Nicholas Kaldor, increasing returns and Verdoorn’s Law

Abstract

Nicholas Kaldor made much of the Verdoorn’s Law and the objective of this paper is to examine the validity of this alleged law and whether it justifies special treatment to manufacturing. This paper reviews the Smith-Young approach to increasing returns and shows that Kaldor was not much guided by this framework when it came to policy making. He was more guided by empirical observations with respect to the applicability of Verdoorn’s Law. The paper also critically reviews Verdoorn’s Law particularly in so far as Verdoorn himself was not fully convinced of its general applicability. The correspondence between Kaldor and Lauchlin Currie (and Roger Sandilands) is also highlighted in this regard and brings out their differing views on both agriculture and industry. The paper’s main conclusion is that even if Verdoorn’s Law is valid it does not call for a special treatment to manufacturing. The logic of favoring manufacturing at the cost of other sectors distorts intersectoral relationships, leads to adverse terms of trade for agriculture, and is likely to pose a demand constraint for industry itself. To undo one distortion (i.e., protection to industry), one has to match it with other distortions like price support and marketing board in agriculture, and dual exchange rates to promote exports. The whole economic system becomes an intricate maze with adverse consequences for growth and productivity for the whole economy.

Keywords:

• Allyn Young
• increasing returns
• Lauchlin Currie
• Nicholas Kaldor
• Verdoorn’s Law

JEL:

• B10
• B20
• B31
• O21
• O14
• O41

Notes

1 In this regard Kaldor’s biographer Anthony Thirlwall (1987a, 519) writes: “His background was Hungarian, but like so many European émigrés, he became more English than the English and reveled in her institutions.”

2 First stage import substitution under moderate protection can always be justified on infant industry grounds as all latecomers to industrialisation such as Germany and USA had to protect their industries. However in its second stage, import substitution can give rise to significant distortions with the persistence or extension of licenses and exchange and quantitative controls, and an excessively dominant role for the public sector that takes it well beyond public utilities and social infrastructure, jeopardizing comparative advantage. See Balassa (1980).

3 Thirlwall (2002) in “Foreword” to Productivity Growth and Economic Performance: Essays on Verdoorn’s Law mentioned that he (with the help of an Italian wife) translated Verdoorn’s original paper into English in 1973 but Verdoorn was reluctant to publish it as he now thought that his law applied only in steady state. Although Thirlwall would have loved to publish it as “scholarship was not being served by the ignorance of the original article,” but respecting Verdoorn’s wishes he refrained from doing so till after Verdoorn’s death when he published it as an appendix to a paper “Population growth and economic development” in a book of essays in honour of Colin Clark (see Ironmonger et al. 1988).

4 Thirlwall (2002, ix) at another place, however, mentions that only two economists made reference to Verdoorn before Kaldor—Colin Clark in 1957 (in Conditions of Economic Progress, third edition) and Arrow in 1962 (in his classic paper “Economic implications of learning by doing”).

5 There is substantial literature on Verdoorn’s Law, as noted by John King (2009), including McCombie, Pugno and Soro (2002), Ros (2000) and Shaw (1992).

6 “As a devisor of ingenious schemes, he had no equal; “the last great innovator” as Professor Ken Galbraith once described him. His view of economics as a moral science—as a branch of ethics in the Cambridge tradition—motivated much of his writing, and led him into policy making at the highest level as a special Adviser to three British (Labour) Chancellors of the Exchequer, and as an adviser to several developing countries” (Thirlwall 1987a, 519).

7 See also Chandra (2020), chapter 4.

8 In a letter to Lauchlin Currie dated 30th April 1979, Roger Sandilands wrote: “I think Kaldor is confusing absolute and relative markets. If commodity A is in elastic demand when it experiences an innovation which enables it to expand supply/demand, it will increase its share of the total market and the share of other products will fall. But this does not mean that the absolute level of output of other commodities falls. On the contrary, that is rising. This must be the case if the demand for product A is elastic since, by definition, when “total revenue” for industry A increases, this means that total supply of other products has increased in exchange.”

9 In Young increasing returns take the form of pecuniary external economies which are better transmitted in a more competitive system. Economies of the division of labour in industry benefit agriculture, and economies achieved in agriculture benefit industry through the vehicle of pecuniary external economies.

10 Young had talked about the role of monetary policy in controlling the business cycle. But he ignored monetary factors in his theory of growth and, for expository purposes, exclusively concentrated on the barter mechanism and the operation of reciprocal demand.

11 This change in Kaldor’s position meant that even advanced economies such as the UK had surplus labour and were subject to dualism in the sense that labour from low productivity uses (like services) could be drawn into higher productivity manufacturing.

12 Rowthorn (1979) criticised Verdoorn regarding the role of labour supply in the model and its equations. Verdoorn’s (1980) remark was related to the theoretical point in his model that the value of the productivity-output elasticity varies with the rate of population growth across countries.

13 If growth is demand determined, employment growth is endogenous not exogenous.

14 McCombie (1983), writing in the same symposium issue, concluded that after taking into account the recent literature there was no reason for altering Thirlwall’s (1983b) conclusions.

15 Despite Keynes’s observation that few laws in economics are incontrovertible, Thirlwall (2002, ix), based on its empirical regularity, regarded Verdoorn’s Law as a strong contender for that status. McCombie, Pugno and Soro (2002, 1) in “Introduction” state that it was fair to regard Verdoorn’s Law as more than just a “stylized fact” as it appeared to be largely substantiated in empirical studies. They further point out that “Verdoorn’s Law is an important piece of analysis, as it can effectively help explain the process of economic divergence among countries and regions, both within a Kaldorian perspective and within the endogenous growth framework” (ibid., 7).

16 Here Kaldor referenced Kaldor (1974) on the role of indusrialisation in Latin American inflation.

17 Here Sayian demand refers to reciprocal demand where the expansion of one sector stimulates the rest of the economy, and expansion of the rest of the economy in turn stimulates the original sector. The entire economy is seen in reciprocal exchange relationships. This derives from Young’s (1928) inclusive definition of the market as an aggregate of productive activities tied together by trade.

18 See Currie (1971).

19 King (2009, p. 1) notes that the global recession was made much worse by the new monetarist policies implemented in Britain and the US during 1979–82 under “free market” governments. So Kaldor, who was already critical of monetarism as an economic theory, devoted all his energies to attacking it as a political phenomenon after 1979.

20 Here Keynesian monetary investment refers to investment financed by additional money creation which may result in inflation if there are institutional rigidities in the system so that the supply response may be lacking.

21 In an unpublished paper “Economic growth and demand management,” Currie (1979) further distinguished between monetary demand management (in the Keynesian sense) and real demand management. While the former refers to matching saving and investment at the existing levels (or where growth in money incomes is kept in line with real output), the latter refers to matching saving and investment at a sustained high level (and can be used to increase employment and output in the chosen leading sectors). He wrote: “Demand management must be interpreted in dealing with real as well as monetary demand. It is perfectly conceivable that the policy may simultaneously call for restraint of demand in the monetary sense and it stimulation in the real sense” (28). Currie further states: “Only rarely and by accident, especially in LDCs, will market forces, unaided, permit the actual rate of growth to be near its potential for any lapse of time or ensure the correspondence between saving and investment at a sustained high level. The interest rate cannot be relied upon to do this. The broad classification of sectors into which investment may be stimulated exogenously and those in which it can be relied upon to follow the growth in the market can simplify and aid in the task of demand management or growth guidance” (ibid., 28–9).

22 Kaldor was deeply influenced by the Keynesian Revolution in the aftermath of the Great Depression of the 1930s and therefore wanted to supplement Young’s growth analysis with Keynesian insights. As Laidler (1999, 3–4) tells us, this revolution itself turned into an orthodoxy for none existed earlier.

23 Kaldor (1996, 28) in his Mattioli Lectures, delivered in 1984 but published much later in 1996, appeared to endorse Smith’s view that “agricultural surplus” determined the proportion of population outside agriculture. This led him to emphasise land-saving innovations in agriculture instead of labour saving (as in the industrial sector). However, Smith’s concept of natural liberty or his “no favours, no handicaps” approach did not imply favouring agriculture (because it supported population outside agriculture) or industry (because the division of labour was better carried out in manufacturing). In Smith the apparent priority of agriculture in the initial stage of development emerged because of the natural course of things, and because of the initial higher rates of return there through the market as noted by scholars like Hollander (1971, 1973) and Reid (1989).

24 As mentioned earlier, Kaldor backtracked from his view that labour shortages posed a constraint to the UK economy. But he continued to maintain that balance of payments posed a real constraint which was later formalized by Thirlwall (1979). See also Thirlwall (1986, 2011, 562–65).

25 In the literature two types of trade strategies have been distinguished: inward oriented (which favours domestic production over exports) and outward oriented (which is neutral between domestic production and exports).

26 For studies on effective rates of protection that can greatly exceed the nominal rates that disguise the true extent of potential market distortions, see Little et al. (1970) and Balassa (1971).

27 The post-war development experience bears this out—those countries which gave a greater chance to the market forces (and outward orientation) prospered, and those which followed extreme import substitution strategies declined in performance. See World Development Report (World Bank, 1987) and Dollar (1992).

28 For an appraisal of Currie’s “leading sector” strategy see Chandra (2006).

29 Currie felt that a theory of growth is different from that of business cycles. Although additional money may help the barter system to work out more smoothly, the Keynesian mechanism diverts attention from endogenous forces of growth to exogenous elements. “What a theory of growth has to explain is the underlying but strong tendency toward increasing returns in the whole economy, so that deviations from the trend are largely self-correcting” (Currie and Sandilands 1997, 419).

Additional information

Notes on contributors

Ramesh Chandra

Ramesh Chandra is an Independent Economist. Address: 7 Matherton Avenue, Newton Mearns, Glasgow G77 5EY, UK. Email: [email protected]

Roger J. Sandilands

Roger J. Sandilands is at University of Strathclyde, Glasgow, UK.