09 May 2014

Heterodox Economists School Krugman on His Flim-Flam Econ

Austrian School, Capital & Interest, Krugman 19 Comments

Wow, I thought I was hard on the guy… In the debate over Thomas Piketty’s book on Capital, many of the heterodox leftist economists are coming out of the woodwork to complain. Specifically, the problem is that Piketty relies on the mainstream notion that interest in a market economy is determined by the “marginal product of capital,” just as wages are determined by the “marginal product of labor.”

This is totally muddled, as the great Austrian economist Böhm-Bawerk showed in the late 1800s. But interestingly, leftist economists such as Joan Robinson brought up a similar critique during the Cambridge Capital Controversy of the 1960s.

In any event, Krugman has been carrying water for Piketty, defending him from all onslaughts. This has led the heterodox leftist economists to go after Krugman.

(1) In this post, Thomas Palley attacks the “flimflam” defense of mainstream economic theory offered by Paul Krugman and Simon Wren-Lewis. My favorite part (all bold in this post is from me):

Krugman’s freshwater – saltwater characterization is profoundly misleading regarding the intellectual state of mainstream economics. Whereas the freshwater metaphor makes sense, the saltwater metaphor does not. The true saltwater school is the now eviscerated Cambridge (UK) School of economics that was home to the likes of Joan Robinson and Nicholas Kaldor. The MIT School is better described as brackish (or even putrid) water.

(2) Then in this post Lars Syll takes Krugman to task because he (Krugman) foolishly wrote:

[KRUGMAN:] And what’s going on here, I think, is a fairly desperate attempt to claim that the Great Recession and its aftermath somehow prove that Joan Robinson and Nicholas Kaldor were right in the Cambridge controversies of the 1960s. It’s a huge non sequitur, even if you think they were indeed right (which you shouldn’t.) But that’s what seems to be happening.

Perhaps somewhat in shock–I know I was very surprised at the flippancy with which Krugman dismissed the Cambridge debate–Syll provides two quotes from mainstream, neoclassical economists who were eyewitnesses to the controversy. The first is from Paul Samuelson who conceded that the Cambridge UK critics had made a good point: “Pathology illuminates healthy physiology. Pasinetti, Morishima, Bruno-Burmeister-Sheshinski, Garegnani merit our gratitude for demonstrating that reswitching is a logical possibility in any technology, indecomposable or decomposable.”

Then Syll quotes from Edwin Burmeister who explained:

It is important, for the record, to recognize that key participants in the debate openly admitted their mistakes. Samuelson’s seventh edition of Economics was purged of errors. Levhari and Samuelson published a paper which began, ‘We wish to make it clear for the record that the nonreswitching theorem associated with us is definitely false’ … Leland Yeager and I jointly published a note acknowledging his earlier error and attempting to resolve the conflict between our theoretical perspectives … However, the damage had been done, and Cambridge, UK, ‘declared victory’: Levhari was wrong, Samuelson was wrong, Solow was wrong, MIT was wrong and therefore neoclassical economics was wrong. As a result there are some groups of economists who have abandoned neoclassical economics for their own refinements of classical economics. In the United States, on the other hand, mainstream economics goes on as if the controversy had never occurred. Macroeconomics textbooks discuss ‘capital’ as if it were a well-defined concept — which it is not, except in a very special one-capital-good world (or under other unrealistically restrictive conditions). The problems of heterogeneous capital goods have also been ignored in the ‘rational expectations revolution’ and in virtually all econometric work.

This is admittedly a very technical area; in this article I try to explain the “reswitching debate” in layman’s terms. But my point in this present post is to show how much Krugman simply bluffs. It is clear from Piketty’s 3-page description and Krugman’s glib dismissal that neither man really understands what happened during the Cambridge capital controversy. In a heated discussion of a 600+ page book devoted to capital and income distribution, that is a very serious weakness.

19 Responses to “Heterodox Economists School Krugman on His Flim-Flam Econ”

  1. Kevin Donoghue says:

    Obviously Krugman’s claim, that Robinson and Kaldor were wrong, is false. (If he said they were only partially right I’d go along with that.) Also, Piketty is liable to cause confusion by using the term “marginal productivity of capital” for what Keynes called the marginal efficiency of capital. The former is defined as units of additional output per unit of additional input, whereas the latter is the internal rate of return on an investment.

    That said, it makes little difference so far as Piketty’s (excellent) book is concerned. He uses “capital” in the everyday sense of wealth. His ‘r’ is just the weighted average return on wealth and his Beta is just the ratio of wealth, valued at market prices, to income.

    • Bob Murphy says:

      That said, it makes little difference so far as Piketty’s (excellent) book is concerned.

      I agree it will make little difference to Piketty’s fans that his entire theoretical structure–which drives his predictions of the evolution of capital income and scares people into accepting his proposal for wealth confiscation–is based on a fallacy.

      • Philippe says:

        you’re being a bit over the top now, Bob.

        Are you going to jump up and down the next time a right-wing neoclassical economist says we should cut taxes on the wealthy, and explain that he is wrong because his theoretical model is based on the fallacy of aggregating capital and assuming that the return on capital in a perfect competition model is equal to its marginal productivity?

          • Philippe says:

            what is the point of that link?

        • Levi Russell says:

          Certainly either case would be an opportunity to educate folks on capital theory. However, real life has a normative element, and it’s all the more important to attack bad theory when said theory is being used to expropriate and destroy wealth.

        • Bob Murphy says:

          Philippe wrote:

          Are you going to jump up and down the next time a right-wing neoclassical economist says we should cut taxes on the wealthy, and explain that he is wrong because his theoretical model is based on the fallacy of aggregating capital and assuming that the return on capital in a perfect competition model is equal to its marginal productivity?

          Philippe, if you show me an example of a right-wing economist justifying a policy proposal I’d like, which relies on r=f'(K), then yes I will criticize it.

          Also, I think you are conflating two things. I’m not saying, “In the real world, the return to capital might not exactly be MPK because of imperfect competition.”

          No, there *is* a “competitive market” in my latest example with the nets and birds. I’m trying to show that the rate of return on financial capital is a totally separate thing–even different units–from the physical increment in output caused by an additional unit of physical capital.

          This is admittedly confusing, because the UK Cambridge people were coming at the issue from a different place. But I just want to be clear that I think you are underestimating the chasm between Piketty and me.

          • Philippe says:

            “if you show me an example of a right-wing economist justifying a policy proposal I’d like, which relies on r=f’(K), then yes I will criticize it”

            All right-wing neoclassical economists use models which assume that, in perfect competition equilibrium, the rate of return on capital is equal to the marginal productivity of capital. They also all use models which aggregate different types of capital into one number. They use their models to justify their policy proposals. So to be consistent you should criticize their policy proposals on the basis that the models they use contain these flaws.

            The fact is however, that Piketty’s policy proposals don’t rely on r=f’(K) being correct. That is just standard neoclassical economics, and nothing unusual. Piketty says himself in the passage you quoted from, that the rate of return can be above, or even below the marginal productivity of capital. So attacking him on this basis doesn’t achieve much.

            What’s actually important is the argument that the return on capital (by which he actually means wealth) can remain above the growth rate of the economy, leading to increasing inequality.

            • Tel says:

              Piketty does worse than depending on r = f’(K), because he also presumes this is constant regardless of K, and that implies no diminishing return on capital investment… which is clearly wrong.

              With a more sensible capital model, r = f’(K) will give you smaller “r” (expressed as percentage per annum) as K gets larger, and thus the first derivative of the physical return on capital always comes to an equilibrium exactly equal to the first derivative of the collective market preferences at that operating point. The reason is obvious: people keep building capital until they don’t see any value in building more. By definition that’s the equilibrium point satisfying preferences, because if they wanted to keep building they would do.

              This is an example where saying it in words is easier than either equations or diagrams.

  2. Tel says:

    r = f ‘(k),

    which denotes the fact that in equilibrium, the real rate of interest is equal to the marginal product of capital, i.e. the increment in output produced by an increment in the capital stock k.

    That much is fair enough, in Nick Rowe’s article you will agree that (r+1) = MRTcc(k) but Nick allows for recovery of the purchase price of capital, while Bob is presuming that’s sunk. Thus the shape of the function is a bit different, but the fundamental concept is the same. But, but, but… analysis of units…

    Recall that in our tractor example, the fatal flaw in the naïve productivity explanation was that it did not explain the initial purchase price, or market valuation, of the tractor, in terms of dollars.

    Wait a moment! The term f ‘(k) is a first derivative right? So it does already include consideration of the dollar value of a tractor.

    If you want it in words “the increment in output” as measured in dollars, divided by “an increment in the capital stock k” also measured in dollars. The numerator relates to the “rent” value or productivity, while the denominator relates to the purchase price; and when you divide dollars by dollars you get a unitless ratio. Of course, there’s still a time factor involved because the tractor purchase price is instantaneous, while the payback happens over time, and the standard expression of interest rates is “per annum” which, for very good reason, covers that time factor. Yes, I’m ignoring depreciation, but if you wanted to worry about that, go back to Nick Rowe’s recovery of the capital purchase price, and presume some lossage. Go nuts and say the farmer puts the tractor up for auction every Halloween.

    NB: because you have divided dollars by dollars, you could divide sheep by sheep or Euros by Euros or even divide Yen by Yen, and the “real” interest rate just does not care about the currency you decide to transact in. That’s what makes it kind of a big deal.

    Suppose I use sheep for my measurement and conclude the interest rate is 100%, but now I use Yen instead and with inflation (measured in Yen) at a shockingly high 10%, I sell my rapidly reproducing sheep on the Japanese market and make 10% extra Yen. Then I devalue those Yen by the same 10% (because this is real interest, not nominal interest) and bingo, I’m back to the value I calculated in sheep. Do it in any currency (of course, at some stage you need to decide what is “real” but that’s best left for Sunday).

    In contrast, consider the sheep example.  In a fictitious world where sheep are the only good, the only measure of a person’s real financial wealth is the number of sheep that he owns.  In this simplified scenario, yes, if someone’s stock of sheep physically doubles every year, then the market-clearing (real) interest rate must be 100 percent.

    That’s a linear model.

    It presumes that the reproduction rate of sheep is always the same regardless of how many sheep you have (i.e. no diminishing returns on capital). With a linear model you will get a straight line on Nick Rowe’s diagrams (I’m told they are also Irving Fisher diagrams). If the equilibrium point of the system happens to be anywhere along that straight line part of the diagram then by gum the real interest rate will be directly related to the slope of the line (allowing for the negative gradient, and the off-by-one, but everyone does that). That’s the thing about a straight line, it only has one gradient; regardless of where you sit on the line, you will get the same first derivative.

    Totally unrelated, my old physics teacher used to bang on about units all the time.


    Ha, ha, “The Bob Booth Archives Room”, what a tribute, hope the NSA never take a peek in there.

  3. Keshav Srinivasan says:

    Burmeister says “In the United States, on the other hand, mainstream economics goes on as if the controversy had never occurred. Macroeconomics textbooks discuss ‘capital’ as if it were a well-defined concept — which it is not, except in a very special one-capital-good world.” But I don’t think that’s the dividing line between Krugman and the people disagreeing with him. Krugman seems perfectly willing to accept the possibility that capital cannot be quantified by a single number. He just thinks it has nothing to do with the validity of marginal productivity theory:
    “Nothing about marginal productivity theory depends on the exact truth of a simple aggregate production function with capital defined by a single number.”

  4. Keshav Srinivasan says:

    Bob, did you see Matt Yglesias’ post yesterday on the Cambridge Capital Controversy?
    It looks like this obscure subject is getting a quite a lot of publicity.

    • Bob Murphy says:

      Thanks, that’s not half bad.

    • Bob Roddis says:

      I thought VOX was an amplifier. Is nothing sacred?


    • Major-Freedom says:


      “If a city imposes a stiff new tax on hotels, it will become less profitable to own hotels in that city. Thus, the price (or value) of that city’s hotels will decline. But it would be an egregious error to conflate a decline in the price of hotels with a decline in the quantity of hotels.”

      If the decline in price is caused by a relative change in the marginal utility of houses vis a vis all other goods, such that the relative nominal demand for and prices of houses falls, and nominal demand for and prices of other goods rises, then ceteris paribus a fall in the prices of houses would be associated with a decrease in the supply of houses. For the relative fall in housing profitability would encourage capital to be redirected away from housing and into other goods.


      Where do profits come from? This one is easy. Profits are the original, primary income in human society. The very first producers did not sell their labor to others, they sold their goods. Sales of goods earns the sellers product sales revenues, not wages. Wages are earned from selling labor. The amount of profit income is the difference between those sales revenues, and any money costs of production, should there be any. If there are no money costs of production, then the revenues earned is all profit. Note that even though nominal profit margins would be 100%, it doesn’t mean they are making high real profits. Real profits, or what profit income can buy, would be quite low, since not much can be produced without the benefit of labor services.

      The reason, and I mean the only reason why the cause or source of profit is so hotly debated and full of disagreements and confusions, is because of Marxian exploitation theory, which so many people have adopted and treat as the default. The Marxian exploitation theory has flipped the truth upside down and claims wages are the original, primary income in human society, that all income rightfully belongs to wage earners, and the only reason wages are jot 100% of incomes “like it used to be”, was because of the birth and rise of evil greedy capitalists who created capitalist states to deprive the working class of a portion of what they justly deserve.

      Keynesians, neoclassicals, even some self-professed laissez-faire types, take for granted that wages are primary and profits are secondary. Thus the constant debates and confusions about the source of profit.

    • Tel says:

      Did anyone read to the end?

      For example, on the neoclassical theory poor countries that successfully get rich should do so by liberalizing their financial systems, running trade deficits, and importing foreign money until over time they build up enough capital for the marginal productivity of labor to increase. In practice, successful catchup stories (first in Japan, then in Singapore and Taiwan and Korea, now in China) work the other way around — countries use financial repression and run trade surpluses to develop increasingly sophisticated local businesses.

      Talk about rewriting history, sheesh.

      There’s a news item going around about Katrina Klett the Truman Scholarship “change agent” teaching beekeeping in rural China. Many conservative commentators are pointing out the typical nutty subject matter of modern tertiary scholarships, after all the Chinese have practised beekeeping since the New Testament was still relatively new… long before Europeans settled the Americas and long, long before the USA existed. I got curious and did a bit of research on that, because I just thought to myself, “Surely she would be bright enough to figure out if all she was doing was going halfway round the world and teaching them to suck eggs, there must be a reason.”


      Consequences of Rural Reform in China

      Decollectivization increased the options available to individual households and made household heads increasingly responsible for the economic success of their households. In 1987, for example, it was legally possible to leave the village and move into a nearby town to work in a small factory, open a noodle stand, or set up a machine repair business. Farmers, however, still could not legally move into medium-sized or large cities. The Chinese press reported an increased appreciation in the countryside for education and an increased desire for agriculturally oriented newspapers and journals, as well as clearly written manuals on such profitable trades as rabbit-raising and beekeeping. As specialization and division of labor increased, along with increasingly visible differences in income and living standards, it became more difficult to encompass most of the rural population in a few large categories. During the early 1980s, the pace of economic and social change in rural China was rapid, and the people caught up in the change had difficulty making sense of the process. [Source: Library of Congress]

      I guess that’s where people in the West have difficulty coming to grips with just how brutal the economic repression of the Cultural Revolution really was. People were offered the amazing boon of being allowed to open a noodle stand, a freaking noodle stand ffs, or repair some machinery, and this happened less than thirty years ago. It chokes me up to think of that, they killed people for showing the slightest sign of individual initiative. You could die for wearing glasses or reading a book, or playing a musical instrument.

      As someone who considers myself as perhaps a bit of a thinker (by which I mean drinker) of course it cuts me that someone would be punished for some trivial economic achievement. What really upsets me is that many other people who might pass as “intellectual” (whatever that means) not only make excuses for the Cultural Revolution, but almost pretend it never happened. How much was lost do you think during that time? We have no idea really.

      Sorry buddy but, China started on the road to a “successful catchup story” only after stopping the most horrific economic and lifestyle repression ever seen in human history. This was the primary reason they needed to become a “catchup story” in the first place!

      I met a guy in Australia from a Chinese family who had grown up in rural China and I got to asking him about what he thought of Australian lifestyle compared with his childhood. His answer was that when he was growing up the supply of meat for the household was about one chicken a week, the rest of their diet was just rice and greens. That pretty much ended the comparison. Thank God Australia never needed economic repression to become a great catchup story. As an Atheist of course I can’t really thank God, but I can thank humans with common sense, possibly bestowed by God.

      • Philippe says:

        you’re mixing things up, Tel.

        “financial repression” refers to:

        – caps or ceilings on interest rates
        – government ownership or control of banks
        – capital controls

        A “trade surplus” means exporting more than you import.

        China has engaged in both of these.

  5. guest says:

    consultingbyrpm blog tag piketty

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