The Transition From Static To Dynamic Theories Of Growth

Most economic theory since Adam Smith has assumed the existence of a static equilibrium between supply and demand. It is this equilibrium that permits the beneficent functioning of Adam Smith's 'invisible hand'. The notion was successively refined by Ricardo, Say, Walras, Wicksell, Edgeworth, Pareto and others in the 19th and early 20th centuries.

In the 1870s Leon Walras formulated the postulate as a competitive (static) equilibrium in a multi-product system with stable prices where all product markets (and labor markets) 'clear', meaning no shortages and no surpluses (Walras 1874). He also postulated a sort of auction process, never really defined, known as tatonnement, by means of which prices are determined in a public manner, without individual pair-wise bargaining, such that all actors have perfect information. Walras' proposition that such an equilibrium is possible was widely accepted, though not proved until long after his death (Wald 1936; Arrow and Debreu 1954). Since then most economists have assumed that the real economy is always in, or very close to, a Walrasian equilibrium (for example, Solow 1970). We find this assumption troubling.

The Walrasian model applies only to exchange transactions, and does not attempt to explain either production or growth. Growth was and is, however, an obvious fact of economic life. It was attributed by theorists in the 19th century to labor force (that is, population) growth and capital accumulation. The latter was attributed to capitalist 'surplus' by Marx or savings by most of the marginalists. Apart from the work of Keynes (discussed below), the most influential models of the 1930s and 1940s were based on a formula attributed to Fel'dman (1928, 1964) equating the rate of growth of the economy to the savings rate divided by the capital-output ratio, or (equivalently) the ratio of annual savings to capital stock. The formula was 'rediscovered' by Roy Harrod and Evsey Domar (Harrod 1939; Domar 1946). These models, which emphasized the role of central planning, a relic of academic Marxism, dominated early postwar thinking about development economics.4 For instance, a well-known 1950s-era text on the subject by an influential academic writer, Arthur Lewis, states without qualification that '. . . the central fact of development is rapid capital accumulation (including knowledge and skills with capital)' (Lewis 1955). Development, for most economists, is still just a euphemism for economic growth.

For a single-product, single sector model, modern growth theory actually began earlier with Frank Ramsey (1928). Ramsey assumed an economy producing a single all-purpose capital and consumption good produced by homogeneous labor and the all-purpose good itself. There is no role in the Ramsey model, or its successors, for physical laws such as conservation of mass, consumption of energy (exergy) or indeed for natural resources - or wastes and losses - of any kind. Note that the Ramsey model is a perpetual motion machine, as described at the beginning of this chapter.

In the closed multi-product, multi-sector static economic system described by Walras, it is only possible to generate a sort of growth process by mathematical sleight-of-hand. The trick is to assume - as in the Ramsey case - that every product is produced from other products made within the system, plus capital and labor services (Walras 1874; Cassel 1932 [1918]; von Neumann 1945 [1932]; Koopmans 1951). Von Neumann made the system 'grow' uniformly in all directions (sectors) - rather like a balloon - by the simple trick of increasing the output of all sectors equally. In his model, the rate of economic growth is determined by the allocation between investment and consumption. But all goods in his model are still abstract, immaterial and not subject to physical conservation laws. In fact, all goods in the model are derived from other goods in the model, which is not possible for material goods. There is no extraction of raw materials, consumption of energy (exergy) or disposal of wastes.

Abstract flows of money and services are presumably exempt from the physical law of conservation of mass-energy. But that law - the first law of thermodynamics - guarantees that waste residuals must be pervasive, just as the second (entropy) law guarantees that all economic processes are dissipative and irreversible and can only be maintained by a continuous flow of free energy (or exergy) from outside the system. Yet the neoclassical conceptualization implies that wastes and emissions - if they exist at all - are exceptional. The standard assumption is that they do not affect growth or decrease the wealth or welfare of society as a whole, and can be disposed of at no cost. We dissent sharply from that view.5

A brief digression on the influence of J.M. Keynes is appropriate here, although he is not regarded as a growth theorist today. However, he was probably the most influential economist of the first half of the 20th century and his influence has not entirely disappeared despite serious problems with his theories. His influence rests on his recommendation of deficit spending by governments to stimulate demand, during recessions, to be followed by a period of budgetary surplus to pay off the accumulated debt, during periods of high employment and inflationary pressure. The first half of his recommendation was adopted half-heartedly by the British government and whole-heartedly by Nazi Germany (though for other reasons), if not by the Roosevelt Administration's 'New Deal' in the US. We need not recapitulate the basis of Keynes' theory, except to note that he asserted (like Malthus) that under-consumption causes recession and unemployment. The debate still rages between so-called 'supply-siders' and 'demand-siders'. In the proverbial nutshell, the former group advocates tax cuts to stimulate investment while the latter group advocates deficit spending to create demand and thus increase employment.

We do not need to engage in this debate, nor to comment on the supply-side critique of Keynes, or his alleged misunderstanding of Say's law (Best 2007). However, there is no doubt that concern with unemployment was a primary feature of the Harrod-Domar models that dominated development economics during the two decades following Keynes' work (Domar 1946; Harrod 1948). Moreover, there is undoubtedly a business cycle that alternates between two 'regimes', namely periods of high employment and growth followed by periods of lower employment and recession (Schumpeter 1939; Kuznets 1940). In fact, we would seriously consider the possibility that the 'true' relationships between factors of production may have a tendency to flip-flop from one regime to the other, depending on stages in the business cycle or other factors (Hamilton 1996).

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