
results from distribution and from the incentives to accumulation. Produc-
tion generates a surplus, the claims to which are determined through the
processes of the market - but the size of the surplus, which depends on the
volume of production, is itself partly determined by the market. The
marketplace is seen as an arena in which social conflicts are fought out
according to certain rules, but the struggle has direct economic conse-
quences. Nor can economics be understood apart from these conflicts.

3 OVERVIEW OF THE BOOK

Part I presents the essential ideas underpinning these contrasting visions,

and lays down the challenge that the Classical picture is significantly
superior in its treatment of essential features of production and distribu-
tion. The general features of the Classical and Marxian systems are
explored, and in particular it is shown that the rate of exploitation, when
interpreted as a measure of the intensity of work, determines and explains
the rate of profit and prices.
In Part II this claim is developed further. Important flaws in the neo-
Classical treatment of produced means of production, the choice of tech-
nique and the formation of a general rate of profit are examined. These
problems undermine a number of important claims normally taken for
granted in mainstream writings - that prices reflect relative scarcities, that
income is a payment for, and made in proportion to, a productive contribu-
tion, for example or, more generally, that distribution is a species of
exchange. But if distribution is the assignment of claims over shares of a
surplus, then it is not a species of exchange. The prices that bring about
such a distribution may have nothing to do with relative scarcities. Further,
if the distribution tends to be stable, the prices will also tend to be stable.
 Introduction xiii

Capital, then, is not a 'factor of production;' it is a way of organizing

production, giving rise to a certain pattern of claims against the surplus,
inversely relating those of wage and profit receivers.
It is natural, therefore, to ask whether there are other, similarly well-
established ways of organizing production and distribution, and whether
any such preceded the emergence of capitalism. In Part III this question is
taken up, and the working of earlier systems is described, particular care
being paid to the way in which the incentives built into these systems leads
to a systematic undermining of their foundations. When such undermining
itself gives rise to technological innovation, this is the process of transform-
ational growth. After an initial discussion of primitive agriculture, tra-
ditional agrarian societies are examined, with a special emphasis on
European feudalism (but also taking a look at the American West). It is
shown that in the early systems the production and distribution of the
surplus through exchange is properly analyzed by means of the labor
theory of value, but that the transformation of traditional agrarian society
into modern capitalism involves the development of a modern pricing
system, based on the rate of profit. Chapter 16 shows that key changes in
technology have a major impact on the way markets work.
This leads on to Part IV, in which the implications of this picture for
macroeconomics are explored. The surplus approach raises the question of
stability in distributive shares; when shares are stable, long-run or bench-
mark prices will also be stable, even if there are fluctuations in demand.
This in turn suggests a reconsideration of industrial technology; mass
production methods are designed to make it possible to vary output in
response to short-term fluctuations in demand, while keeping productivity,
and therefore running costs, constant. Hence prices will tend to be stable,
while output and employment vary with changes in demand, which pro-
vides a foundation for the macroeconomic theory of aggregate demand.
Chapter 17 develops the crucial arguments.
But the conventional formulation of macroeconomics will have to be
reconsidered. According to the textbooks, equilibrium is reached when
household saving equals business' planned investments spending. But
household savings are problematical; in the US they tend to be offset by
households' debt payments for home mortgages and consumer durable
finance. By contrast business profits, and business retained earnings, are
unquestionably withdrawals. The basic principle can be reformulated to
state that employment - which in the short run generates the surplus -
adjusts to provide the profits which offset investment. Framed in this way
the principle allows us to see the connections between the payment of
money income, as wages and profits, and production in response to
expenditure pressure. Three separate concepts can be clearly dis-
tinguished: income, output, and expenditure; these are commonly con-
flated in mainstream models, which seldom introduce an explicit equation
xiv Introduction

for income as wages plus profits - with the consequence that they mis-
specify the income determination process. When corrected this provides a
better approach to employment and the labor market, for it shows that
employment is likely to vary directly, rather than inversely, with the real
wage in the short run. It also enables us to distinguish clearly between
investment plans and investment spending; the former depends on long-
run considerations, including technological innovation, expected market
growth and other factors that may be difficult to model with any precision -
summed up by Keynes as 'animal spirits'. But the current level of spending
in carrying out previously detemined plans depends on current sales
revenues in relation to capacity, the current level of interest rates, di-
vidends and stock prices, the expected levels of these in the immediate
future, the current real wage, and similar variables. Investment spending
can thus be readily modeled, and reveals a pattern of cyclical instability
grounded in the working of the financial system. A new and significantly
different view of inflation emerges, as the process by which the market
determines who shall bear the burden of an adjustment to a change in costs
or distribution. This takes on added dimensions when corporations are
able to exercise some degree of control over the direction of market
growth. Prices and investment will become even more closely related in
these conditions. Finally, the section closes with critiques of the macroecon-
omics of the right, the center and the left - Friedman, Patinkin and Marglin
- in each case for failing to spell out the process by which income - wages
plus profits - is generated in conditions of mass production.
Part V concludes the book by drawing out some of the implications of
the surplus approach for understanding questions of justice. The first two
studies (Chapters 26 and 27) draw out the implications of the capital
critique for the 'Chicago' perspective on the economy, while the third
(Chapter 28) examines the ideal of pure socialism. Quite apart from the
issue of taking literally what is at best an analogy, the Chicago account of
the marriage market and the family rests heavily on invalid marginalist
relationships. The same applies to their account of the entrepreneur and
his just rewards. By contrast, Chapter 28 suggests that the surplus ap-
proach is well-adapted to an examination of principles of fairness and just
distribution.

4 FINAL REMARKS

The surplus approach requires a careful account of the way claims to the
surplus are translated into money; for the Classics, this was the problem of
the circulation of money. It was treated extensively, and unsatisfactorily,
by Marx in Volume II of CAPITAL. But it has largely disappeared from
the modern scene. These studies are addressed to current issues dividing
 Introduction xv

economists, and for this reason the discussion of monetary circulation does
not appear in the present work. Since it is important, I have tried to deal
with it elsewhere; the interested reader is referred to Part III of Keynes
After Sraffa. Policy issues related to the surplus approach were examined in
Prosperity and Public Spending.
No attempt will be made in these papers to develop the n-sectoral
analysis of prices and the rate of profit, or growth and consumption.
Well-known results will simply be assumed here; even wholly new points
(as in Chapter 4) will be explained in the simpler two-sectoral format. Joint
production problems will be ruled out on the grounds that for the most part
in manufacturing principal products and by-products are clearly identifi-
able (so that single-product results carry over), and genuine joint pro-
duction occurs chiefly in primary industries, in which profits are governed
by different forces, and consist largely of capitalised rents. The notation
follows standard practice and, as far as possible, has been kept consistent
from chapter to chapter. But there are some differences, and each paper
defines the symbols used in it.
Acknowledgements are indicated separately in each Chapter, but a
special debt is owed to Keith Povey and his staff for a fine job with a
difficult typescript.
Finally, there will be found some overlap and repetition; it has been kept
to a minimum, but in their present form the studies can each be read
independently, and this seemed desirable.
Preface: Joan Robinson - a
Memoir*
When I first met her in the fifties, I liked to think of Joan playing opposite
Humphrey Bogart in a John Huston film about the Resistance. She'd have
been perfect - black clothes and red'stockings, a commanding presence,
cool, tough, single-mindedly loyal, fiercely partisan. Strong progressive
opinions, but no nonsense about accepting dogmas, Marxist or otherwise.
Critical of bourgeois society and its hypocrisy. A fighter, fearless and tough
as they come.
Perhaps not a film, though. Joan was always part of real life, not of art.
Later I thought, more like the Sandinistas - an English Nora Astorga! But
again, perhaps not. Nora Astorga seems comfortable as a woman; I don't
think Joan was. Which may partly account for what many found dispropor-
tionately harsh in her criticism.
Yet it was really not the harshness which was the problem; her op-
ponents complained, but perhaps they deserved what they got. There was a
lack of balance in her work between the positive or constructive and the
negative and critical. Her emphasis, and the conclusions she highlighted, in
her principal contributions have mostly been critical: in capital theory, of
course. But consider her essay on Marx; it was her criticism of the labor
theory of value that caught attention. As for Keynes, it is her critique of
'bastard Keynesianism' that is remembered. Even ingenious theorems like
the 'Golden Rule' were developed during the course of a critique of
marginal productivity theory. The Accumulation of Capital ends up in a set
of disconnected scenarios designed to show what was wrong with Harrod's
approach, on the one hand, and neo-Classical thinking on the other. Even
The Economics of Imperfect Competition had a primarily critical objective
- to undermine the marginal productivity theory of wages, and the as-
sociated ideas of perfect competition. (Of course, it also had the positive
aim of explaining the existence of excess capacity in conditions that were
clearly in some sense competitive.) And finally, after initially welcoming
Sraffa's great contribution, she turned critical of the efforts of some of her
closest friends and associates to develop a constructive account of capital-
ism on the foundations Sraffa laid. It was an equilibrium theory, she
argued, and equilibrium can tell us nothing about history. At a stage in her
life where she might have been expected to sum up her life's work in a way
that might have provided guidance for her students and followers, she

• G.R. Feiwe1 (ed.) Joan Robinson and Economic Theory (London: Macmillan, 1989).

xvii
xviii Preface: Joan Robinson - a Memoir

offered a critique of the whole project: instead of answers, she gave us

What Are the Questions?
Well, why not? The profession certainly needs critics, and harsh ones.
Look at virtually any mainstream journal these days and you will find
pre-Keynesian thinking, standard and marginal productivity theory, per-
fect competition, and all the rest, parading through the pages as if there
were nothing wrong.
But this is exactly the point. You can't beat something with nothing. No
matter how fierce the criticism, not matter how well delivered the blows,
neo-Classical theory never dies. Like a vampire it rises from the grave the
next night, to prey on the unwary. Only those protected by the amulet of
another theory will be safe from its ravages. And that is the protection that
many of Joan's students and followers sought, but which she never
provided.
Yet she might have. The materials were certainly there, particularly in
The Accumulation of Capital, and the later Essays. The presentation may
be deficient, but the conception is clear: here, for the first time in academic
economics is a two-sector 'classical' growth model, turning on an inverse
relationship between wages (=consumption) and growth (financed by
saving out of profits). Neither prices nor choice of technique are governed
by scarcity relationships; by contrast, investment, depending chiefly on
'animal spirits', governs both output and profits, (given the saving rate)
and thus, indirectly, the choice of technique. Prices depend on technical
coefficients and on profits, and so, ultimately on investment. Her objective
was to extend Keynes's vision to the long run, showing that investment
governs savings, the active dominates the passive, there also, exactly
reversing the neo-Classical growth models developed by Solow, Swan,
Meade, Uzawa et al. She tried to provide both the vision and some of the
technical foundations.
My favorite among her later works has always been Exercises in Econ-
omic Analysis, a relatively good-tempered and constructive work, full of
common sense and shrewd insight. (Also excellent diagrams that students
have to draw for themselves.) But it was rudimentary, from a technical
point of view. It contained the basis for a theory of accumulation, of the
rate of profit and the rate of interest. It set forth a theory of the mark-up,
and, by way of contrast, an account of scarcity prices. It contrasted
socialism and capitalism, with many perceptive insights; and it dealt with
effective demand, and provided important hints about the working of the
monetary system. It contained criticism, of course, but the positive side
was much more in evidence. These were the topics that provided a basis for
an alternative account of the working of the economy. The material was
there, but it needed more work, not only by Joan, but by a school of
supporters. It could have been developed, but so far it has been neglected.
(A later attempt, jointly with John Eatwell, fell between two stools; it did
 Preface: Joan Robinson - a Memoir xix

not dig deep enough to build new theory, but it was too abstract for a
textbook.) Her later work became overwhelmingly critical. In her last
years, she was acutely aware of what she called the failure to found an
alternative school, and she lamented the drift back to neo-Classicism,
occurring even at Cambridge.
Yet the simplest explanation for the failure of the alternative vision is
that it has never been fully developed. Where is the constructive non-Neo-
Classical work to compare with James Meade's multi-volume magnum
opus? Where is the alternative to Samuelson's Foundations, Hicks's Value
and Capital? To the constructions of Arrow and Debreu, or Arrow and
Hahn? An alternative vision is one thing, an alternative construction quite
another. The General Theory makes too many concessions, Production of
Commodities is a prelude, a foundation, but the edifice is still to be built.
The Accumulation of Capital, or the later Exercises, reworked and devel-
oped fully, as a positive theory, could and should have been part of such a
construction, but it has yet to be erected.
These essays are offered as a contribution to this project.