Other Criticisms Of The Current Neoclassical Theory

Apart from its questionable simplifications, above, the standard Solow-Swan theory suffers from a crucial - and recognized - deficiency: it cannot explain the main - but exogenous - driver of economic growth, often identified as 'technical progress'. Unfortunately, there has never been any real theory to explain technical progress. Notwithstanding fancy packaging and the use of enormously sophisticated 'computable general equilibrium' algorithms, virtually all economic projection models nowadays are still driven by single-sector Solow-type models using either Cobb-Douglas or CES production functions of capital and labor.10

These models always assume some underlying long-term rate of productivity increase, while simultaneously remaining in Walrasian (static) equilibrium. As pointed out above, US economic growth is not explainable by an accumulation of the two standard factors of production, namely reproducible capital stock, and human capital stock. The unexplained residual is usually attributed to a homogeneous stock of technological 'knowledge' that grows (by assumption) smoothly and automatically, due to factors outside the economy.

There are serious problems with neoclassical growth-in-equilibrium. It assumes that technical change is exogenous, uniform and smooth. In fact, it assumes that labor (and capital) become steadily and continuously more productive, while the economy remains, at all times, in equilibrium. However, as we argued in Chapter 1 and, especially, Chapter 2 smooth, gradual change, uniform across all sectors - whether attributable to learning, experience or scale effects - cannot explain either technological or economic history. It is especially inconsistent with observed patterns of structural change that characterize the real world and would therefore have to be reflected in multi-sector models.

Walrasian static equilibrium is clearly inconsistent with inventive activity or innovation at the micro-scale or structural change at the macro-scale. Thus growth-in-equilibrium is essentially an oxymoron. Detailed critiques of the equilibrium assumption are hardly original with us (for example, see Kaldor 1971; Kornai 1973).11

The standard neoclassical growth model has other drawbacks. For instance, the Solow-Swan theory had a built-in tendency for declining productivity due to declining returns to capital investment. When this point of 'capital saturation' is reached, further growth per capita can only result from 'technical progress' or TFP, which (as noted) is itself unexplained.

This feature of the Solow model implies that countries with a small capital stock will grow faster than countries with a large capital stock. Thus the model also predicts gradual 'convergence' between poor and rich countries. In the late 1980s and early 1990s there was considerable interest in the theory of convergence, supported by a wide variety of examples. In fact, for a time, it appeared that a new regularity in empirical economics had been discovered, namely the existence of an underlying convergence within 'convergence clubs' at the rate of 2 percent per annum (Baumol 1986; Baumol et al. 1989; Ben-David 1994; Barro and Sala-I-Martin 1992; Sala-I-Martin 1996).

However, subsequently it has been discovered that the apparent statistical uniformity might be misleading and that, while convergence clubs apparently exist at both ends of the economic spectrum, the rich clubs and the poor clubs are polarized and diverging. Moreover, it appears that this divergence of the rich and poor dominates the apparent 2 percent convergence that had briefly been accepted as conventional wisdom (Quah 1996).

However, subsequently it has been discovered that the apparent statistical uniformity might be misleading and that, while convergence clubs apparently exist at both ends of the economic spectrum, the rich clubs and the poor clubs are polarized and diverging. Moreover, it appears that this divergence of the rich and poor dominates the apparent 2 percent convergence that had briefly been accepted as conventional wisdom (Quah 1996).

A consequence of the saturation effect predicted by the Solow model was that richer countries should grow more slowly, and developing countries should grow faster and gradually catch up to the more industrialized countries. In fact, economic growth in the industrialized countries has not slowed down to the degree suggested by the theory, while a major subset of the so-called 'developing countries' have not been catching up (Barro and Sala-I-Martin 1995). There is some evidence for convergence between rich clubs and poor ones in East Asia, but not in Africa or Latin America. Recent work suggests that there is convergence from above, but not from below (Okada 2006).

In response to this perceived difficulty, some theorists have suggested that capital and labor augmentation - in the sense of quality improvements - might enable the Solow-Swan model to account for the observed facts. For instance, education and training should (and does) make the labor force more productive. Moreover, knowledge and skills presumably do not depreciate. Similarly, capital goods have become more productive as more advanced technology is embodied in more recent machines, thus compensating for depreciation. Augmentation of labor and capital are, in some degree, observable and quantifiable facts. Allowing for it, a number of cross-sectional econometric studies were carried out in the 1990s to test this idea. Indeed, some of them seemed, at first, to provide empirical support for the idea that exogenous technological progress (TFP) can be eliminated from the theory and that factor accumulation alone could, after all, explain the observed facts of economic development (Mankiw et al. 1992; Mankiw 1995; Young 1995; Barro and Sala-I-Martin 1995).

However more recent research has contradicted that conclusion, based as it was on statistical analysis of imperfect data. Later results have essentially reinstated the original Solow view, namely that factor accumulation is not the central feature of economic growth after all (Easterly and Levine 2001). Easterly and his colleagues, having extensively reviewed the published literature of economic development studies, argue - as Solow did - that 'something else' accounts for most of the observable differences between growth experiences in different countries. Easterly et al. adopt the standard convention of referring to this 'something else' as TFP. In this and the next few chapters we hope to cast some new light on the origins of this unexplained driver of growth.

As we have said, the theory as articulated by Solow and others does not allow for 'real' material flows in the production function. Production and consumption are abstractions, linked only by money flows, payments for labor, payments for products and services, savings and investment. These abstract flows are governed only by equilibrium-seeking market forces (the 'invisible hand'). There is no room for path dependence and no deep fundamental connection in the neoclassical theory between the physical world and the economy. The equilibrium assumption is needed mainly to justify the assumption that output is a function of capital and labor inputs and that the output elasticities of the factors of production (that is, marginal productivities) should correspond to factor payment shares in the National Accounts.12 This 'requirement' is a consequence of the equality of output elasticities with factor shares in equilibrium, proved for a single-sector, single-product economy in Appendix A.

The production function approach is generally coupled with an assumption of 'constant returns to scale' which essentially means that N copies of an economic system would produce exactly N times the output of one system. Putting it another way, a big country like the US will not necessarily be richer per capita, by virtue of its size, than a small one like Switzerland or Sweden. This assumption is in reasonable accord with observed facts. It is also mathematically very convenient, since it sharply limits the mathematical forms of allowable production functions to homogeneous functions of the first order, also known as the 'Euler condition'. On the other hand, even if the strict constant returns to scale postulate is violated in the real world (that is, if big economies grow slightly faster than small ones due to economies of scale, ceteris paribus), the violation cannot be very great. In other words, while the factor productivities of a Cobb-Douglas (C-D) production function might conceivably add up to slightly more than unity, the deviation cannot realistically be large.

Apparently there is (or has been) a widespread assumption among economists, that the constant returns to scale condition (the sum of the two exponents in the C-D function equals unity), is empirically based. This has been confirmed by many econometric tests. Paul Romer was puzzled to note that 'the exponent relating to labor can be substantially inferior to its share in (national) income' (Romer 1987b). Sylos Labini points out emphatically that many (most) econometric tests do not support the notion that the sum of the exponents is close to unity (Sylos Labini 1995, table 1, pp. 490-91).13 He also offers an explanation. The three tests that did support the Douglas hypothesis over a period of about 20 or 25 years were all cross-sectional. The explanation of the sum of the exponents being close to unity in these cases was probably due to the fact, previously pointed out by Mendershausen and Phelps Brown, that, between one industry and another, the relationships between labor, capital and output tend to change in the same proportion (Mendershausen 1938; Phelps Brown 1957). This explanation has nothing to do with the marginalist theory of income allocation that is usually cited.

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