Suppose one were to ask the typical “person on the street:” which agents or institutions are the movers and shakers in modern capitalist economies? Most likely, business firms, perhaps in the form of the large corporation, would appear at the top of the list. Firms hire and fire. Firms set prices. Firms develop the technologies and invest in the capacity to transform labor into goods. Firms determine what consumers can buy. Yet, mainstream economic models present the firm as a remarkably passive agent. Macroeconomic theory, especially, usually portrays the firm as a technological automaton that mechanically spits out homogeneous final products from simplistic labor and capital inputs to maximize owners’ profits.
In sharp contrast, an important part of heterodox research explores the behavior of firms as active economic entities. Firm management has interests and aspirations that exist independently from its anonymous owners. When making production decisions, these firms must assess demand fluctuations. As it makes technological and investment choice, the active firm must confront fundamental uncertainty that cannot be reduced to simplistic, objective probability distributions. The active firm provides the heartbeat of macroeconomic activity.
This chapter does not focus on all heterodox approaches to the active firm. Instead, it considers Crotty’s conception of the firm by primarily focusing on two significant pieces of work. In 1990, Crotty published “Owner—Manager Conflict and Financial Theories of Investment: A Critical Assessment of Keynes, Tobin, and Minsky.” This paper proposes a fundamental role of management, independent from owners, in the decision-making processes of modern firms. In a remarkable 1994 essay, “Are Keynesian Uncertainty and Macrotheory Compatible? Conventional Decision Making, Institutional Structures, and Conditional Stability in Keynesian Macromodels,” Crotty develops the theme of fundamental uncertainty and how firms respond to it. While these papers explore a broad range of issues, this chapter focuses on their contributions to an active theory of the firm as the basis for macroeconomic analysis.
It seems obvious that firms are the engine of modern economic activity in developed countries. Virtually all members of the labor force work for a firm. Large corporate institutions clearly sit at the pinnacle of economic power, and wield enormous influence in the halls of government. But in neoclassical theory, especially in the much-discussed “microfoundations” of macroeconomics, the institutional complexity and behavioral autonomy of the firm is almost completely absent. In the typical model, the perfectly competitive representative firm passively maximizes profits. The firm is a mere repository of the technology for transforming inputs into output, and that technology is usually independent of any action of the firm or its managers.1
Why does mainstream theory rely on such a passive concept of the firm? A partial answer comes from the focus of neoclassical theory on the allocation of resources rather than the creation of economic activity. The competitive general equilibrium model that provides the foundation for neoclassical theory begins from the problem of allocating pre-existing resources to isolated consumers with exogenous preferences. Graduate courses in advanced theory begin (and sometimes end) with models of “exchange economies” with no production at all. While such models are obviously simple abstractions that are just the starting point for theory, their place at the foundation of neoclassical thinking suggests that they capture the essence of the phenomena that the theory is designed to illuminate. That is, we can start our analysis of modern capitalism by abstracting from production completely. When the time comes to introduce production, the objective is to do so with as little additional theoretical structure as possible. Thus, the theory posits the firm as simply a mathematical entity that maps inputs into outputs, maintaining the idea that the primary economic action is allocation of given resources (now in the form of inputs) to satisfy competing consumer preferences. Indeed, in many macro models with production, the firm has disappeared all together. The “Robinson Crusoe” representative consumer is simply endowed with the production technology. Crotty (1992:483) identifies this approach as “ideological” based on what Schumpeter would call a “pre-analytic Vision” of a “theory of how markets efficiently coordinate the decisions of atomized agents.”
Crotty’s papers present a strikingly different concept. Writing about Keynes’ view of economic agents he says (1994:111):
The economic outcomes we observe over time … are generated by an ever-changing system of agents, agent preferences, expectations, and economic, political, and social institutions, a system of “originative” choice in which future states of the world are in part created by the current agent choice process itself.
This conception contrasts sharply with the mainstream neoclassical approach (p. 119) in which: “agents are … autonomously constituted, lifeless Walrasian calculating machines.”
These observations about agents in general apply especially to firms. Crotty’s firms are complex social institutions that actively create economic outcomes. Their behaviors are rich and their decisions fundamentally strategic. Crotty and Goldstein (1992) lay out several key properties that distinguish modern firms from the passive model usually employed in mainstream macro models:
Although Crotty clearly draws heavily on Keynes, he explicitly distances his theory of the firm from Keynes in the 1990 paper. In Keynes’ investment theory, the dominant role of asset markets implies that owners drive investment decisions. Crotty argues, however, that there is no strong basis in Keynes’ theory for this assumption. Why should owners’ interests in short-term gains in volatile asset markets dominate managers’ objective to sustain the firm’s long-term viability? Keynes fears that the short-term speculative motives of firm owners will overcome the “enterprise” of managers that reflect a longer horizon. Crotty has more confidence in the ability of management to assert its control: “enterprise management will always have more complete and higher-quality information about those variables that determine the expected profitability of a prospective capital investment than even the best-informed stockholders, never mind Keynes’ ‘ignorant individuals’” (1990:535). By imposing its interest in long-run viability, Crotty clearly raises the status of the firm as an autonomous institution, not simply a repository of technology acting as a lapdog for shareholders.
Has the ability of the managerial class to control firm decision-making decreased in recent years? The answer is probably, to some extent, yes. From a theoretical point of view, mainstream finance and industrial organization have encouraged greater shareholder control to overcome so-called “agency problems.” Crotty would likely classify these developments as ideological for similar reasons that he attributes this label to the basic passive theory of the firm found in most mainstream macro models. In neoclassical theory, a more owner-responsive firm seems a better profit maximizer and hence seems closer to the neoclassical ideal of efficiency and optimality. But this welfare criterion is exceedingly narrow, and it assumes that the true social role of the firm is as a passive technological repository. Are firms that bend more easily to shareholders’ short-term interests really better at promoting social welfare? A detailed answer lies outside the scope of this chapter but there are clearly reasons to doubt that the answer is yes. Excessive catering to the short-term horizon of outside investors may reduce profits in the long run, a reflection of Keynes’ speculation versus enterprise insight. Modern corporate strategies designed to please shareholders also threaten employment and long-run connections between workers and employers, with negative social consequences. The evolution of finance, particularly the emergence of the leveraged buyout and private equity strategies have likely reduced managerial control, which, according to the Crotty perspective, likely elevates short-term returns over long-run stability and viability. The result could easily be an industrial structure that serves society less well.2
Perhaps an even more important aspect of the Crotty firm is its location in an environment of fundamental uncertainty. This requires an active conception of the firm because it must make strategic decisions when much relevant information is simply unknowable. In Crotty (1994), following Keynes again, he argues “that the future is unknowable in principle” (p. 111, emphasis in original). Why should this be the case? It is exactly because economic agents, firms in particular, are indeed active, that is, their decisions and strategies shape the future:
the economic outcomes we observe over time, [Keynes] argued, are generated by an every-changing system of agents, agent preferences, expectations, and economic, political, and social institutions, a system of “originative” choice in which future states of the world are in part created by the agent choice process itself.
(p. 111)
Some researchers have rejected fundamental uncertainty on the basis that it is a dead-end for economic theory. If agents can’t “know” future probability distributions, how can theorists model their behavior in contexts where current actions have future consequences? Crotty rejects this view and proposes a rich theory of expectation formation and decision-making under fundamental uncertainty. His core idea, taken from Keynes but developed significantly, is the concept of convention. Agents know they cannot obtain or infer information about the true probability distributions they face (indeed, these distributions probably do not exist in any meaningful sense), but they assume the future will be more or less like the recent past in the absence of any compelling information to the contrary. One reason is that normal experience supports this behavioral rule much of the time, perhaps as a kind of self-confirming equilibrium: if agents believe the future will be similar to the recent past they will take actions that typically reproduce the conventional outcome. Although this interpretation is not taken directly from Crotty’s writing, it has support in his concept of “conditional stability.” Crotty (1992:487) writes that “conventional decision making creates a significant degree of continuity, order, and conditional stability in a Keynesian model in spite of the potential for chaos and perpetual instability seemingly inherent in the assumption of true uncertainty” and (1994:116) that “history demonstrates that capitalist economies move through time with a substantial degree of order and continuity that is disrupted only on occasion by burst of disorderly and discontinuous change.” Most of the time, therefore, conventional expectations are confirmed by experience.
Complementary support for conventional expectations arises from humans’ deep-seated desire for control. Uncertainty may be ubiquitous, but it is also discomforting. Although Crotty sharply criticizes the mainstream assumption that firms make decisions with the knowledge of objective probability distributions, he writes (1994:120), somewhat ironically, that
people want to believe that they are in the same position in which economists place neoclassical agents, with all the information required to make optimal choices…. Keynes tells us that we have a psychological need to calm our anxieties, to remove the constant stress created by forced decision making under inadequate information, a need that is neither irrational nor socially or economically dysfunctional.
In the context of firms, human managers convince themselves of the relevance of conventional expectations as a kind of defense mechanism against the nagging insecurity of uncertainty. In addition, convention acquires a social reinforcement. In the absence of objective information about how to behave, agents refer to others in their social reference groups, a kind of psychological law of large numbers.3 Such behavior likely imbues convention with more weight of truthfulness than it objectively deserves. Think about the perception of perpetually rising energy prices in the late 1970s or the sense that home prices in the early and mid 2000s could never fall. Rousseau said “the mind decides in one way or another, despite itself, and prefers being mistaken to believing in nothing.”4
While agents follow convention in forming expectations and experience often confirms them, conventions can and do fail. Such failure may be unusual, but it is among the most significant of macroeconomic events. Conventional expectations are not based on objective reality that is independent of human perception. The very fact that active agents make creative, originative choices implies that things will happen that could not, even in principle, have been forecast ahead of time. While sudden change may occur in either direction, periods of “crisis” receive the most attention for macro purposes. Crotty (1992:487) writes that “at such times, confidence in the meaningfulness of the forecasting process will shatter, and key behavioral equations may become extremely unstable.”
These observations imply the presence of a rich, autonomous set of firm behaviors to navigate a world of uncertainty. Crotty (1994:119) expresses the idea exceptionally well: “agents are socially and endogenously constituted human beings…. The theory of agent choice, therefore, must reflect both the social constitution of the agent … as well as the psychological complexity of the human-being-in-society.” In this role, firms actively create economic outcomes. These are the firms the person on the street can identify with, not the passive “Walrasian calculating machines.” The contrast with a mainstream view comes into sharper focus with an analogy to geology. The earth is a complex system. Interesting, unpredictable, even chaotic phenomena happen as one set of geologic forces raise mountains while others wear them down. But, absent the active intervention of a deity, there is no “will” or “agency” in these forces. The neoclassical approach, with all its formal complexity, can generate a wide variety of outcomes. But the models reduce human agency to the analog of impersonal geologic forces. Crotty’s vision of human agency, particularly applied to the locus of production in the modern firm, is qualitatively different. We now apply this conception of the active firm in two contexts: production and capital investment.
Firms choose production levels and firms hire works. Thus, firms make the decisions that, in the most simple and direct sense, provide the microfoundations for macroeconomic outcomes that drive the business cycle. In mainstream macro, the production choices by passive firms are exceedingly dull. Under perfect competition, exogenous technology and the pre-determined capital stock entirely determine production and the demand for labor. The sale of output poses no constraint at prices set independently of firm behavior. Given technology and the assumption of profit maximization, there is not much else to say about firm behavior.
This hollow caricature seems an inadequate depiction of the modern firm, especially when it faces the uncertainty identified in Crotty’s research. The firm cannot assume that it can sell all it wants at the prevailing price level (with perhaps the exception of corn farmers in Iowa or similarly situated small producers of homogeneous commodities that constitute a trivial portion of modern capitalism in developed countries). The firm must forecast demand and make strategic production, employment and inventory choices (we consider investment in productive capacity in the next section). I argue that expected sales is the most important factor that determines a firm’s short-term production choices, dominating the variables that get top billing in neoclassical models, such as the relative price of labor. It seems obvious that the central problem firms face in a deep recession is an involuntary constraint on the ability to sell what they could produce, not that the real wage has risen inducing simplistic “Walrasian calculating machines” to voluntarily reduce output and employment.5 But to forecast demand, adjust employment strategically, assess the risks of excess inventory in a downturn or stockouts in a boom, etc. requires an active management. Management must form expectations and therefore the willful behavior of real human beings provides the “microfoundation” of production.
These observations suggest an active conception of firm behavior, rooted in managerial choice with fundamental uncertainty, lies behind Keynesian macro. I know of no systematic empirical evidence that is directly relevant to assessing the relevance of active behaviors in contrast to the passive and mechanical technical response of the “representative firm” in most mainstream macro. The absence of tests may reflect the utterly obvious fact that firms adjust production in response to sales expectations. Are firms responding to rapid and uncertain developments in detailed markets or are they mechanically setting the real wage equal to the marginal product of labor? My intuition strongly suggests the former alternative, and I believe that vision of the production decisions flows from Crotty’s conception of the firm. But further research should take the radical step of asking firms how they make production choices over the business cycle.
Crotty (1990:534) writes that the “capital investment decision will be considered to be of the utmost importance by management because it is the most important, most risky, and least reversible influence on the intermediate and long-term prosperity of the enterprise.” Capital investment, including long-term development of technology through R&D, is the foundation for the long-term viability of the firm. With fundamental uncertainty, the active character of firms’ investment behavior again contrasts strongly with conventional views. Neoclassical models of investment assume that firms know future probability distributions over all possible outcomes (or that firms have perfect foresight). The resulting theory depicts investment decisions as a mechanical optimization problem of matching dynamic marginal productivity with the “user cost” of capital and (unobservable) marginal adjustment costs. Might firms, for example, adjust investment in response to a new investment tax credit? Perhaps yes, especially the timing of their investment around a tax change. But this kind of decision-making, representative of the typical issue illuminated by neoclassical theory, seems far removed from the strategic decisions taken by firms as conceptualized in Crotty’s work.
The active firm facing uncertainty must both imagine a set of strategies it might pursue and then probe the space of imagined possibilities to find, if possible, a configuration of capital that generates profit. Some things work out, others don’t. Some things might work for a while in a given environment, and therefore be expanded and copied. But when the environment shifts, the strategy could ultimately fail. Consider for example, investment in energy extraction during the late 1970s when conventional wisdom predicted rising oil prices as far as the eye could see. For a few years, such investments seemed like they “couldn’t miss,” but the world changed in unforeseen ways, and the expectational convention shattered. As another example, during the years prior to 2007, the conventional expectations in the mortgage lending industry held that home prices would continue to rise and refinancing terms would remain easy. In this environment the lending revolution proceeded, raising household lending until it may well be reaching a breaking point as of this writing. Were the conventional expectations that housing prices would keep rising indefinitely ever realistic? Probably not, but they became convention, and firms making residential construction and mortgage-lending decisions, could not see the systemic problems coming.6 Crotty writes (1994:125): “From time to time events take place that will make it impossible to sustain the convention that the future will look like the present extrapolated.”
This perspective applies to the link between investment and finance.7 Neoclassical investment theory through at least the early 1980s, epitomized the passive firm in the realm of capital investment: firms invest when the marginal product of capital exceeds the Jorgensonian user cost. The theory again focuses solely on relative prices and technology. When one considers Crotty’s managerial perspective for firm behavior, however, the story changes. External finance raises investment possibilities but threatens managerial autonomy. With fundamental uncertainty, the long-term viability of the firm becomes subject to risks of bankruptcy or shareholder revolt that cannot be known in advance, even probabilistically. For this reason, external finance cannot be a perfect substitute for internal cash flow, as it would be in the Modigliani—Miller world. The financing decision therefore cannot be passive, indeed it is among the most important strategic decisions that management must take. Again, rather than simply mechanistically transforming inputs into outputs with the “optimal” capital structure, the human agency of firm managers actively creates the future as new activities are pursued and financial commitments are established.
The decision to seek and accept external financing confronts management with a significant tradeoff that could easily dominate the technological—relative price tradeoff of neoclassical theory, and that places finance at center stage for the active firm. Crotty and Goldstein write that when
the firm is in a financially precarious position, management responds to the threat to its decision-making autonomy by placing more weight on financial security relative to growth and, therefore, is less willing to undertake inherently risky investment projects. Financial fragility constrains investment.
(1992:5, emphasis in original)
This perspective obviously applies to firms that face financial setbacks, for example, when a recession curtails funds available to service debt. But the tradeoff also impinges on a successful, growing firm as its managers contemplate the value of growth versus the control that they must sacrifice to lenders or new shareholders to obtain external funds. The way in which firm managers facing fundamental uncertainty navigate the risks of external finance compared to the growth potential new funds provide is far from mechanistic and passive. These choices depend on expectations and confidence that constitute a central and autonomous behavioral component of modern capitalism.
It is not just the decision to take on external finance for investment that poses a challenge to the modern firm. Firms must also confront the terms on which they can obtain finance, if they can get it at all. That is, firms face financing constraints. This idea has become more common in mainstream analysis over the past 25 years, particularly due to the attention given to asymmetric information in credit markets (see Fazzari and Variato 1994). As such, the mainstream has moved some distance away from the passive firm model. When a firm cannot finance all investment projects with positive net present value the firm’s internal structure and history, such as its reputation and collateral value, affect its access to finance and the firm becomes more than just a repository of technology. This progress, however, still leaves a big theoretical gap with the active Crotty firm. The firms modeled in asymmetric information-financing constraint models are more interesting than the technological automatons of earlier neoclassical models. But these models typically assume that firms and lenders know the probability distribution of investment returns. They do not recognize the psychological nuances of human agency, indeed agent behaviors assumed in these models could be programmed into a computer! The mainstream has yet to understand how seeking finance and managing the tradeoff between expansion and threats to viability and control risk is a key creative activity of the active firm.
There is extensive empirical evidence to support the view that finance matters for investment (recent work is summarized by Brown et al. (2009)), but this evidence is not particularly useful in distinguishing the channels through which financial effects operate. The widespread evidence that internal cash flow affects investment spending, even controlling for profit expectations, rejects the passive financial neutrality of Modigliani—Miller. In the mainstream, these results are taken to support the presence of external financing constraints due to asymmetric information and agency problems that drive a wedge between the opportunity cost of internal funds and the explicit cost of external finance. But cash flow effects on investment could just as well signal management’s drive to maintain control of firm activities.
Another prominent feature of empirical research on investment and finance is “heterogeneity:” financial effects appear to be stronger for firms that are a priori more likely to face external financial constraints. For example, small or young firms have larger cash flow effects on investment than large or mature firms. These findings do not imply the absence of managerial control considerations. It is certainly possible that internal control effects co-exist with external financing constraints. Future research, however, might refine our understanding of this issue. For example, how are investment and finance related across large, mature firms, with supposedly easy access to external finance, that face different degrees of takeover threat? One might also study the effect of uncertainty per se on investment. The Crotty firm should invest less when conventional wisdom is in turmoil and confidence in forecasts is low. It is tricky to measure the degree of uncertainty, but creative research along these lines could deepen our understanding. Crotty and Goldstein (1992) offer an interesting contribution along these lines by showing that greater competitive pressure (measured by the degree of import penetration), which should threaten managerial control and long-term firm viability, increases investment even after controlling for measures of profitability. More work along these lines, particularly with micro data, will be welcome.
In modern capitalism, the firm matters as a human institution, with complex behaviors deriving from the way its managers respond to inherent uncertainty. Crotty (1994:121) writes:
In place of the complete information appropriate to the fairy-tale world of neoclassical agent choice, Keynes substitutes an expectations formation and decision-making process based on custom, habit, tradition, instinct, and other socially constituted practices that make sense only in a model of human agency in an environment of genuine uncertainty.
The managers of firms make production and investment decisions in an effort to preserve and expand the institutions that provide their livelihoods. Economists need to understand the nuances of firm behavior by exploring the psychological motivations of “human agents” situated in a fundamentally social and fundamentally uncertain environment. The active behavior of firms cannot be deduced from the simple constrained maximization problems of neoclassical theory. We need empirically based behavioral models to make sense out of firm choices and to lay the foundation for macro-dynamic theory.
Recent contributions to “behavioral economics” have begun to peek into how real people behave in economic settings. This work is interesting, but has not yet offered much to reveal the motivation of modern firms, the central characters in the capitalist economic play. These are the behaviors that create the modern economy and macroeconomics emerges from their aggregation. This style of macroeconomics largely eludes the mainstream, but the research of James Crotty has confronted these issues directly, illuminating a rich perspective on firm behavior, and its macroeconomic implications, long before the recent wave of behavioral ideas became popular in conventional departments of economics. Nearly 15 years ago, Crotty (1994:131) wrote that:
Keynes’s stress on the humanity of the agent suggests the use of observational and experimental methods for the study of the psychology of individual and group decision-making, and his work on conventional expectations formation calls for the legitimation of institutional, sociological, psychological, historical and survey research methodology as complements to the traditional deductive logic of economic theory.
Crotty was ahead of his time and we hope to see this vision realized.
1 This description of mainstream theory is admittedly somewhat limited. Industrial organization models, for example, often emphasize “agency problems” and endogenous growth models consider the evolution of technology. Due to space limitations, I will not consider these models further here. Crotty (1990) discusses the relation between his concept of the firm and neoclassical models with agency problems.
2 These comments probably apply primarily to the large corporations of monopoly capitalism. The ability to start small enterprise possibly has been enhanced by the evolution of financial markets, particularly the availability of new sources of external equity finance. See Brown et al. (2009) for further discussion.
3 Akerlof (2007) relates firm behavior to social norms. The extensive role of social influence on consumption and household debt is developed by Cynamon and Fazzari (2008) who provide extensive further references.
4 Quoted by Mark Lilla in “The Politics of God,” New York Times Magazine, August 19, 2007.
5 See Fazzari et al. (1998) for a more detailed discussion of this point, albeit in a static setting without fundamental uncertainty.
6 Of course, the same point applies to the borrowing households, see Cynamon and Fazzari (2008).
7 Aspects of this topic were the subject of a published interchange in Crotty (1996) and Fazzari and Variato (1996).
Akerlof, G. A. (2007) “The Missing Motivation in Macroeconomics,” The American Economic Review, 97: 15–36.
Brown, J. R., Fazzari, S. M. and Petersen, B. C. (2009) “Financing Innovation and Growth: Cash Flow, External Equity and the 1990s R&D Boom,” Journal of Finance, 64: 151–86.
Crotty, J. R. (1990) “Owner-Manager Conflict and Financial Theories of Investment Instability: A Critical Assessment of Keynes, Tobin, and Minsky,” Journal of Post Keynesian Economics, 12: 519–42.
——(1992) “Neoclassical and Keynesian Approaches to the Theory of Investment,” Journal of Post Keynesian Economics, 14: 483–96.
——(1994) “Are Keynesian Uncertainty and Macrotheory Compatible? Conventional Decision Making, Institutional Structures, and Conditional Stability in Keynesian Macromodels,” in G. Dymski and R. Pollin (eds.) New Perspectives in Monetary Macroeconomics: Explorations in the Tradition of Hyman Minsky, 105–42, Ann Arbor: University of Michigan Press.
——(1996) “Is the New Keynesian Theory of Investment Really Keynesian?” Journal of Post Keynesian Economics, 18: 335–57.
Crotty, J. R. and Goldstein, J. (1992) “The Impact of Profitability, Financial Fragility and Competitive Regime Shifts on Investment Demand: Empirical Evidence,” Working Paper No. 81, Levy Economics Institute.
Cynamon, B. Z. and Fazzari, S. M. (2008) “Household Debt in the Consumer Age: Source of Growth—Risk of Collapse,” Capitalism and Society, 3: 2, Article 3. Available at: www.bepress.com/cas/vol3/issz/art3.
Fazzari, S. M. and Variato A. M. (1994) “Asymmetric Information and Keynesian Theories of Investment,” Journal of Post Keynesian Economics, 16: 351–69.
——(1996) “Varieties of Keynesian Investment Theories: Further Reflections,” Journal of Post Keynesian Economics, 18: 359–68.
Fazzari, S. M., Ferri, P. E. and Greenberg, E. D. (1998) “Aggregate Demand and Micro Behavior: A New Perspective on Keynesian Macroeconomics,” Journal of Post Keynesian Economics, 20: 527–58.