Capital Complexities

The definition and treatment of capital is an important issue that arises quickly when discussing neoclassical approaches to the business cycle. In particular, one can rapidly fall down the rabbit hole of the Cambridge Capital Controversies. However, if the objective is to focus on what is important for understanding the business cycle, we see that capital is hard to easily model, and this is related to the opacity of business cycle analysis.

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Heterodox economists put great weight on the Cambridge Capital Controversies. They argue that neoclassicals do understand the implications, which call into question the internal consistency of neoclassical theory. For example, see "What Even Famous Mainstream Economists Miss About the Cambridge Capital Controversies," by  Marc Lavoie and Mario Seccareccia. My argument is that the debate is complex because it is in reference to the internal consistency of neoclassical macroeconomics. However, if one takes the viewpoint that neoclassical economics is only useful if it has applications in the real world, there is no need to be derailed by worrying about its internal consistency. The problem with the neoclassical approach is that it is starting from a bad place to make the theory understandable.

What is Capital?

Capital is a word that has a variety of meanings. In accounting, it is related to equity, such as its usual in bank capital regulations. However, the meaning in economics has flipped to the other side of the balance sheet, being synonymous with non-land fixed assets.

The operational definition of capital is that it is a variable in the production function, that appears along side labour (and possibly other variables). It has a few key properties.

  1. It is permanent, although it might depreciate.
  2. It can be added to via investment that uses up produced goods. (This is why land is ruled out. If we want to add land to the production function, it is another variable.)
  3. It is meant to be tangible, which rules out some things like intellectual property. 

This corresponds to non-land fixed assets on business balance sheets, but importantly, it is a  physical measure. E.g., what matters is the number of drill presses, not how they are valued on the balance sheet. The easiest way to understand this if you play strategy video games -- capital refers to the various production units that you control, which then have associated production mechanics (the production function).

The reason we care about this definition of capital is that fixed investment is a major driver of the business cycle.

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Disclaimer: This article contains general discussions of economic and financial market trends for a general audience. These are not investment recommendations tailored to the particular needs of an ...

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