Neoclassical Theory in America

6.3.1. Clark and the marginal-productivity theory

It was Clark and Fisher who brought the new theoretical system to America, while Frank Taussig was active in spreading the message.

particularly suited to interpret the American situation, and this was another reason for the abandonment of classical economics by American economists.

Clark was undoubtedly the most influential and esteemed economist of the period. Even in his own life he was considered the principal apostle of marginalism. As a student of Knies in Heidelberg, he had been strongly influenced by the German Historical School. Both the method and spirit of that school was evident in his first work, The Philosophy of Wealth (1886), which included a forceful yet respectful attack on the premisses of classical theory. The Ricardian system was described as ‘the apotheosis of egoism’. Clark advanced the counter-proposal of State intervention to reduce the economic power of the industrialists, to enforce distributive justice, to replace competition and conflict by co-operation, and, in general, to bring the economic process under the control of moral principles.

During the next twenty years, Clark was absorbed by the intellectual challenge created by the problem of the functional distribution of income. A series of papers paved the way for his major work, The Distribution of Wealth (1899). In this period, Clark completely changed his orientation by embracing the neoclassical theoretical system; and the conversion was radical, as are all adult conversions.

Underlying the marginal-productivity theory of distribution is a very simple rule: each production factor must receive a share of the national income proportional to the contribution it gives to production. Assuming that the distribution is based on the same principle for all categories of income and all individuals, it follows that all incomes can be reduced, directly or indirectly, to labour incomes. Even profit would be the com­pensation of a particular working ability, that of the entrepreneur, who co-ordinates production and bears the risk. Even the pure incomes from capital can be indirectly linked to labour incomes: they represent the remuneration of loaned capital, which in turn comes from accumulated savings and therefore from incomes produced, in a previous stage, by means of labour. The differences between the various forms of income, if any, are only formal; in any case, no fundamental difference depends on the fact that individuals are divided into social classes. The one exception to this rule is land rent, which is considered to be a spurious form of income, as it originates only from the scarcity of land.

After removing every sociopolitical connotation from the distributive problem, so as to be able to demonstrate that each subject receives a share of the national income proportional to his production contribution, it is

necessary to postulate that the marginal productivity of a factor represents the correct measure of that contribution.

The first consequence of this theory is that the primary classical rela­tionship between wages and subsistence consumption no longer applies.

Second, the application of a general rule such as that of marginal pro­ductivity seems to satisfy two fundamental principles: the principle of effi­ciency, since the possibility is excluded that unproductive resources can be part of the distribution of income and can continue to be produced; and the principle of equity, since it seems ethically legitimate that each agent receives an income in relation to what he has contributed to produce. In other words, the distribution of income is governed by a ‘natural law’ which attributes to every agent the amount of wealth he has contributed to produce. The notion of exploitation loses all meaning in this context.

The third important consequence is that the study of the functional dis­tribution of income turns out to be the same as the study of the structure of factor markets, since it is in these markets that the prices of the factors and the quantities exchanged are determined. From the marginalist point of view, therefore, the problem of distribution becomes that of formulating a theory of supply and demand of factors; a theory which is symmetrical to that of the supply and demand of goods, and which allows the demonstration of the following proposition: the operation of the factor markets ensures that the voluntary exchanges among rational and virtually equal individuals lead to an efficient and mutually beneficial distributive setting.

The Distribution of Wealth was inspired by an ambitious project: to integrate into a single theoretical system consumption and production, capital and labour, interest, wages, and rent, marginal productivity and marginal utility. However, Clark limited his ambitions to the stationary-state case, leaving the work on dynamics to others. Clark’s aggregate model was taken up again in the 1950s by Swan and Solow, in two pieces of research which marked the beginning of neoclassical growth models.

Clark’s approach is not Walrasian; rather it is of an aggregate type and is based on the assumption that wages and interest, i.e. the returns on labour and capital, tend to uniformity among the various productive sectors. Competi­tion and factor mobility should guarantee this result, but in the equilibrium described by Clark there is ‘mobility without movement’. In his theory, the capital factor has to be homogeneous and malleable, so that it is possible to calculate its specific marginal productivity independently from the various technical forms assumed by the means of production in diverse allocations and over time. This ‘capital’ should not be confused with capital goods, which differ from industry to industry and from time to time. The latter make up, according to Clark, the specific and transient embodiment of the general and permanent factor called ‘capital’, i.e. the fund of savings accumulated over time. Furthermore, Clark included land in the stock of capital, a choice that aimed at eliminating ab ovo all the problems of Ricardo and Malthus. In a stationary state the capital stock is constant, even though the capital goods which make it up can change. From this point of view, capital is similar to labour, which remains homogeneous while different individuals enter and leave the labour force. An output is obtained from these two factors, which is also homogeneous. It is produced under conditions of constant returns to scale. In perfect competition, the marginal productivities of the factors, which depend on the respective supplies, determine wages and interest.

Clark encountered great difficulties in distinguishing between variations of labour in regard to the existing capital goods and variations of labour in regard to the ‘capital’ stock.

6.3.2. Fisher: inter-temporal choice and the quantity theory of money

Although during his life Fisher was heavily criticized, after his death his work was the object of great admiration. Time has proved Schumpeter’s prediction correct: ‘some future historian may well consider Fisher as the greatest of America’s scientific economists up to our own day’ (History of Economic Analysis, p. 872). Schumpeter himself gave two reasons for this evaluation. The first is that Fisher was a spokesman on several non-economic subjects: he was a follower of eugenics, a strong supporter of prohibitionism, and a versatile writer on politics. The second reason is his extraordinary knowledge of mathematics (Gibbs, the great physicist of thermodynamics, was one of his mentors); and this enabled him to make economic applications ahead of his time. Fisher was, for example, the inventor of the index numbers and a pioneer of econometrics. He was also, however, a hopeless interpreter of economic facts and a disastrous speculator on the stock exchange. In the autumn of 1929 he declared publicly that the share values were not too high and that Wall Street would never undergo a crash. Then, operating on the basis of this presupposition, he lost not only his reputation as an economist but also almost the entire family wealth.

Over his career Fisher was interested in the same set of problems as Clark.

His main theoretical heritage is rather to be found in Jevons, Auspitz, and Lieben. The two Austrian economists had published a book, which was at that time the only Austrian contribution of worth to mathematical eco­nomics. Fisher particularly admired their partial-equilibrium analysis of price under competitive conditions, an analysis which in its essence was comparable to Marshall’s much more famous study. In his theory of general equilibrium, Fisher was convinced that there were deep formal analogies between thermodynamics and the economic system, and tried to apply to economics some of the innovations which Gibbs had introduced in vector calculus. Recent advances by Herbert Scarf in computational aspects of the solutions of general-equilibrium systems have in Fisher an important precursor.

Fisher’s general-equilibrium model tended to overlook the problems of supply, and in particular did not take into account either capital or interest. He devoted Appreciation and Interest (1896) and The Nature of Capital and Income (1906) to the problems raised by capital. These works laid the basis for a great deal of the later work on the subject. Schumpeter believed it was ‘the first economic theory of accounting, [and] the basis of modern income analysis’ (p. 872). Here the notion of income as consumption was first pre­sented; a consumption that naturally includes that of the services of durable goods.

Fisher’s famous theory of the determination of rates of interest is to be found in The Rate of Interest, published in 1907, and in the new enlarged edition of the same work, published in 1930 under the title The Theory of Interest. Fisher revised the original text because the critics had only focused on the role of ‘impatience’ as a determinant of the rate of interest, over­looking the role of ‘opportunity’. In The Theory of Interest, he formulated what he called an ‘impatience and opportunity’ theory of interest, where the ‘investment opportunity’ was defined as ‘the rate of return over cost’, and where both cost and return were defined in terms of income streams. In fact, this concept was extremely similar to the Keynesian notion of ‘marginal efficiency of capital’, as Keynes himself was later to acknowledge. Fisher extended general-equilibrium theory to the problem of inter-temporal allocation, an extension which allowed him to anticipate some of the conclusions of the famous life-cycle model, i.e. those that explain why individuals prefer to spread their consumption over time, whatever the time­path of their expected incomes. Fisher’s theory of individual savings is, basically, still accepted in the neoclassical literature today. His approach allowed him to remain above the controversies about capital and interest which were already brewing in that period. By reasoning in terms of ‘investment opportunity’, he had no need to assume a productive factor, ‘capital’, that enters as an argument into the production function. In this theory, interest is not considered as a cost of production. To understand its nature, it is necessary to assume that, starting from a situation of equality between current and planned future consumption, the individual requires a quantity of future consumption greater than that of current consumption, as a ‘compensation’ for an additional unit of saving. Fisher attributed this rate of compensation to ‘impatience’, forcefully rejecting the idea that interest represents the cost of the services of a production factor called ‘abstinence’ or ‘waiting’. In this sense, the American economist opposed the Austrian argument, made popular by Btjhm-Bawerk, that waiting contributes to increase the product. The explanation of interest is to be found in impatience; on the other hand, the brevity and uncertainty of life are the facts accounting for time preference.

In 1911 Fisher published The Purchasing Power of Money, which contains his contribution to monetary theory: the equation of exchanges or quantity equation, P = (MV + M⁰ V^r)IT, where P denotes the price level, M the quantity of money in circulation, V its velocity of circulation, M' the current­account bank deposits, V' the rate of turnover of the deposits, and T the transactions. No other mathematical formula in the whole of economics, nor, perhaps, in any other discipline, with the exception of Einstein’s, has ever enjoyed greater fame, a fame still intact today. It represents the tradi­tional idea according to which variations in the money supply, if its velocity and the volume of transactions remain unchanged, will generate variations in the level of prices. This quantity equation is the origin of the theoretical apparatus of modern monetarism, a theoretical system which became pop­ular during the 1960s, especially thanks to the work of Milton Friedman. Even if it is also true that Fisher introduced several qualifications, as we will see in Chapter 7, to take into account the adjustments of the transactions and the effects of variations in V and V', a strong and clear monetarist message still emerges from his work.

Finally, the theory of ‘debt deflation’ deserves mention, although we shall come back to it in Chapter 7. Based on this theory, in 1932, Fisher endea­voured to offer an explanation for the Great Depression that diverged from the popular opinion at the time, which saw it as a phase of the normal business cycle. He explained it in terms of a dynamic process of price and debt reduction following an initial state of over-indebtedness. Fisher came to the conclusion that only an expansive monetary policy would succeed in

warding off the worst. But he was not taken seriously, despite his efforts at lobbying.

6.4.