The Rate of Interest and the Stationary State
The Review of Economics and Statistics devoted its February 1943 issue to thirteen articles marking what Schumpeter called “a lamentable event”— his sixtieth birthday.66 This was obviously something to which Samuelson would contribute, and he chose to discuss Schumpeter’s theory that the rate of interest would be zero in a stationary equilibrium.u Samuelson began by analyzing the terms “static” and “dynamic,” central to Schumpeter’s theory of economic evolution, a literature that he contended was unsat- isfactory.67 Understanding the relationship between statics and dynamics in theoretical physics was fruitful, but few possessed the necessary technical knowledge to handle this correctly, a criticism that he illustrated with his Chicago teacher, Frank Knight.68 Attempts to approach dynamics though biology had also been disappointing: “one looks in vain for any new weapon, secret or otherwise, for discovering scientific truths.” After seeking to clarify the discussion by proposing a consistent set of terms, he turned to Schumpeter’s notion that the rate of interest would be zero in a stationary state.
u. One reason why he may have been interested in this problem at this time is that Everett Hagen, with whom he was working closely in the National Resources Planning Board (see chapter 19 this volume), turned to Frank Knight’s theory of capital in order to analyze the implications of net investment for the distribution of income, which was central to their work on consumption (Hagen 1942).
Samuelson reviewed the theories of Schumpeter, Lionel Robbins, and Frank Knight (together with his “disciple,” George Stigler), claiming that Schumpeter’s critics, Robbins and Knight, had failed to understand basic ideas such as the difference between a static situation and a stationary equilibrium that was the end result of a dynamic process, or the difference between reaching zero and approaching zero asymptotically.
Citing the literature on stochastic processes associated with Yule, Slutsky, and Frisch, and drawing heavily on an article by the Cambridge mathematician Frank Ramsey, his message was that economists ignored mathematics at their peril.69 Even Schumpeter did not escape criticism, for it made no difference to his theory of the business cycle whether, in the absence of innovation, the rate of interest converged on zero or on some positive rate of interest. Samuelson saw Schumpeter’s arguments as having “dramatic value,” even though Samuelson’s preference was not to “reify” Schumpeter’s stationary state but, rather, “to concentrate on the dynamic path” toward such an equilibrium. The question of whether or not opportunities for productive investment were limited was an important one, but it was a “factual question,” not the theoretical one that Schumpeter, Robbins, and Knight had made it out to be.However, while there were reasons for him to be thinking about such problems in 1942 when viewed against the background of his other work, this article, clearly written because he wanted to honor a teacher whom he held in high regard, appears to be a throwback to the work he was doing as a junior fellow in the late 1930s. Rather than developing theoretical ideas in discussion with his contemporaries, he was using mathematical argument to show that the debates of his elders, who did not understand the mathematics, were confused and misleading. Perhaps more telling than the criticism of his elders’ mathematical failures was his dismissal of their concerns as “esoteric.” This was very much the attitude he had taken to the literature on consumer theory that preceded his own. The mathematical models he cited might lead to seemingly unrealistic results, but this was the fault of the assumptions made, not of the mathematics. For example, if the rate of interest approached zero, the mathematics of discounting implied that a permanent asset should have infinite value. Echoing a theme from an earlier paper, he wrote,
If the infinite value of permanent assets in a zero interest rate economy seems anomalous, the paradox springs from the unreal character of the assumption that men maximize utility in terms of an infinite horizon. It is questionable whether the whole process of saving is illuminated by the attempts to explain it in terms of adjusting consumption streams over time.70
This statement makes it clear that, though he was familiar with mathematical theories in which saving was the result of households’ optimizing over time, he rejected such an approach as unrealistic.
He was thereby rejecting the framework that would, in the 1950s, become the standard approach to modeling consumption and saving. As his remark about the importance of limited opportunities for investment makes clear, he was viewing Schumpeter’s theory of the rate of interest through the lens of Hansen’s theory. Moreover, though he attached great importance to the theory of optimizing behavior, he did not view saving as determined by intertemporal optimization.Schumpeter told Samuelson that he found the paper very stimulating and that he hoped to have an opportunity to discuss it with him, continuing,
If you get reprints do not forget to send me one. I like to have a complete collection of Samuelsonia. Most of all of course I value the sign of goodwill on the part of one of the ablest economists of our time.71
This episode shows that, despite the criticisms contained in his article, Samuelson still held Schumpeter in high regard, and that this respect was reciprocated. It also serves as a reminder that, though Samuelson’s work was moving on, he was still willing to point out the confusions into which his elders had fallen. Taking a problem that was important to Knight as well as Schumpeter, he was arguing that, because they did not understand the mathematics, his elders had made serious mistakes. As in his thesis, he was using mathematics to clarify ideas, rendering old debates redundant, and thereby breaking with the past. In contrast, in his other work during this period, he was involved in developing the theories that would become the foundation on which most postwar macroeconomics would be based and that would be disseminated through his textbook. Some of these made it into print, but because of the pace of his activity, he failed to get some important papers to the point where they could be published.
The ideas being discussed in this chapter—the “New Economics”—centered on the multiplier, now appear very simple and naive to most economists: they are considered suitable for introductory economics courses and can be passed over very quickly by more advanced students, who may not even take them seriously as a starting point.
In the 1970s, these Keynesian models were displaced by other models based on the systematic application of the intertemporal optimization framework that Samuelson rejected as unrealistic and they were widely seen as being misconceived. However, for many years, economists did take these models seriously, developing and complicating them, using them as the basis for forecasting and policy analysis. What the sometimes convoluted debates discussed in this chapter and chapter 20 this volume show is that in the early 1940s, these ideas were far from simple. The mathematics might be trivial to a modern graduate student in economics but the conceptual basis for the theory was far from trivial especially when the ideas had to be related to the national accounts. Ideas that Samuelson was to present in a simple form in his introductory textbook a few years later were simple only because they had been extensively discussed and the conceptual problems clarified during this period. Just as important, they were central to the main policy issues faced by the United States in wartime. This meant that the primary place where the New Economics was being discussed was among the network of economists working in government agencies in Washington. Samuelson joined this network in 1941, when, though he continued to live in Cambridge and though teaching remained his main occupation, he began to commute to Washington to work as a consultant to the National Resources Planning Board.CHAPTER 19 Hansen and the National