Book X. Conclusions

Conclusions

Some of the conclusions can be best understood in relation to the work of others. There are two sets of authors: those who take a general position and those who concentrate on the poverty issue.

41. Relating to Mankiw’s “Principles”

Mankiw (1998)’s “Principles” textbook is becoming a corner stone in the education of economics - and very understandably so. As a teacher I would likely prefer this book myself too. It will be clear, however, that Mankiw’s book does not mention many of the fundamental points made here. This makes that one would wish, and in a sense should predict, that Mankiw adapts his text to them. My own suggestion however is that we allow students the advantage to better appreciate the gap between economic thinking ‘before’ and ‘after’ the current new analysis. Such appreciation will be an asset to their historical perception and understanding of the role of economics in society. So, buy both Mankiw’s book, as it is now, and this book, as a package deal.

Discussing income redistribution, Mankiw states: “(…) here we digress from economic science to consider a bit of political philosophy.” (p431) Tinbergen, Keynes, Marshall, Mill and Smith turned in their graves. Income redistribution and the underlying philosophies are a topic of Political Economy - and thus they still are economics !

Mankiw himself states: “When the government enacts policies to make the distribution of income more equitable, it distorts incentives, alters behavior, and makes the allocation of resources less efficient.” (p421) and “The more equally the pie is divided, the smaller the pie becomes. This is the one lesson concerning the distribution of income about which almost every one agrees.” (p441).

I find these statements problematic. The matter is put in a binary ‘pro-con’ manner. The same approach happens in the back of the book, when the student is confronted with ‘pro-con’ questions. Such an approach in itself stimulates debate, but decisions in reality are subtler. A ‘pro’ view can change into a ‘con’ view if a tax rate proposal differs by only a percentage point.

For the income distribution:

First of all, even if the pie would be smaller, the system still would be efficient. Mankiw uses the word ‘efficiency’ incorrectly, mixing up growth with efficiency, and stirring up adverse feelings against income redistribution by using a wrong accusation.

Secondly, indeed, if all incomes were equalised - as even the communist parties of Russia or China didn’t and don’t succeed in doing - the pie could get noticeably smaller. However, for the practical measures we are talking about - in the 40% - 60% range for the marginal rate - the change might not be that relevant. There are not only disincentives for the rich, but also incentives for the poor to participate in society. There are so many other effects. Alleviating poverty, by getting people into jobs, could reduce the crime problem. Or, a rich person may decide to work less and spend more time on a hobby or with the kids - and might find out that he or she is actually better off. The prime comment, and the prime economic observation, is that the pie itself is relevant, but the social utility derived from it is even more relevant. If a democratic, Madisonian, society decides to redistribute income, that itself is evidence and proof that it moves to a superior welfare position.

It is true that a rich person may earn $100,000 per annum and can be outraged by a 40% or 50% tax on it, claiming that society steals it. Strangely, while governments spend so much energy in monitoring the poor, they are quite reluctant to calculate the benefits going to the wealthy. The value of industries depends upon government regulations. The value of city property is also caused by public investments. What we earn now, depends so much on what our ancestors have been doing. It is truly difficult to determine what our own personal contribution is. The $100,000 earned are only the proceeds from a market situation - but the market is an amoral beast, and not a god of justice that allocates what people ‘deserve’. And thus, having such a marginal tax rate could well be one of the necessary ‘rules of the game’ to create a both prosperous and civilised society.

Mankiw shows an awareness of this on some pages, but not integrally so.

On the subject of designing an incentive compatible tax system, he states: “Thus, policy makers face a tradeoff between burdening the poor with high effective marginal tax rates and burdening the taxpayers with costly programs to reduce poverty.” (p440).

Well, indeed, this is the current view among economists - that this current book shows to be wrong.

Mankiw’s discussion on GDP seems rather balanced. Yet, for all his caution, he still seems to favour GDP as the “the single best measure for welfare”, or “a good measure of welfare for most - but not all - purposes” (p490). I think that the latter still is unwarranted, and I’d rather would favour the conclusion: GDP is a crude measure for income - and I would keep some distance from welfare implications.

Mankiw (p490) tries at a short ‘international comparison’, and shows that GDP per capita ‘tends’ to associate with a higher life expectancy. However, he uses India, while Sen (1998:47) - discussed below - argues that the substate of Kerala (30 million people - twice as many as Holland) is quite different. Table 17 gives the 1993 data of Mankiw and the 1994 data of Sen (read from the diagram). In short, the ‘tendency’ that Mankiw notes is much like the ‘storks and babies’ regression - if the data are right.

Mankiw p515 slips into a ‘summary statement’ that textbooks are inclined to provide but rather should avoid: “Richer countries have more automobiles, more telephones, more televisions, better nutrition, safer housing, better health care, and longer life expectancy.”

Table 17: GDP per capita and life expectancy

India

Kerala

GDP per capita

$24,680

$1,240

$500

Life Expectancy

Why, oh why, argue that a GDP measure can do more than it can do ? Why create the suggestion that governments employ sufficient numbers of economists, and that we don’t need loads more ?

Mankiw’s discussion would benefit from reading Hueting (1980) and P. Dasgupta & K.-G. Mäler (1999) on the environment. And on the causes for famines (p531) he could also benefit from a closer study of Sen’s work. Perhaps there could be another ‘principle of economics’ here.

I would think that a ‘principles’ book should contain explanations of ‘ex ante’ and ‘ex post’ and of ‘animal spirits’. Perhaps I am European and perhaps I value a historic sense, but I really don’t understand that Mankiw does not used the ‘ex’s, and only mentions ‘animal spirits’ on p722 without explanation.

Similarly, I don’t understand why Mankiw adopts the word ‘natural rate’ and then explains that there is little ‘natural’ about ‘natural’. Is this not obviously a stupid and ridiculous way of teaching ? Let us please ditch the word, and use ‘system rate’ (or rather CWIRU as above). Note too that Mankiw’s ‘explanation’ on p566 that the system rate of unemployment “does not go away of its own” is awkward, since the economic system is heavily regulated, and events hardly ever are “of their own”. There are always people taking decisions.

There are some points on indexation. (1) The productivity slowdown - US output per hour dropped from 3.2% per annum in 1959-1973 to 1.3 % per annum in 1973-1994 - is related to GDP per capita, and this is dangerous, while it should be simple to include hours in the latter graph. The explanation for the slowdown remains in the air - and I would like to see mention of lower investments (due to lower profits and inflation uncertainty in the 1970s, and high real rates of interest since). (2) Mankiw does not provide much light on the ‘CPI correction problem’. His p504 chart on GDP and CPI does not really clarify how Alan Blinder can come up with a correction of -1% per annum on the CPI. While the CPI of course is important for understanding the situation - e.g. the productivity slowdown and the Fed’s inflation policy ! I should mention that I, at this moment of writing, am indeed in doubt of what to think about this American problem - and I am pretty alarmed by this insecurity. We should consider this a major failure of economics (or of government to provide for sufficient numbers of measurement officials). (3) On p544 we see the Dow Jones and S&P indexes mentioned, but not explained, while freshmen economists should be taught to laugh about the Dow Jones index - see also Bernstein (1996). (4) P404 gives a graph of the US ratio of earnings of college graduates to earnings of highschool graduates, and the ratio goes from about 1.6 in 1975 to 1.85 in 1995. Mankiw’s graph looks dramatic, because of the chosen axis - and the graph thus should be redrawn with a normal axis.

Mankiw (p502) states: “Congress could change the Social Security program so that benefits increased every year by the measured inflation rate minus 1 percentage point. Such a change would provide a crude way of offsetting the measurement problems and, at the same time, reduce government spending by billions of dollars each year.”

What kind of argumentation is this ? Well, we could also slash all Social Security: and also get rid of the measurement problem and save billions more ! Pity the US, with all the students who have only one course in economics, and then get Mankiw’s “Principles” !

My own analysis shows that indexation on income is rather more advisable.

Where Mankiw discusses the labour market (e.g. p565), I miss the ILO dictum: “Labour is not a commodity”.

Mankiw’s final chapters give an overview of macro-economics. I have some doubts on this presentation, in particular where macro demand and supply curves are made price sensitive - while Keynes showed that the aggregate price is rather an income. Anyway, my own present book itself is an amendment on economics.

It remains interesting to note Mankiw’s statement on p574: “It is, however, important to note why minimum wage laws are not a predominant reason for unemployment.” Well, they are - and they can have large multiplier effects.

42. Relating to Krugman, Phelps, Ormerod and Heilbroner & Milberg

Krugman, Phelps, Ormerod and Heilbroner & Milberg have produced forceful analyses on the current state of the economy, society and economic theory itself, and all with a distinct attention for unemployment. These authors agree on many points, but disagree on major points too. Interestingly, where these authors disagree, my own work offers new answers, on angles clearly not considered by them. My analysis solves conflicts, fills gaps, and complements on useful points. By relating my work to theirs I hope to enable these authors and their readers to plug into - what I consider - a new synthesis for (a renewed) mainstream economics.

Introduction

Mainstream economics appears to accept high rates of (equilibrium) unemployment as the apparent characteristic of the modern economy. In this view, unemployment is not inefficient, but the unavoidable price to be paid for other desirables. Take for example the case that the United States has low welfare provisions, less unemployment but more poverty and many prisons, while the European Union has high welfare provisions, high unemployment, less poverty and far fewer prisons: these differences then are explained in terms of political choices for example about institutions, labour market flexibility and employability; and it is suggested that such choices are made at the efficiency frontier. Research economists however are more focussed on the question whether current policy really is optimal and whether current unemployment is really (in-) efficient. The search is for a Pareto improving solution such that some can advance - notably the unemployed and the poor (underemployed) - without costs to the others.

Specifically, Paul Krugman, Edmund Phelps, Paul Ormerod, Robert Heilbroner & William Milberg) and myself have tried to supplement the mainstream approach. The first authors have received a lot of attention, but did not succeed in finding a Pareto improving solution to current unemployment. My analysis has received little attention, though I must confess that I did find such a solution.

In the following I’ll concentrate on the major issues, and then refer to that part of my own work that links to the work of these authors.

Review of positions and qualities

The other authors and myself have come up with different answers on the causes for and solutions to current unemployment. Table 18 reviews the different positions.

We may also note that most authors do not (explicitly) refer to each other. The reason for this may be practical, in that books that appear in 1995 may have difficulty to refer to Phelps (1994). We may also note that even though the inflation-unemployment relationship is crucial to the analyses of all, the focusses differ. Disagreement often leads to neglect rather than to explicit criticism, and it may well be that I have selected top scorers of different citation communities. However, all authors may be justified in neglecting one another. No one of them gives an essential contribution to the understanding of current unemployment. Theoretically their work might be skipped, as I did in practice while developing my analysis.

Table 18: Different positions

Causes and solutions on unemployment

Refers only to

Myself

Taxes & the Trias Politica structure

Phelps (1994)

Krugman

We don’t know

Phelps 1967-70

Ormerod

Moral values & collective responsibility

Phelps

Subtle combination of turnover costs etcetera

H&M

Lack of a positive ‘vision’ of the public sector

Phelps 1967

At a lower level, when we look into details, then there are more points of overlap. An analysis of a practical economic problem (in this case unemployment) of course must have an econometric substratum in order to be taken seriously. Table 19 contains three technical issues, the shift of the Phillipscurve and the influence of technology and globalisation in the model. Here economics would advance if the authors could convince each other (allow me to add: of my analysis).

It also appears that some of the differences originate from the styles of analysis, which styles also have to do with roots. Ormerod, Phelps and myself have econometric roots, Krugman’s first love was history (see Krugman (1993)), and Heilbroner is clearly a literary economist (‘though’ summa cum laude, Harvard 1940). (I don’t know about Milberg.) It is important to identify these styles.

I like to use econometrics in the way Jan Tinbergen did. It should be technically sound, but not fancy for reasons of its own; it should be relevant for a serious problem, and communicated to the general public in a responsible, modest but still clear manner (even if clarity makes it sound immodest). I also am very much interested in philosophical aspects (what H&M calls the ‘vision thing’), which however is not quite the style of Tinbergen. It appears that the various authors do not share all these qualities in the same degree. Taking these criteria to classify the four authors and myself gives Table 19. The names in the table are in alphabetical order. Actually, Table 19 summarises the discussion below.

Table 19: Comparing on style and content

Yes (comparable to me)

No (not so)

econometric roots

Ormerod, Phelps

Heilbroner, Krugman

technically (fairly) sound

Krugman, Ormerod, Phelps

Heilbroner

modest & clear

Krugman

H&M, Ormerod, Phelps

the vision thing

H&M, Ormerod

Krugman, Phelps

technology isn’t the cause

Krugman, Phelps

H&M, Ormerod

globalisation isn’t the cause

Krugman

H&M, Ormerod (Phelps ?)

uses a shift of the Phillipscurve

H&M, Ormerod, Phelps

(Krugman ?)

Krugman: “We don’t know”

The world should be very grateful to Paul Krugman for explaining economic essentials, and not only for these explanations themselves but for his choice of words as well. Krugman’s writing are a display of fact & logic and scientific argument and humour & good will: a quality blend that one hardly ever sees. I can only presume that you have read these books, and then continue my line of reasoning.

My thesis differs from Krugman’s in one major respect. He claims that “we don’t know” about the causes of the productivity slowdown - whereas I claim that ‘we’ do.

The following Krugman quotes are useful - and testify of his intellectual honesty:

1. “I find that almost anything having to do with taxation is better than a sleeping pill”. Krugman (1993)

2. “But let me cut to the chase: the real answer is that we don’t know.” (1994b, p5, his italics)

3. “The key objective of the supply-side tax reduction was to lower marginal rates, that is, the rates that people pay on any additional income they make. That makes economic sense: marginal rather than average rates determine the incentive to work and invest.” (1994b, p155) Comment: I have shown this to be false.

4. “I’m not an expert on taxes.” (Said in a public exchange following his Tinbergen Lecture 1996, to be published by the Dutch “Koninklijke Vereniging voor Staathuishoudkunde” - Royal Dutch Association for Political Economy)

These points are relevant for understanding:

1. See my analysis on taxes.

2. Krugman (1994a) makes a big issue of productivity. Comment: Quite correct. Note that I am rather sure about the explanation of and cure for the productivity slowdown, but that my certainty derives from mathematical proof and trained intuition, and not from an econometric model exercise on the (world) economy. My analysis does not invalidate what others have said on the shift to the service economy - and the difficulties of measurement - etcetera, while I also present relatively new insights. One of the ideas that I would have liked to look into, but have had no time for, is, that the return on consumer investments (like home improvement for the elderly) may be larger than that on financial stock (“savings”), and that this return is not adequately accounted for (also as a tax base). Another idea, also emphasised by Phelps, is that real rates of interest are high (anyway). A major cause is that Central Banks have to be tough, given the reduced competition on the labour market. Another cause is that government doesn’t dare to raise marginal rates given the current misconception about taxes; so governments borrow (at a higher rate) what actually should have been taxes. Subsequently, investors buy government bonds and grow lazy and spoiled about taking risk (that otherwise would have spurred productivity).

3. Krugman (1994b) p186 onward discusses East Germany and its relation to the downfall of the European Monetary System. The story is familiar: the then-existing policy paradigms of the EMS forcing a recession in Europe when Germany raised its interest rates. Krugman suggests that exchange parities should have been adjusted before the markets forced this. He suggested that preoccupation with fixed rates seduced policy makers to adopt the Maastricht Treaty on the EMU: “(...) by early 1993 political and economic stresses had made the solemnity of Maastricht seem almost comic. If there is a lesson here, it is that serious and dignified men and women in impressive international meetings may have absolutely no idea what they are talking about.” (p192). Comment: This is too quick. When Germany decided that wage earnings in the East should be equal to those of the West (to reduce migration), it should also have decided to let wage costs reflect productivity. This is a better approach than parity adjustment; and known at the time, see my work and the Financial Times editorial “Time for Mr Kohl to act”, July 26 1991. In the same way, EMU can still aspire at monetary stability, and this can be done when countries use their tax structures (thus, structure as opposed to level only) to balance wage costs with productivity. Even though EMU is not a logical beauty, and East Germany still suffers from a wrong policy mix, the gut feeling of EMU - one economy, one means of payment - was admirably correct. This is even clearer given my work on taxes and their influence on wage costs. Note that many top economists make fun of EMU instead of providing answers of how to deal with the policy challenge. This is not so professional. One possible answer is the following. With one rate of interest for the EMU territory, and rates of inflation differing by regions (countries), real rates will tend to differ. Some markets will be interested in the real rate instead of the nominal rate. So loans indexed to the local inflation rate might suit many, for example Dutch government and Dutch pension funds, for part of the portfolio.

The following points are only interesting:

1. Krugman makes a point that income developments are fractal. Laywers get much more than cleaners, but top lawyers get much more than average lawyers. Comment: Ditch ‘fractal’. It still is a lognormal distribution.

2. Krugman (1994a & b, 1996a) suggests that international influences are less important, due to the size of proportions, than commonly thought. Yet, he himself (1996b) comes with the ‘parable of clocks’: international fluctuations may get into phase, similarly like clocks. Comment: So, though fluctuations may only be the cream on top of fundamentals, there still is a new research topic. Note too that the Great Depression and the Great Stagflation were OECD phenomena and more than ‘cream on the top’; these may be traced to the Trias Politica.

3. Krugman (1993): “I had some trouble getting that paper published - receiving the dismissive rejection by a flagship journal (the QJE) that seems to be the fate of every innovation in economics”. Comment: My experience is the same. People in responsible position have the awkward tendency to start criticising before asking questions. They fail to see that their criticisms can be formulated as questions - which then are a reason for publication. And they are insulated against protest to this injustice. I recently came upon some beautiful comments by Bellman (1968) on the evolution of scientific ideas. Note, though, that Krugman’s wonderful books since 1990 have only been made possible since my analysis has been blocked from general attention: so that is a form of comfort.

4. Note: With respect to Table 19, I’ve hesitated about classifying Krugman as having less roots in econometrics. His credentials as a technical economist are quite adequate. But, my experience with econometric modelling has been extensive and will not easily be copied. Also, I don’t particularly like the topic of taxation myself either, but it only by going through the details of a complete model (too) that I came upon that explanation. Though, Paul may make me regret this classification.

Addition 2004: Krugman (2001), “Fuzzy math”, and particularly (2003), “The great unraveling”, are advised reading for anyone who wants an enlightened view on the world economy. Yet, Paul Krugman has not yet benefitted from reading the analysis in these pages, and the reader must make amends for that.

Phelps: “Structural slumps”

Phelps (1994) is as creative as the others, but also the technically most advanced author who also presents econometric tests for some of his conjectures. His book is impressive.

My first reaction in 1994 to Phelps’s book was guided by his explanations in plain English. Given those explanations, his study dropped in my priority list. My attitude is (in line with Tinbergen and Keynes) that substance comes before technique. So it may come as a surprise to the reader that I as an econometrician did not jump to the occasion to comment on Phelps’s techniques and tests. But of course, had I had more time, I would have studied those pages too. And of course it is still appreciated that Phelps has produced these technical pages. They have affected his style, and they allow for wider tests at a later stage. Indeed, for the purposes of this chapter, I have looked into the estimation sections more deeply. My comments below however remain preliminary, since, indeed, I have not fully read all chapters.

The major comments are:

1. Phelps (p374-375) is sceptical about how politicians abuse economics, and about how economists themselves react to (new) ideas. Comment: Talk to Krugman, and study my analysis on the Trias Politica.

2. Phelps: “There is already a moral-philosophical case for employment subsidies targeted at the low end of the wage scale to bring the rewards for work not having a high scarcity value more nearly in line with the requirements of econmic justice.” (p366) and he seems to approve of proposals also made by Dennis Snower. Comment: I even show that these measures cost nothing and are Pareto improving. Do you agree that there may be an ‘equilibrium’ in your sense, but inoptimal ? (See below.)

3. Chapter 18 contains a ‘concise postwar economic history’. Comment: The reader is invited to compare that history with my amendment to the Bruno & Sachs story.

4. Phelps catalogues monetary aspects as temporary (‘high frequency’) and nonmonetary aspects as structural (see p4 and 335). Comment: I agree that it is valuable to look at nonmonetary effects. But the major issue is the Phillipscurve, a relation between unemployment and inflation, and thus it is difficult to neglect monetary policy. When Central Banks have a wrong theory, and cause the rate of interest to rise, then this should be in the model. On page 314, the acceleration of prices (change of inflation) is introduced in a Phillipscurve in an ad hoc manner. Similarly, on page 329 the possible influence of Bretton Woods is discussed, and Phelps remarks that this system allowed for adjustable pegs - but then misses the point that the pegs were pretty fixed in practice. No doubt, Phelps will agree that the whole story contains both elements.

5. Phelps uses the calculus of variations, and his marginal tax rate is T(y)/ y. Comment: This is proper in this theoretical development, but it should be replaced by a dynamic marginal rate when the theory is translated to the real world. In chapter 29 it is explained what I mean by this, and it is shown that this dynamic marginal rate may be close to the average rate. Curiously, Phelps’s econometric exercise uses average rates (p 314 & 318), and finds a contractionary relationship. In a sense, this supports my analysis, which allows lower average taxes and thus lower unemployment. However, I think that the estimated equation is too simple for the true model.

6. Turnover costs appear to be very effective in one of the major models. Comment: That would mean that a simple subsidy would have huge effects. This does not seem realistic. The huge effect comes - I surmise - from the homogeneous labour assumption, and it is more appropriate to assume heterogeneous labour.

7. “The shifts and long swings in unemployment are an equilibrium phenomenon, not a matter of misperceptions or misforecasts and consequent wage-price misalignments” (p vii). Phelps then uses “(...) the equilibrium case in the expectational sense of the term: the case of correct expectations about the course of the economy.” (p1) Comment: The Moon falling on and past the Earth - and expecting to fall so - is a story of disequilibrium and of equilibrating forces but also of equilibrium. What you use is just a matter of perception and of words. More important is the inoptimality of present unemployment. Phelps writes on optimality: “(...) much of what we measure as unemployment reflects job rationing, hence is involutary and imposes private and social net burdens (...)” (p viii, see also Phelps p9). Thus note that there is another concept of the “natural rate” (NAIRU), namely the market clearing rate. Even when expectations are correct - even when happens what you predict - then you can still be unhappy about that and look for change; and thus there can still be forces towards the clearing rate. Fulfillment of expectations is not the only utility that you are after. Phelps’s emphasis on the expectations definition suggests that his analysis is incomplete. Inoptimality may also have causes in the political structure, a point that gets less attention by Phelps regardless of his comment on p374-375.

8. Phelps: “A worldwide increase of public expenditure (...) was not found to be expansionary (...) The same is true of a worldwide increase of public debt. (...) Prudence requires putting aside the Keynesian approach for the time being in favor of taking up the structuralist approach.” (p330) However, the page before: “(...) the economy is so complex an organism, so to speak, that it would be naive in the extreme to imagine that, at long last, the true macroeconomic model of equilibrium unemployment determination had been discovered. A question that permanently looms over any such research as this is whether the results interpreted as favorable to the theory are in reality the expression of some mix of other theories, some likely to be old and some not yet known.” (p329) Comment: I fully agree with the statement on page 329 but think the statement on page 330 overdone. The body of neoclassical thought is too big and strong to be replaced by a mostly ad hoc econometric exercise. This is hubris ! For starters: government expenditures rose as a result of unemployment benefit payments. So there is a positive relation between unemployment and expenditure. Secondly, “Keynes” is much more complex than the simple idea that deficits would reduce unemployment. Macro-economics aspires at wise management of economic development, only occasionally using deficits to reduce unemployment. (What politicians do, is another story.) One needs a more complex structural model to disentangle the various relationships, instead of a two-equation reduced form estimate as Phelps does.

Less important comments are:

1. “The natural rate moves!” (p vii) Comment: The book suffers from the emphasis on the novelty of this idea. However, the nonconstancy is part of its definition, and this was not so revolutionary, in 1994. For example, see Solow (1976). It was a common notion to me in 1989/90 when I generated my analysis, and Phelps (p xii) mentions a 1979 paper by Jeffrey Sachs. But note that the book reflects a 20 year research project, e.g. Phelps discusses on page ix early models of the early 1980s that assumed a constant NAIRU. So it may well be that some researchers settled for constancy, and that it was a struggle for Phelps to get rid of constancy; and we should be tolerant of struggles like this. But, objectively, the emphasis on a non-novel idea is out of touch with modesty.

2. The opposition of “structuralism” to “neoclassical” (p14-19) is rather constructed, and not modest again.

3. “(...) historical evidence that unemployment is (or was) trendless (...)” (p x) Comment: Agreed. Note, though, that my analysis is that due to differential indexaton of taxes and subsistence, there is a trend in a component of unemployment (namely, minimum wage unemployment, and poverty (underemployment)).

4. On technology: “the theory averts any implication that secular productivity growth puts the equilibrium unemployment rate on a trend (...)” (p xi) Comment: Talk to H&M.

5. “(...) the present study is the most comprehensive econometric model of unemployment to date” (p 313). Comment: Well, there is Lawrence Klein’s Project Link, there is .... etcetera.

6. Phelps (p352) relates to Jude Wanniski, an ‘amateur fiscal theorist’ who wrote ‘an interesting book’, and dismisses him as a serious thinker. On p353 Phelps speaks about ‘professional theorists in the supply-side movement’ without mentioning names. Comment: See Krugman (1994b). Note that the editorial of the Wall Street Journal of October 17 1995 quotes the then new Nobel Prize winner, Lucas: “I have called this (...) an analytical review of ‘supply side economics’, a term associated in the United States with extravagant claims about the effects of change in the tax structure on capital accumulation. In a sense the analysis I have reviewed supports these claims. In what I view as conservative assumptions, I estimated that eliminating capital income taxation would increase capital stock by about 35%. (...) I believe we would be a better society if we followed their advice.” Also, in 1999 it appears that the 1999 Nobel Prize winner Robert Mundell has been the leading force behind that Reagan Supply Economics programme - though he let Laffer take much of the credit.

Addition 2004:

Phelps (1997) is advised reading and usefully available on the internet. It is short, eloquent, compelling. The reader comes away from it for 99.99% convinced. My first impression was to support it also for the remainder. However, there is the Keynesian point that investments cannot be left to the market. There must be some macro-economic management and an Economic Supreme Court to safeguard that management. Phelps (2000:88) unfortunately states: “The extraordinarily low unemployment rates in continental Europe in its “glorious years” from the 1950s to the mid-1970s were the result of special circumstances” This is either an open door, in that 1950-1970 are not the historical average, or a misguided view that they cannot become the average. Phelps’s (short) analysis of that period does not include the analysis of the tax void yet.

Similarly, Phelps (2000:90) “It is now dawning on policy discussion, in Europe and to some extent in America, that countries can engineer a reduction of unemployment without a sacrifice of low-end pay or a rise in low-end pay rates without a sacrifice of employment (or some of both). This can be done by means of tax-subsidy measures that produce a favourable shift of the inclusion locus. Already several countries have introduced, some many years ago, fiscal programmes aimed to do just that, though generally on a small scale and often targeted at particular sub-groups in the low-wage population. Taking such a step on a large scale – large enough to make a big difference – involves a paradigm shift in political economy that some policy makers are not yet ready to take.” This issue has been discussed by this author since 1989 and in this present book again and one would wish that Phelps got time to read it.

Phelps (2000:99) “Such tax relief is seriously cost-ineffective next to graduated employment subsidies owing to the way that personal income tax liability is formulated. The budgetary cost of graduated employment subsidies is only the disbursement of the subsidies to the firms employing low-wage earners, since high-pay employees are ineligible for such subsidies from the first euro earned, while an equivalent disbursement of income-tax relief in the low brackets – for example, the first $16 000 of annual income – will cost the government the loss of tax revenue on all higher earners’ first $16 000.” This is absolutely unfounded. See Figure 28 or Figure 29 that shows that this is not the case. Furthermore, in a reduced form there is no difference between tax reduction and wage cost subsidy, which means that they can be translated into each other.

Ormerod: “Death of economics”

The book’s name “The death of economics” is not inviting to serious research. One may appeal to a “The King is death. Long live the King !” approach, and indeed Ormerod’s last chapter “Economics Revisited” seems to suggest this. But this is so round-about and distractive ! Why first make people believe that you want to get rid of economics, and then tell them that you have a better economic analysis ?

This way of presentation also gives too much credit to decisions makers. Politicians and economic advisers who believed in those theories are presented as misguided persons, and victims of failing theories of old. Just as anybody can make errors. However, the proper story is that illusions and ideological views have been maintained in the face of contradictory evidence, and against the advice of renowned economists. Ormerod’s presentation obscures this evidence and its meaning. The proper story, that Ormerod misses, poses the question of reform in the structure of economic decision making.

Agreed

I agree with Ormerod: “The whole challenge of economic policy is to shift the attractor points around which the economies move, and hence the whole solution path of the economy over time.” (p208)

Disagreed

1. He claims that there is a new analysis of unemployment moving around an “attractor” (that itself can move). Comment: This attractor is nothing else but the NAIRU. It is true that it can be clarifying to shift from the conventional parlance to the parlance of chaos theory, but it is not revolutionary as claimed. The same immodesty as Phelps.

2. He defends the macro-economic approach, e.g. on using a rather simple relation between inflation and unemployment. Comment: Defence is fine, but the correct approach still is based upon micro-foundations.

3. Ormerod writes: “The distinguishing feature of chaotic systems is that their behaviour is impossible to predict in the long run (...)” Comment: The word “chaotic” means “deterministic looking like random” in mathematics. Above quote is only true for (systems of) equations with a random term somewhere. “Chaos” has the connotation “random” in the public mind, so it might be best not to use the term in books for the general public. Ormerod gives much attention to uncertainty, and the way that he presents it carries with it the suggestion that nothing can be done about unemployment. Though uncertainty is important to macro-economics indeed, it however is not really relevant for his main thesis that something could be done about unemployment. Quite tiring.

4. He claims that the 1950s were a special period of reconstruction, in the sense that the success of these years is not easily repeated. Comment: In my analysis, the conditions of economic success can be influenced, and similar results achieved again. The mood of optimism would follow the results, rather than conversily (though there is feedback too, of course).

5. Ormerod: “So what can be done ? One solution to the problem of high European unemployment, for example, is work-sharing.” (p207) To achieve this, he appeals to social values. Comment: But work sharing is not necessary (see my work in general), and less easy to achieve anyway.

6. Ormerod: “But perhaps the most important point of all, linked though it is to the underlying mathematics, must be stated in words, for it is a question of moral values. The concept, rampant in the free-market philosophy of the 1980s, that there is no such thing as society is one which, if it is allowed to persist, will prevent the creation of full employment regardless of the form which economic policy takes.” (p211) Comment: There is little use in discussing whether there is or is no “society”, since it would seem to be a matter of definition. If a government would choose not to solve unemployment, then this should be accepted in a democratic society. It is a different thing that we now can show a solution to inefficient unemployment, since that is a matter of logic and intellectual honesty.

H&M: “Crisis of vision”

Heilbroner & Milberg (1995) are very wordy and imprecise - and the many words are used for hyperbole instead of exactness. It is very easy to get irritated.

There are only a few points that I agree with, but even these points are formulated vaguely and annoyingly, and my comments are guarded. Also, to reduce the irritation, I only usefully comment mainly on chapters 1 and 7:

1. H&M: “(...) Keynesian theory can be judged a success (... when allowance is made for ...) bargaining power of labor.” (p57) and “Stagflation has come to an end with the political and economic events of recent years. The bargaining strength of labor in the advanced industrial countries has been threatened in part by the rise of international competition.” (p59) Comment: Advanced nations are ‘service countries’, and see Krugman on “international competition”. Bargaining power is a very important variable, but you go too fast on the impact of international competition on that. Taxes are neglected. With unemployment and poverty so large, we are only at the low inflation asymptot of the Phillipscurve, and stagflation is not dead yet. Strangely, H&M’s book is motivated by social problems, but the problem is declared dead ! In other words, they don’t see that their problems are caused by stagflation.

2. “(...) the extraordinary combination of arrogance and innocence with which mainstream economics has approached the problems of a nation that has experienced twenty years of declining real wages, forty percent of whose children live in “absolute” poverty, and which has endured an unprecedented erosion of health, vacation, and pension benefits. (reference) The commitment to full employment legislated in 1946 has been “honored” in these socially destructive years not by vigorous employment-generating programs such as the reconstruction of its cities, but by redefining “full employment” as a higher level of unemployment.” (p6) Comment: Agreed on the concern, disagreed on the rest. Do not mix up politics with economics. See Krugman’s description of how policy fashions drifted from economics proper. Also, there were serious questions regarding the causes of unemployment, and these questions cannot be played down so so easily and derogatory.

3. “It is the legitimacy of the public sector within capitalism that lies at the core of the contemporary crisis of vision.” (p120) Comment: They are too vague on this, so they might as well be wrong. But agreed in principle, see my advice to adapt the Trias Politica. In general, H&M don’t clearly distinguish between economists as scientists (who have all the time of the world to doubt) and economists as policy advisers (who also have to take into account that decisions have to be made here and now).

4. “(...) the mark of modern-day economics is its extraordinary indifference (to the connection between theory and reality /TC). At its peaks, the “high theorizing” of the present period attains a degree of unreality that can be matched only by medieval scholasticism.” (p3-4) Comment: Yeah, for “peaks”: that may be. It is good we have those peaks.

“Analysis has thus become the jewel in the crown of economics. To this we have no objection. The problem is that analysis has gradually become the crown itself (...)” Comment: Well, that is an overstatement. Is the suggestion that all economics now is a “peak” ? Besides, did you really look at the practical work at the relevant institutes ? H&M miss the point that my analysis is fine work in the mathematical tradition, and that it is neglected by many (by him too). Rather than downgrading all math, they should highlight the work that matters, and state the reasons why it matters.

5. H&M see the following causes for unemployment:

a) “On the domestic front, they include a technology of rampant automation that has created severe employment strains in all advanced countries (...) The result is prospective increasing dependency on government-financed programs of unemployment relief or public works.” (p120-121)

b) “Meanwhile, on the international front, (...) “globalization” of production carries unsettling implications for all advanced capitalisms, including the lowering of social, environmental, and labor standards (...)” (p121)

c) Other issues are volatility of financial flows, demography and immigration, ecology and nationalism & terrorism.

Comment: This is bad economics. See Krugman & my work.

H&M’s book is recommended on the back-flap by Lester Thurow as “essential reading”. They and their readers are advised to read Krugman on Thurow.

There is a final caveat. With my European background it is easier for me to see the value of government involvement, cost-benefit analysis and policy analysis. I am not familiar with the American academic situation, and it may be that H&M really have a case that these aspects are underappreciated in the US.

Note 2000: I found P. Dasgupta (1998) also criticising Heilbroner. My problem in this discussion is that both authors do not adhere to the definition of economics, and thus don’t really communicate. Many of Dasgupta’s points however are accurate. On the other hand, what is of value in Heilbroner’s view is that Political Economy seems to be getting less attention than one might hope for. This point is not really answered by Dasgupta - who seems to neglect the Political Economy issue of integration of scientific knowledge for the management of the state.

All authors

All authors advise their colleagues, policy advisers and politicians. All however accept the current institutional setting of economic policy making, and accept that their thoughts get less unbiased attention than could be useful.

My advice however is a constitutional amendment for an Economic Supreme Court. The lack of sufficient checks and balances is a major cause for the tragic economic record of the last century. When experts know of Pareto improving possibilities, then policymakers have too much freedom to neglect this. Policymakers have too much freedom to pursue their own pet theories even in the face of contradictory evidence.

43. Relating to Sen, Galbraith and Cox & Alm

Sen: “Development as freedom”

When Amartya Sen writes a book, it is likely a useful one. Sen (1999a) will help economists to refocus on freedom instead of income, as Hayek once tried but failed to convince. Sen admits that his message is not new (see p289). But when it has been forgotton, or told unconvincinly, then it sounds pretty new.

One of the prime reasons why Sen is convincing, is that he makes the connection with Adam Smith’s ‘sympathy’ argument. Sen is both liberal and social, and presents freedom as a private and social goal. Hayek often got out of touch with ‘sympathy’, or at least allowed that reputation to grow.

One of the prime reasons why economists have been seduced to put income before freedom is pure pragmatism. Income is a quick and dirty variable - and by itself already hideously complex to properly administrate and monitor. Income tax laws and the execution of them require huge bureaucracies. Price index measurements are a monk’s paradise. Maintenance of fair incomes requires extensive labour relations and social security laws. And this is just simple income.

If we would look at the freedoms, then we get unobserved variables, their unobserved shadow prices, and a proliferation of equity questions. While we seem to have gotten used to a concept like the ‘income distribution’, we draw a blank with a ‘freedom distribution’. The issue of the (im)possibility of utility comparison comes strongly to the fore again - and the question again arises whether ‘utility’ is a proper concept in the first place anyway.

The fact that income is such a pragmatic variable however does not absolve economists from their task of thinking about the proper meaning of, and means for, The Good Life. While it certainly may take some centuries more to solve most of the Grand Problems of the ‘freedom distribution’, in the short run economists still need to think on the matter.

One of the most powerful arguments in Sen’s book is that he shows that some policies are clearly misguided from a freedom point of view: So that we don’t need Grand Solutions to start correcting some errors already. Where developing countries experience problems providing for basic freedoms, there we find that many of these already have been solved to some extent, namely in the Western nations.

Sen slowly but systematically demolishes the ‘different cultures’ arguments, and shows that these cannot be used to withhold basic freedoms. The idea, so popular in the West - and a reference is Barro (1996) - that poor countries first need to develop up to a certain income level, before they can afford e.g. democracy, is a contradiction in terms, a serious error of judgement, and a disaster for the billions of paupers concerned: for they are denied their freedoms and thus will remain poor and underdeveloped for much longer. The pitfall for (regression) analysts like Barro (1996) is that they take income as the prime target, and investigate whether ‘more freedom’ correlates with ‘more income’, presuming that the latter is the most interesting. But when the true variable is The Good Life - also defined by a low infant mortality or the absence of famines - and when it can be shown that it requires a certain level of democracy if such horrors as famines are to be prevented, then such (regression) analyses are terribly misguided.

Perhaps this summary does injustice to the intentions of these researchers, but the point is true that there exist such views, and that Sen is only one of the few academics to seriously oppose them.

Solutions for freedom as they exist in the West can be tried in the developing countries as well, and, while cultural adjustments indeed may be required, adjustment is something else than withholding.

Sen’s analysis will provoke much discussion. Researchers, like Barro, will be challenged to reconsider the issue. The policy makers at the World’s capitals will be challenged as well. Certainly the ‘cultures’ argument will be a strong subject for contention. The prime thing to hope, however, is that the academic tendency to research, research and research will not be abused by the politicians to bury the Sen argument - and we can only hope that the scientists are aware of their responsibility in this.

On the cover of the book, Kofi Annan, the UN Secretary General, already states gratefully that the UN “has benefited immensely from the wisdom and good sense of Professor Sen’s views”. This is wonderful recognition. But we can clearly see that this is only a beginning of a longer change. As a question, that I perhaps may raise myself, I wonder whether it would not be time to take the World Bank from its current track on traditional ‘income economics’, in which it has become so set in its ways, and change it to monitoring the freedoms. On second thought, it would be a pity to throw this current expertise away, since income still is something useful to have - if I may put it that way. Would it not be much better to create a new ‘Liberty Board’, or whatever name, for the administration, help, guidance and inspection on such freedoms ? In fact, as Sen clarifies, the freedoms can arise in all dimensions of human life, and can have surprising interconnections. Logically, one would have to monitor freedoms in all such dimensions - as, in fact, governments in Western nations have all kinds of Ministries and Agencies. Logically, again, the UN might as well mirror that kind of organisation. “Rest assured,” I once remarked to Jan Tinbergen, “that world government will come about surely, one day.” - and I got a smile as a response. It would be good if this logic could be echoed in the advice of our fellow economists to the larger public.

I enjoyed a certain perspective on Adam Smith. First the Smith quote:

“Whenever the legislature attemps to regulate the differences between masters and their workforce, its counsellors are always the masters. When the regulation, therefor, is in favour of the workmen, it is always just and equitable; but it is sometimes otherwise when in favour of the masters.” (Sen:323).

The perspective is that Smith’s aversity against government meddling derives to some, and perhaps a large, extent from such imbalance of power. Conservative political views of Smith emphasis the first, no government meddling, but forget the precondition. In a democracy, Smith would well have come to a more positive approach to government influence - no doubt still critical, but less averse to meddling in principle.

A point of critique. Sen compares the population control in China, based on restrictive laws, with that in Kerala, India, based on emancipation of women and on influencing convictions under basic freedom of decision. He finds both equally effective. The Kerala approach then clearly is preferable - while, Sen critically notes, the Chinese one may also result into problems when there is a political crisis and people no longer believe the authorities. He uses this to show that freedom is both a target and a means. My problem with this comparison is that Sen, while surprisingly subtle in many points, may not be subtle enough. There are many differences between Kerala and China, and not just the difference between these policies. As once found for Italian districts: their kind of democratic attitude and level of economic development were found correlating with their kind of government in the 15th century city states. Nature’s way are quite complex and surprising. Yes, this is precisely the ‘cultures’ argument, the major bone of contention.

My point therefor is that Sen’s argument is convincing at a logical level - which means that we thus must reorganise Development towards the Freedom paradigm - but that for each separate issue it is up to the specialists to determine their findings. I don’t have to decide about birth control methods, but I can agree that freedom is an important variable that needs to be taken into account, as means and objective, and it is useful that there is an agency that helps the Chinese government to see how they can improve their policies. With lots of diplomacy, good dinners and the big stick of public opinion.

Sen’s analysis nicely fits my own analysis: that basic economic necessities have been neglected by our governments, and that economics itself has played a bad part in this. I have concentrated on Western unemployment and poverty, referring to lack of freedom from the perspective of Montesquieu, and referring to Roosevelt’s Four Freedoms. Sen considers development or the whole economic problem relating to The Good Life. Strangely he does not refer to Roosevelt. But our arguments supplement and strengthen each other. Also, one of the implications of my analysis is that when all governments start having Economic Supreme Courts, then these will exchange information, and this will create a network of international co-ordination, which is another part of the solution to the ‘world government’ problem.

Sen rightly comments that Europe only gives money to the unemployed, but takes away their freedom and right to a normal life with professional and social recognition. A point of critique is that he does not seem to understand the cause for European unemployment. My hope is that he gets to read my book and will agree with my analysis.

Sen also does not see yet the proper solution to the Arrow paradox. I have discussed his statements in an appendix to the ‘Arrow chapter’ above. We should note that Sen in some respect suffers from a tragedy. On the one hand he wants to explain that social decision making is important (for example to guarantee freedom), on the other hand his erroneous presentation of the Arrow Theorem has blocked good research into social choice and has induced many to become very critical of social decision making.

In a next edition, this should be adapted: “The butcher sells bread to the consumer (…)” (p256). We find the correct ‘meat’ a few pages later, so it is not because Sen is vegetarian.

Sen’s discussion of Hayek I discuss again in the Hayek appendix below.

It should be observed that, when Sen’s argument is stripped from all its footnotes and its rooting into economic theory and history for the sake of the economic community, then many of the key insights are of such a character that they not only must be, but also can be, communicated to that larger public. For example, the relation of the emancipation of women to lower child mortality does require a statistics apparatus and an analytically proper explanation before it can be be established as a scientific finding, but once it has been established, then it is something that the general public needs to know, and can easily understand. Communicating these findings is, again, a task for the specialists.

The Dutch government could help create more public attention for Sen’s analysis, for example by starting to provide development aid to the poor in the US American cities who in some dimensions are worse of then the people in Kerala. It will be interesting to see how the US Congress reacts to that, and how the media will report on that.

Galbraith: “Created Unequal”

James Galbraith’s “Created Unequal” (1998) is advised reading. Galbraith provides a quite accurate and chilling history of how prosperity gave way to stagflation as a result of misguided policy - and he shows how economists provided the misdirections and the apologies. Galbraith is clear of thought and masterly in language, ‘another Paul Krugman’. And actually, Galbraith presents us with an original contribution to political economy, while Krugman is more of a chroniquer.

A useful qualifier to this: Galbraith also has many thoughts and ideas, and this makes the book on occasion a tough read. He admits: “This book began as an inquiry into the origins of the inequality crisis. It has become in part a tract on the reform of monetary policy.” (p232). The reader has to be as flexible as the author, otherwise this book will be lost to you.

A good critique of the book has been written by Thomas Palley (1999). Palley’s review is some six pages, and since it is a very good review I concentrate here on the relation of Galbraith’s analysis to my own.

I am quite amazed by the similarity and closeness of Galbraith’s analysis and my own. And where we differ, the analyses rather complement each other. But not fully. Though our two analyses run parallel for many pages, he comes out with a somewhat different conclusion.

Galbraith is focussed on the pre-tax earnings distribution and pays less attention to the after-tax net distribution. In this respect he is quite American, where meddling with the income distribution via taxes is somehow quite unpopular.

Galbraith does not use my analysis. Hence he does not use topics like differential indexation, the tax void, tax induced crowding out on the labour market, etcetera. Often the educated reader can see such thoughts glimmering between the lines, but they are not explicit. Galbraith tends to neglect the impact of taxes on the minimum wage, and to downplay the latter’s importance for labour’s competitive position. He actually advocates a rise of the US minimum wage, in terms that suggest that he is thinking of the gross minimum !

Galbraith’s basic argument is that ‘a decent level of equality’ is both a goal in itself and an instrument to control the economy. Looking at causes for the rise in inequality in the US, he finds unemployment the main cause, and economic policy to be the main cause for that again. Hence his next focus on US monetary policy. Galbraith presents a regression analysis to back up this line of reasoning. The relation has a good causal explanation, and the R2 is high, so this is a recommendable result. In my research I am however less motivated by the inequality issue. I consider unemployment itself the main problem. It so happens that the two analyses then merge on the latter. But it also calls to question whether inequality is a useful lever for the debate. The topic of inequality may distract people - and actually repel those who are not interested in that subject per se.

With Krugman, Galbraith rejects the claims for ‘technology’ and ‘globalisation’ as the causes for stagflation. He rightly criticises the role of economists in economic policy advice, where they have suggested such causes. Galbraith’s argument against such ‘skill bias’ is remarkedly similar to mine:

“In periods of high employment, the weak gain ground on the strong; in periods of unemployment, the strong gain ground on the weak. (…) All are best reconciled to a theory of differential power, rather than to a theory of differential skill.” (p266)

Strangely, the notion is missing from the book that taxes could and should be used directly to create a better bargaining position for the lowly productive.

He also criticises the ‘liberal supply siders’ - i.e. those intellectuals who defined the agenda of ‘progressive’ politics in 1980-2000. Ira Magaziner pops up again. Galbraith recalls that Krugman already criticised these demagogues, but adds the criticism: If education is to be regarded as a tool for competitiveness, then we lose the idea of eduction for eduction’s own sake. And mutatis mutandis for public goods. It is about time that this critique is given.

While Krugman argues “we don’t know” - though recently seems to incline to the ‘technology’ argument - Galbraith provides a clear answer: Policy abandoned the commitment to full employment under a stable price level. Of the 1950-1970 prosperity he says, as I have been argueing for some years too:

“There is no compelling argument that this achievement was anomalous or irreproducible. I believe, on the contrary, that it resulted from a sustained period of sensible policy, later abandoned.” (p267)

The major error that economists made was - in Galbraith’s eyes - the adoption of the NAIRU framework. This requires a longer discussion, some paragraphs below.

Galbraith’s argument has to do with the ‘political’ aspect of political economy. Around 1980 Carter and Volcker considered inflation far too high, and the decision was made to let the Fed go ‘all out’ for inflation control. Galbraith shows that this was a break with the past. In the past more tools were used and many government branches co-operated with the Fed. The 1980 decision changed the economic policy making structure and culture, and it became socially acceptable to have high unemployment as a way to tackle inflation.

I think that Galbraith’s argument is correct in this. And he is quite correct in argueing (e.g. page 233) that this structure should be changed again to the workings of old, if we want full employment under a stable price level again.

I am afraid, though, that this part of Galbraith’s argument will hardly convince the fellow economists. Economists already know about the 1980 switch, and Mankiw (1998) dilligently explains the ‘sacrifice ratio’. The experience does not cause economists to think that ‘full employment and stable inflation’ really can be combined. Economists regard the 1950-1970 period as rather a freak accident, dependent upon some ‘after WW II culture’ (or other ‘amateur sociology’).

Galbraith relies on the ‘equality as goal and tool’ paradigm. Restating on p240-246 what he sees as the old recipe and the lessons from fighting inflation:

“Thus, we need to develop an equalization strategy that is simultaneously a comprehensive anti-inflation program: low interest rates, high employment, a higher minimum wage supported by a stronger union movement, a maximum-minimum pay ratio, and a national prospective inflation adjustment. Neither taxes nor transfers play the critical role here, as the idea is to bring about an equalization of economic incomes before taxes and transfers, not afterwards.”

The problem that I have with this statement is that economists will tend not to be convinced by it. The 1980 problems that led to the abandonment of the ‘old ways’ were very real - and the ‘old ways’ really did not seem to work at the time.

Also, referring to the 1950-1970 period and suggesting that things solved themselves, as Galbraith is in danger of suggesting (‘major inflations are caused by wars’ p233), does not sound convincing either. There was some real policy making then - that somehow lost its power around 1980.

Where Galbraith suggests a more modest role for the Central Bank, I also think that economies cannot afford losing the Central Bank as a ‘fighter of last resort’ - who has to raise the rate of interest if all other methods fail. So some of Galbraiths specifics would have to go, though the general line of reasoning is laudable.

Galbraith’s analysis of the regime switch is correct, but he does not provide the true cause. My point therefor remains: If politicians and their economists don’t understand my DRGTPE analysis, and the mechanisms of differential indexation and the tax void and the consequences thereof, then these policy makers might well be right to prefer fighting inflation even at the cost of unemployment.

In my view, for sure, the fellow economists who would dismiss Galbraith’s argument would be too fast too. Galbraith’s argument actually is balanced and to the point. Yes, a return to the ‘old ways’ of sharing the reponsibility on fighting inflation and unemployment is useful. But Galbraith is too optimistic about the fire power of his guns. His scheme requires more for it to work. Indeed, I think that it are the tools that are provided by my own analysis that would warrant that such a system can work - as it worked in 1950-1970.

Galbraith usefully criticises monetary policy for its impact on the distribution of income. The mechanism is peculiar strong in the US where the rich pay relatively few taxes. If the Fed raises interests rates - and thus, in the current economic system, unemployment too - then it also ‘taxes’ the middle class with both an ‘interest tax’ paid to the rich and a ‘social security insurance tax’ paid to the poor. In 1998, Alan Greenspan, Fed chairman, argued about the distribution of income: “Yes, I am very concerned, but the Fed can’t do anything about it.” Galbraith shows this to be wrong, and argues that the pre-1980 Fed was involved in doing something about it, and that a restructured Fed can be involved again.

Galbraith’s analysis is fitting for a book on inequality - but I think that a middle class person would not need the inequality argument to be opposed to such taxes. Alan Greenspan now is an American Hero - and I think that he deserves much of that credit - but Galbraith provides a narrative that would cause many Americans to reconsider their views.

Galbraith correctly calls to memory that the Fed is not really an impartial government institution, but a body from within the banking system. There are some private interests here, which would be sufficient reason for reform anyhow. In an appendix I give the ‘parallel argument’ of the Economic Supreme Court with respect to the Central Bank. Galbraith’s text set me thinking on this.

Galbraith proposes that the US Fed becomes more accountable to the US Congress - as it is ‘a creature of Congress’. I tend to opt for independence like now exists for the European Central Bank. There must be some co-ordination in economic policy making, and co-ordination becomes somewhat difficult if too many institutions and interests are involved.

As a European, it strikes me that Galbraith concentrates so much on pre-tax equality, while I would be satisfied with after-tax equality. I don’t believe the stories that many of the fellow economists tell about ‘technology’ and ‘globalisation’, but my approach tends to be to let them argue and research, and concentrate on the after-tax equality. This however is not Galbraith. He attacks the conventional wisdom on the pay structure.

He correctly reminds us that pay is not so much an outcome of marginal productivity in a free market, but as much a result of social rules - education, laws, unions, living standards, and such. Where laws and customs affect the economy, then we know from Coase’s Theorem that perhaps the final utilisation of resources is not affected, but at least the distribution of welfare is so. Galbraith here is in line with Keynes’s attention for relative wages, and my reference to the ‘pecking order’.

However, when Galbraith argues that ‘more equality also helps to control inflation’, then his argumentation is less convincing. For example:

“We will discover that efficiency improves when a larger number of people feel they have a fair shot at being middle class, and when ‘middle class values’ come again to define our broader culture.” (p268).

He here refers to Nothern Europe and Japan. I tend to think that there is value in this argumentation, but I doubt that US free market economists will agree. They will point out that, alas, Europe has an official rate of unemployment of 10%, while the unofficial rate is higher. So, Galbraith here likely is right, but loses the argument because his munition isn’t strong enough yet.

At one place he shows him aware that Germany has such a high unemployment rate, but then he suggests that this is caused by an error in policy making (p235). So in one place ‘more equality’ is advanced as the solution, and at another place it is not enough. I am a sympathetic reader, and can see through the argumentation. But the argument now is vulnerable to readers with less sympathy. Also, Galbraith’s critique on European policy differs from mine.

The reason why I find value in Galbraith’s argumentation should be clear. Proper tax measures can keep the lowly productive in the labour market, and thus increase competition: making it more difficult for the higher productive to demand pay rises. Thus, there is a valid argument that should convince the US free market economists - and Galbraith’s and my arguments nicely complement each other. But I don’t use the inequality argument: I use market positions.

In fact, Galbraith does use - in one place - the same argument on market positions ! Namely:

“(…) a change in the relative market power of skilled and less skilled workers can occur for reasons not connected in any direct way to political decisions. (…) firms (…) allocate the squeeze in their cash flow occasioned by the rise in price of an important input, in such a way that a disproportionate share of the burden falls on less skilled, less powerful, more readily expendable workers. (…) When changes such as these are run through an analysis that has been constructed from the beginning to be blind to the presence of monopoly power, these kinds of changes would, and do, show up in the data as “skill-biased technological change.” Skill bias is thus a phrase that can account, with perfect plausibility but equally perfect meaninglessness, for many different phenomena (…)” (p46)

So the wonder is why Galbraith does not stick to this - sufficient - argument, and later drops it and continues on ‘middle class values’.

Note too that elsewhere he explains - quite correctly - that ‘skill’ is an abused term, since someone can be very skilled (e.g. in making typewriters or other obsolete objects) and still be displaced. What counts is the ‘economic empty box’ of ‘productiveness’ - for which an education is only an indicator.

Similarly, it was a pleasant surprise to me that Galbraith (p48) also found the ‘sheltered - exposed sector’ argument. He does not refer to the impact of taxes (of course) but uses an example of a change in the terms of trade.

Galbraith is of the opinion that you can only see these mechanisms if you drop the assumptions of a fully competitive labour market, and allow for monopolistic power. I am not entirely sure of this. Heterogeneous labour might be congruent to monopolistic competition - but, anyhow, I’d rather take heterogeneity as the starting point, and then proceed with the model, and stay away from the - perhaps ideological - debate on market type. This actually might provide a test for our two theories: it the tax approach would not work, then monopolistic competition might be a force too strong - and the next candidate for the ‘main cause’.

I was very much surprised about Galbraith’s rejection of the NAIRU concept. On second thought, I think that he has some argument. But it is convoluted, and needs to be straightened out.

Note first of all that I have been using the NAIRU myself consistently, and have been arguing since at least 1989 that it shifts. The use of the concept is quite natural for an econometric model that is used for prediction and policy analysis. I also have been quite critical about tax policy, and have been arguing that the NAIRU may be as low as 2% if policies are correct.

Galbraith does not have that background. Instead, he has a field day in making fun of our fellow economists who - indeed - make fool of themselves. Galbraith nicely remarks: “The NAIRU, like the wage rate, is downward sticky.” (p180) Perhaps in reality, but certainly in the estimates that the colleagues have been providing in these last years. Economists lag behind the observations. Robert J. Gordon, who I greatly respect, appears to provide a NAIRU estimate with a confidence interval that seems to make it rather useless for policy. Galbraith rightly comments that the NAIRU in this manner becomes a ritual blessing for the powerful and the status quo - and is far away from real science. Galbraith gets upset, and quite justified so, since so many innocent people are victims of this intellectual incapacity.

Nevertheless, Galbraith himself mentions an unemployment target of “4 percent or lower” (p171). This causes the question with me whether this is not a NAIRU again, and why it cannot be 2%. In his suggestions for anti-inflation measures, Galbraith also advocates wage restraint, and I cannot but think that the threat of unemployment has a role here.

Galbraith recalls the Friedman quote where the ‘natural rate’ of unemployment is ‘ground out’ from the ‘Walrasian system’. Galbraith makes fun of this, essentially arguing that ‘Walras’ was before ‘Keynes’:

“From a proper Keynesian perspective, the correct response to Friedman’s second formulation of the natural rate hypothesis would have simply been, “Sorry, but at the aggregative level the ‘labour market’ is a misconception; it does not exit.”” (p177)

Part of this is going too fast. First of all, we should ditch the word ‘natural’. Secondly, if we drop ‘Walras’ from the Friedman quote and substitute ‘the proper model’, then we have a proper argumentation. (And we should remember that Walras was a very subtle economist, with more attention for dynamics than perhaps commonly thought.) Thirdly, I don’t see why we cannot model the labour market as a ‘market’ with aggregate impact and spillover - even though I value the ILO dictum “Labour is not a commodity”. The ‘market’ model is useful economics, and the models can be used for policy advice.

So I think that Galbraith might well adopt the NAIRU and use it to his advantage. It is a useful modeling tool. If you put the hammer in the toolbox, instead of on the shaky shelf above your head, it won’t hit you on the head so often. Note also that Graafland (1990a) and Gelauff (1992) following Hersoug (1984) have provided more theoretical foundations to the concept, so that the complaint ‘an empirical regularity in search of a theory’ no longer seems valid.

Whereas I use a whole earnings distribution, Galbraith uses a Theil measure (and calls this a measure for inequality) - and, again quite parallel, we both link these to fiscal and monetary policy.

It may well be that an inequality measure is more efficient to use than a whole distribution. Such measures have been around for a long time, but it seems to me that Galbraith’s book is the first time that it is both developed in the present detail and linked up with policy.

Interestingly, Galbraith uses his measure to find that US unemployment should be below 5.5 % in order to keep equality constant or improving. Referring to the ‘natural rate’, he calls this the ‘ethical rate’. I wish he hadn’t done that, and had dumped the word ‘natural’ too. But as such his analysis nicely sharpens our insights in the dilemma’s of policy making.

Galbraith provides some technical evidence on the developments in the various industries. This research is interesting in itself too, but while the book progresses, it appears, a bit to the dismay of the reader, that the industrial analysis is primarily given to show that it is less relevant.

Galbraith has found a ‘productivity measure’ (‘P-measure’) - defined as value added per production worker hour - that enables him to find three clusters in the US economy: a ‘knowledge’ K-cluster, a ‘consumption’ C-cluster and a ‘service’ S-cluster. The graphs show that these clusters can be found in the data indeed. The P-measure might be less convincing, and might appear ad hoc. However, when it turns out that these clusters can (‘basically’) be represented too by the share of the wage bill of non-production workers - more and higher paid R&D and marketing workers - then the clustering starts making more sense, and good sense actually.

The link between this part of the book and the rest is rather weak. The idea seems to be that this research underlines the monopolistic tendencies in the US economy. For such a conclusion, however, more work needs to be done. Another line of thought is that this novel understanding of the US industrial development would help us to better understand the role of technology - and its impact on wages and inequality. That may be true too - but I was already convinced of the less relevant role of technology anyhow.

In my view this part of the analysis will surely help to better model the economy, but it is less relevant for the analysis of inequality proper.

I have been critical of aspects, but in general Galbraith has written a great and very useful book. It is seductively well written, and the subtle points, that are clearly recognised by the author, might easily be overlooked by the readers. My suggestion for a next edition is to split the book in the two books that it actually consists of. This would also give more room to drive the subtleties home.

I may emphasise again that I see a quite parallel line of thinking with my own analysis. I hope that others will see this too, and that they will see that there indeed is something to the arguments.

Cox & Alm: “Myths of rich and poor”

Cox and Alm (1999) wrote a book that one shouldn’t buy. Though the book contains almost 50 pages of footnotes, it is not a scientific but an ideological and highly contorted book. Many of the arguments are at the level of ‘An apple a day keeps the docter away’ - superficially convincing but nonsense at a quick closer look. As such it gives a good idea of what science is up against - and it is not a pretty sight.

In their preface the authors refer to a list of books that spell America’s doom, and they rightly comment that “spreading the bad news has become a cottage industry” (p ix). My problem with their list of books is that it hardly contains any serious economic study. They don’t refer to Krugman (1994a, b), while stagflation is a real economic issue. Of course, if you are a victim of such ‘doom books’ then you might benefit from Cox & Alm’s exposition, but then you shouldn’t forget about the serious literature, and the authors should warn about that.

One of the reasons why the book is unbalanced is that it seems to serve two goals. On one hand the argument seems to be that America is doing well ‘on average’ (and even for the majority of the people) and on the other hand the argument seems to be that the poor are not as poor as claimed. This creates the contortion that, when it is shown that the average American home now contains many electronic gadgets, there apparently is also the suggestion that this would be true for the poor - while this certainly cannot be the case. Conversely, where it is argued that many of the legally poor actually are retired people with $300,000 valued homes, then this indeed is useful to note (and points to a possible error in America’s laws) but it doesn’t clarify anything about the working poor.

The authors intend to shake up America from a sense of doom, and the book contains a lot of hyperbole of the kind that ‘things really are OK’. The authors of course are right that there has been hyperbole about American failure. Their suggestion that this sense of doom originates from the midlife crisis of the baby boom generation, may well be true too. Cox and Alm likely are right as well that emotions with such deep psychological roots require tough counter-measures. But their argument remains unbalanced. If the penis is the problem, please stay away from economics ! Not surprisingly, they often misrepresent the real issues in the economics debate.

A positive point about the book is that it provides a number of facts on the American situation that may not be available in this conjuction elsewhere. Such facts for example concern some basic results of the University of Michigan Panel Survey on Income Dynamics, the plots of the diverging of data series on average hourly wages and total wage compensation (that includes fringe benefits such as health care), and an overview of the findings of various authors on the overestimate of the Consumer Price Index.

It is an entirely different subject how Cox and Alm use these data. About the image of doom they first suggest that ‘the argument rests’ (p4, they don’t say who gives this argument) on the hourly wage index. Then Cox and Alm come to the rescue, and show that total compensation has actually be on the rise. Gentlemen, please, this is no way to behave in a civilised discussion: (a) say who gave this argument, (b) serious economists always consider total compensation, so - especially when you write a book that mentions trivialities such as that computers get cheaper every year - also explain why your hour wage index would not include fringe benefits. (In other words, the note on p215 on ‘wage data’ does not explain much.) (c) a discussion on poverty is not about averages, (d) and it is entirely misleading to suggest that per capita income is a good indicator, for either average or the poor, since this includes the profits and interest of the capital owners.

Similarly, the Income Dynamics data show that people from the lowest 5th quintile can migrate to the higher quintiles . OK, many students first are poor and later earn a good living. The point of the poverty debate however is that many of the poor are not students. Mutatis mutandis for others who manage to escape. And even for students one might question why they should live in poor conditions. Cox and Alm again misrepresent the issue.

Cox and Alm spend pages on illustrating the various technological improvements since the 1950’s or even the 1970’s. The argument e.g. that the PC has come about since the 1970’s, and has gone down in price enormously, is of course of little value to the poor person who cannot afford it anyway. The argument that ‘we benefit from cheaper products’ is rather contorted. Cox and Alm have a point that incorporating technological improvements is a difficult issue in statistics. Still, it is not a new point, and giving a list of gadgets is not a sufficient method to settle the price index problem either.

The authors refer to p182 to Maslow’s theory of psychological stages. The suggestion is a bit that the poor should be happy that they at least have their physiological necessities, and that self-actualisation is a luxury limited for the rich. One would hope that Maslow’s theory will be applied more critically. Even a poor person or even ‘primitive’ societies can have degrees of self-actualisation. These aspects are so much part of the definition of being ‘human’ that they do not represent a sequential order, but are relevant simultaneously, with different degrees and formats depending upon economic and social means and conventions.

Another way to look at this book is to see that it highlights many predicaments in the debate on poverty, so that it shows that the issue of poverty is not as simple as many may think - including, apparently, the authors themselves.

Cox and Alm summarised their argument in the article “Why Some Americans Want More Poverty” in the Wall Street Journal, European edition, November 10 1999. To show how convoluted some arguments are, I can usefully quote that article, and then comment on it.

“America could soon get a lot poorer.

The U.S. Census Bureau is experiment­ing with a new formula that would raise the poverty threshold for a family of four to $19,500 from $16,660. Through a simple change of definition, one that has nothing to do with economic realities, 12 million Americans might become “poor” overnight.

It’s true that existing measures of poverty are riddled with flaws. But the problem isn’t that they underestimate poverty; it’s that they overestimate it. When we’re trying to determine well being, the proper yardstick is consump­tion, not income. They aren’t the same thing — especially among the poor. The poverty rate tells us how many Americans earn low incomes, not what they’re able to buy.

Households in the bottom fifth of the income distributon consume well beyond their earnings. In 1997 an average low ­income household made $7,086 year before taxes. Consumption — what the poor spent, not what they earned — totaled $14,670.

How can poor families consume more than they earn? Many supplement their income through welfare, Food Stamps, unemployment benefits, Medicare, Medic­aid, school lunches, rent subsidies and other programs, all of which the statistics leave uncounted. And the poverty statis­tics ignore wealth, which can be more important than current income. Workers temporarily laid off don’t get paychecks but they often have savings to fall back on. Although many retirees earn low in­comes, their houses, cars and furnishings are paid for, and they’ve got nest eggs. In 1993, 302,000 families with incomes of less than $20,000 lived in homes worth more than $300,000.

When you’re really poor, everything you see is something you can’t have. But over the years, the poor have gained ac­cess to more goods. Government statistics show that poor households own many of the consumer goods usually associated with middle class life in the United States.

The percentage of poor households with washing machines rose to 72% in 1996 from 58% in 1984. Ownership of dryers went to 50% from 36%. Two-thirds of poor families had microwave ovens in 1996, up from one in eight a decade ago. Ninety-seven percent of poor households have color televisions, and three-fourths have videocassette recorders. Almost three-quarters of poor families own at least one car.

By the standard of day-to-day liv­ing — the standard that really matters — the poor have gotten much richer. Indeed, poor households in the 1990s are in many ways better off than average families in the early 1970s. Two-thirds of poor households had air-conditioners in 1997, compared with less than a third of all households in 1971. And it wasn’t a wel­fare program that made it possible; it was the free market which has introduced innovative new products and brought the prices down.

Spending patterns help explain how the poor can afford more of the trappings of middle-class life yet still not escape the poverty statistics. Among American households below the poverty line, outlays for food, clothing and shelter were 37% of con­sumption in 1995, compared with 52% two decades earlier, 57% in 1950 and 75% in 1920. Thus poor households have consider­ably more discretionary income than they once did.

One reason is that the U.S. govern­ment has already been raising the poverty threshold too quickly. For more than three decades the government has been adjusting the poverty line every year for inflation. The Boskin Commission con­cluded in 1996 that the consumer price index overstates the actual rise in the cost of living by a percentage point a year. What’s more, the overall CPI has risen 40% faster than the cost of groceries since 1965.

The crux of the debate over the pro­posed new statistics is tbe purpose of measuring poverty. As originally con­ceived, the poverty statistics were meant to be diagnostic. They emerged in the mid-1960s as a benchmark for President Johnson‘s “war on poverty.” What Ameri­cans wanted to know then—what they should still want to know today—is whether they’re reducing tbe number of families struggling to obtain the basic ne­cessities of life.

The answer is yes. A recent Heritage Foundation study examines the incidence of the bedrock problems of poverty—mal­nutrition, crowded housing and lack of ac­cess to medical care. It concludes that 8.7 million Americans, or just 3.7% of the pop­ulation, make up the nation’s “hardship population”—the truly poor.

In 1993, University of Texas economist Daniel Slesnick recalculated the poverty rate based on spending rather than in­come. To remove the vagaries of inflation, he established the poverty threshold at three times the cost of a nutritionally ade­quate diet for all members of a household. Mr. Slesnick’s results show that the pro­portion of poor in the U.S., measured by consumption, has fallen steadily, from 31% in 1949 to 13% in 1965 to 2% at the end of the 1980s.

It’s not hard to discern the political agenda of those who want to conjure up another 12 million poor people. Having more poor families enlarges the con­stituency for programs that dole out money to the poor. But if it’s simply a mat­ter of deciding which families are eligible for government programs, then the issue really comes down to how much Ameri­can’s are willing to sacrifice to the insa­tiable god of equality.”

My (closing) comments:

(1) Poverty is always relative, and its definition is always a search for what the better-off regard as acceptable rather than a search for objective truth. Opponents of a reduced welfare state, like Cox and Alm, should rather accept that relative standard, rather than confuse the debate with some absolute arguments. For example, a Dutch poverty debate in the early 1900’s was about whether a table would be part of household necessities or not. Defining poverty as three times the grocery bill would surely answer that question. But it is more likely that society’s standard would start including air-conditioners too (by some regarded as the most important invention this century).

(2) One of my main arguments is that society even tends to update poverty with the general level of welfare. That the US has been using only the CPI would counter that argument. But that the CPI has been overstated, that all kinds of provisions like Medicare have been added for purchasing power, and that one is experimenting with a serious update, is supportive again. Similarly, Cox and Alm p201 even state “What were once luxuries are now viewed as necessities”. It would be better to make welfare indexation the official line, and stick to it.

(3) The political argument given by Cox and Alm is doubtful. The few votes of the new beneficiaries may well lose out against a huge majority that could be against the proposals, including the current beneficiaries. Why start the whole discussion about democracy again ?

(4) Poverty definitions, though relative, nevertheless should be as sound as possible. If wealth is not properly accounted for, as Cox and Alm point out, then the debate gets noisy, and popular support for the poor indeed suffers. (Even though the 302,000 families with expensive homes are only a fraction of the 13 million real poor.) Similary, implementation of anti-poverty policies will often be very murky. (‘Did you really try to get a job - and shouldn’t we not take you from the programme ?’) There is no alternative but to accept this murkiness, and try to instill operations managers with the spirit that they should try for a good performance anyhow.

(5) To clarify the argument, to get rid of some of the murkiness, I myself take a stylized approach. Then we don’t bother with the question whether air-conditioners are part of household necessities. We assume some historic subsistence and exemption level, and then work through the arguments of indexation etc. This thus eliminates much of the need of statistical measurement.

At one point, Cox and Alm oppose socialism and capitalism: “Socialism, a failed and receding system, sought to impose artificial equality. Capitalism, a successful and expanding system, doesn’t fight a fundamental fact of human nature - we vary greatly in capabilities, motivation, interests, and preferences.” (p87). The argument is at kindergarten level again. The American success story derives as much from FDR’s initiatives as from ‘capitalism’. Western European welfare states have come about by active participation of Christian and Social Democrats. The latter often called themselves ‘socialist’, but certainly didn’t close their eyes to human differences. Indeed, there is quite a difference with Cox and Alm.

44. Relating to the OECD and some of its authors

The OECD in general

It has been well-recognised that OECD economies have a problem with jobs with a low level of productivity and thus a low level of market-earned income. The OECD has done great research here. A standard reference here is to the OECD (1994) “Jobs Study”, that also was followed up with studies such as OECD (1995), Marsden (1995), Tyrväinen (1995), OECD (1998), the OECD Economic Studies 31 (2000/II) issue, with contributions of Pearson and Scarpetta (2000), Hotz and Scholz (2000), Dilnot and McCrae (2000), Fitoussi (2000), and Phelps (2000). But, while all this is recognised, the OECD shows no attention for this present analysis, even though it has been available on the internet since 1995.

Two main comments can be made with respect to the OECD (2000) Outlook,