Solow’s Nobel Prize Lecture: Talking Out Both Sides of His Mouth

Fixing the Economists Article of the Fortnight

by Philip Pilkington, Fixing the Economists

The other day I did a post comparing Solow’s growth model to the older Harrod-Domar growth model. After writing it I read Solow’s 1987 Nobel Prize address which looks at the history of growth theories in context. It is a fascinating document and I would encourage anyone interested in these issues to read it in the original; it is also very readable because, although I think that Solow is a rather disingenuous writer, he is also a very good one. Here I will just try to deal with some broad points.

First of all, it should be said that Solow completely misrepresented Harrod and Domar’s approach. He says that they assumed that the variables in their models were basically fixed and independent. Actually, this critique goes all the way back to Keynes’ letters to Harrod in the 1930s. But as Jan Kregel shows in his excellent 1980 paper Economic Dynamics and the Theory of Steady Growth: An Historical Essay on Harrod’s Knife-Edge this was based on a fundamental misunderstanding.

This misunderstanding was not just Solow’s. Indeed, it was perpetuated by Kaldor and Robinson in the 1940s and 1950s. What Harrod was actually doing was laying out the key variables for analysing the system by assuming fixity and independence and then using them to analyse the trade cycle in a properly nuanced and historical way. The model itself should be thought of wholly as a sort of ‘grid’ through which history is then interpreted. (How Robinson and Kaldor missed this, I have no idea; after all their own growth theories have always struck me as being in the same vein…).

Another point that Solow raises in the lecture is the idea that the Harrod-Domar model was ‘depression economics’. To him he always thought that it could not explain capitalism because capitalism was far more stable than the Harrod-Domar representation allowed for (I hope the reader appreciates a certain American ideology seeping into Solow’s argument here…). He writes,

Keep in mind that Harrod’s first Essay was published in 1939 and Domar’s first article in 1946. Growth theory, like much else in macroeconomics, was a product of the depression of the 1930s and of the war that finally ended it. So was I. Nevertheless it seemed to me that the story told by these models felt wrong. An expedition from Mars arriving on Earth having read this literature would have expected to find only the wreckage of a capitalism that had shaken itself to pieces long ago. Economic history was indeed a record of fluctuations as well as of growth, but most business cycles seemed to be self-limiting. Sustained, though disturbed, growth was not a rarity.

Again, this goes back to the first misunderstanding. If we take Harrod and Domar’s argument literally — i.e. that their model is an actual analogue of functioning capitalism and that the variables within it are indeed fixed and independent — then Solow is correct; the theory would then predict that the business cycle was not self-limiting and that extreme events would occur on a very regular basis indeed. But that is far too literal an interpretation. Again, the model is better seen as simply a ‘grid’ through which we then read economic history. In such a reading there are self-limiting tendencies when we turn to the real world. Which tendencies are most important then becomes an empirical issue.

This actually speaks more to the way Solow conceives of economic models. He thinks that when we build a model we have something of an actual map of real economic processes. This is a truly primitive manner of viewing economic theorising. But I don’t think that Solow is being particularly honest here. You see, he gave the lecture at a moment in history when New Classical and New Keynesian economics, with their Rational Agent microfounded models, were in the ascent, and Solow did not find these convincing at all. Unfortunately for Solow, if we apply his own criteria he used in judging Harrod and Domar in the mid-1950s to the microfoundations criticisms applied to his own work he quickly finds that he loses the argument.

Thus he is stuck in having to appeal to his audience to add a bit more intuition to their economic theorising. He writes,

When I say that Prescott’s story is hard to refute, it does not follow that his case can be proved. Quite the contrary: there are other models, inconsistent with his, that are just as hard to refute, maybe harder. The conclusion must be that historical time series do not provide a critical experiment. This is where a chemist would move into the laboratory, to design and conduct just such an experiment. That option is not available to economists. My tentative resolution of the dilemma is that we have no choice but to take seriously our own direct observations of the way economic institutions work. There will, of course, be arguments about the modus operandi of different institutions, but there is no reason why they should not be intelligible, orderly, fact-bound arguments. This sort of methodological opportunism can be uncomfortable and unsettling; but at least it should be able to protect us from foolishness… I include the sort of information that is encapsulated in the qualitative inferences made by expert observers, as well as direct knowledge of the functioning of economic institutions. Skepticism is always in order, of course. Insiders are sometimes the slaves of silly ideas. But we are not so well off for evidence that we can afford to ignore everything but time series of prices and quantities.

I’m sorry but I think that this is very rich indeed coming out of Solow. Solow was one of the key founders of this awful tendency in macroeconomics to take leave from the real-world and build highly unrealistic models. Indeed, if he had given some thought to institutions and history and interpreted Harrod and Domar’s work in this way then the problems with instability he raised would simply evaporate.

He thus seems to be talking out two sides of his mouth in this lecture. When it comes to Harrod and Domar he insists that we take their argument literally which then renders it an unrealistic portrayal of the actual economy. But when it comes to the marginalist models he gives his audience a wink and says “we really must not argue as if these models are literal representations of the real-world… some nuance, please!”.

This, so far as I can see, is classic Solow. When it suits him he will take the work of others literally and refute it on purely logical terms; but when faced with purely logical criticisms of his own work he says that we really should not take it so literally. He refused to interpret Harrod and Domar’s work as a grid through which we view a rich, institution-filled economic landscape but then insists that we interpret the rest of economic theory — especially his work — in just this manner.

All that aside, Solow actually makes an interesting point in the middle of the lecture. One which resonated with me. He writes,

Today I would put the unsolved problem as follows. One of the achievements of growth theory was to relate equilibrium growth to asset pricing under tranquil conditions. The hard part of disequilibrium growth is that we do not have-and it may be impossible to have-a really good theory of asset valuation under turbulent conditions. (1987 is an excellent year in which to make that observation!)

What Solow is hinting at is that if we have substantial asset price instability this will knock the economy off any sort of equilibrium. He then goes on to say that this is a most promising direction for future research. I entirely agree. This is precisely one of the results that I am trying to show in my work on asset-pricing. In my (otherwise rather problematic) paper A Stock-flow Approach to a General Theory of Pricing I wrote,

As is well known, New Keynesian and Neo-Keynesian macroeconomic theories typically rely on the idea of ‘sticky’ wages and prices to produce below full employment equilibrium results, i.e. to overturn Say’s Law. If we substitute the above theory of pricing for the standard marginalist theory of pricing, however, we need no longer assume that prices are sticky in order for the market to clear.

The reason for this is due to the distinction we laid out above between speculative and fundamental demand. As we showed above, investment may flow into either channel. It thus need not be assumed in our framework that investment capital flows into sectors that will increase both output and income. Rather it might flow into sectors that lead only to increases in prices through the process of speculation and only to a rise in financial income which, of course, is not counted in the standard measures of income.

The end result is that investment capital may simply drive up prices through the process of speculative demand and not increase real incomes or output. This increase in prices will then, ceteris paribus, ensure that markets do not clear and no full employment equilibrium is reached. By doing away with the notion of market equilibrium in the setting of prices we have, in a sense, completed the Keynesian revolution in that we cannot assume whatsoever that markets will clear given flexible wages and prices – indeed, as we have seen in our discussion of Kaleckian price dynamics the latter may actually encourage speculation, exacerbate price increases and thus ensure that markets do not clear. (pp41-42)

I have also made this same point elsewhere in a different manner with regards to the so-called ‘natural rate of interest’. Once we introduce a speculative component in the pricing of assets we must assume that the economy, even if it otherwise operated purely in the manner it does in the marginalist analysis, would be in a persistent state of disequilibrium. In order to refute this fundamental point a theorist would have to argue in favour of a strong-form EMH (Efficient Market Hypothesis).  If they do not, they must admit that capitalist economies cannot reach the equilibrium that they often attribute to them.