Short History of Welfare Economics

 

B.Contestabile       admin@socrethics.com       First version 2009   Last version 2016

 

 

 

 

Table of Contents

 

Abstract

 

1.      Introduction

2.      Classical Economics (18th and 19th Century)

2.1 Definition

2.2 Classical Utilitarianism

2.3 Criticism of Capitalism

3.      Neoclassical Economics (since ca.1870)

3.1 Definition

3.2 Old Welfare Economics

3.3 New Welfare Economics

3.4 Social Choice Theory

3.5 Micro- and Macroeconomics

3.6 Neoclassical Synthesis

4.      Modern Development Economics (since ca.1950)

4.1 Definition

4.2 Neoclassical Theory

4.3 Capability Approach

5.      Happiness Economics (since ca.2005)

5.1 Definition

5.2 Criticism of Neoclassical Economics

5.3 Surveys

6.      On the Philosophy of Economics

6.1 Positive Economics

6.2 Normative Economics

7.      Conclusion

 

References

 

 

 

 

 

Abstract

 

 

Starting point

Classical utilitarianism started with the slogan “The greatest happiness for the greatest number”.

Welfare economics is supposed to increase national welfare.

Traditional approximations for welfare are

- income for the welfare of the individual

- GDP (calculated by the income approach) for the welfare of society.

 

 

Type of problem

Richard A.Easterlin, professor of economics at the University of Southern California found, as expected by most economists, that, within a given country, people with higher incomes are more likely to report being happy. However, in international comparisons, the average reported level of happiness does not vary much with national income (GNI) per person, at least for countries with income sufficient to meet basic needs (Easterlin Paradox, Wikipedia).

Does welfare economics contribute to happiness?

 

 

Result

The history of welfare economics seems to confirm the following suspicion:

 

The mathematical maximization of welfare is extremely useful – as a form of employment for economists   (author unknown).

 

Whereas many branches and techniques of economics are indispensable, the mathematical maximization of welfare cannot live up to its promise.

Newer strategies have given up the idea to derive happiness exclusively from economic welfare:

 

The Capability Approach emphasizes that – once a decent level of economic welfare is reached – human rights become a major determinant of happiness.

Happiness Economics builds on empirical data about individual happiness instead of mathematical functions and bureaucratic indicators like the GDP and GNI.

 

With regard to economic welfare the hope rests on simulation models, which forecast the outcome of competing economic policies. Unfortunately, however, these models did not foresee the worst economic crises since the Great Depression.

 

 

 

 

 

1. Introduction

 

 

 Starting point

         Classical utilitarianism started with the slogan “The greatest happiness for the greatest number”.

         Welfare economics is supposed to increase national welfare.

Traditional approximations for welfare are

o   income for the welfare of the individual

o   GDP (calculated by the income approach) for the welfare of society.

 

 

Type of problem

Richard A.Easterlin, professor of economics at the University of Southern California found, as expected by most economists, that, within a given country, people with higher incomes are more likely to report being happy. However, in international comparisons, the average reported level of happiness does not vary much with national income (GNI) per person, at least for countries with income sufficient to meet basic needs (Easterlin Paradox, Wikipedia).

Does welfare economics contribute to happiness?

 

 

 

2. Classical Economics (18th and 19th Century)

 

 

2.1      Definition

 

The historical context of classical economics was the age of enlightenment, the French Revolution (1789-1799) and the industrial revolution.

 

1.      Classical economics is widely regarded as the first modern school of economic thought. It is the idea that free markets can regulate themselves. Its major developers include Adam Smith, David Ricardo, Thomas Malthus and John Stuart Mill (…) Adam Smith's The Wealth of Nations in 1776 is usually considered to mark the beginning of classical economics. The school was active into the mid 19th century and was followed by neoclassical economics in Britain beginning around 1870.

2.      Classical economists attempted and partially succeeded to explain economic growth and development. They produced their "magnificent dynamics" during a period in which capitalism was emerging from a past feudal society and in which the industrial revolution was leading to vast changes in society. These changes also raised the question of how a society could be organized around a system in which every individual sought his or her own (monetary) gain.

3.     Classical economists reoriented economics away from an analysis of the ruler's personal interests to a class-based interest. Physiocrat Francois Quesnay and Adam Smith, for example, identified the wealth of a nation with the yearly national income, instead of the king's treasury. Smith saw this income as produced by labor applied to land and capital equipment. Once land and capital equipment are appropriated by individuals, the national income is divided up between laborers, landlords, and capitalists in the form of wages, rent, and interest.

(Classical economics, Wikipedia)

 

A notable current within classical economics was underconsumption theory, as advanced by the Birmingham School and Thomas Robert Malthus in the early 19th century. These argued for government action to mitigate unemployment and economic downturns, and were an intellectual predecessor of what later became Keynesian economics in the 1930s. Another notable school was Manchester capitalism, which advocated free trade, against the previous policy of mercantilism.

(History of economic thought, Wikipedia)

 

 

 

2.2      Classical Utilitarianism

 

Origin

The origins of utilitarianism are often traced as far back as the Greek philosopher Epicurus, but, as a specific school of thought, it is generally credited to Jeremy Bentham (1748-1832) (Utilitarianism, Wikipedia)

 

Utilitarianism retains the Epicurean view that humans naturally seek pleasure and avoid pain, but while Epicureans laud pleasure seeking and pain avoidance for their effects on the psychological state of the actor, utilitarians use it to express the consequentialist view that a good action maximizes pleasure and minimizes pain in the society (Epicurus, Science Encyclopedia)

 

 

Bentham’s utilitarianism

Bentham’s utilitarianism is based on the following assumptions:

1.      Each individual knows best what is good for him/her

2.      Each individual should decide him/herself in private matters

3.      The welfare of an individual does not depend on other individual’s welfare

4.      The welfare of each individual can be added in order to evaluate the total welfare of the society.

5.      Each individual has the same weight (rights) in collective decisions.

6.      Utility is interpersonally comparable

7.      The principle of competition increases welfare, if applied under the conditions of equal opportunity.

8.      Economic welfare correlates with general welfare.

9.      Utility can be measured by cardinal numbers and utility functions are linear.

[Kleinewefers, 37-38]

Utilitarianism was originally developed as a challenge to the status quo. The demand that everyone count for one, and one only, was anathema to the elitist society of Victorian Britain (Utilitarianism, Wikipedia)

For more information on Bentham’s utilitarianism see Negative Utilitarianism and Justice.

 

 

Liberalism

The development into maturity of classical liberalism took place before and after the French Revolution in Britain, and was based on the following core concepts: classical economics, free trade, laissez-faire government with minimal intervention and taxation and a balanced budget. Classical liberals were committed to individualism, liberty and equal rights. The primary intellectual influences on 19th century liberal trends were those of Adam Smith and the classical economists, Jeremy Bentham and John Stuart Mill (Liberalism, Wikipedia)

There is, however, a profound difference between liberalism and utilitarianism:

         Utilitarianism attempts to increase the total utility of the community. The individual is subordinated to this goal.

         Liberalism claims that individual actions are only restricted by the condition not to harm others.

How could Mill claim that liberalism is compatible with utilitarianism? For an answer to this question see Negative Utilitarianism and Justice.

 

 

 

2.3      Criticism of Capitalism

 

The main critic of capitalism was Karl Marx.

         Communism emerged in response to the miserable living and working conditions of the working class in the new industrial era. The economic and political theory published in The Communist Manifesto (1848) and Das Kapital (1867) combined with the dialectic theory of history inspired by Friedrich Hegel (1770–1831) provide a revolutionary critique of nineteenth-century capitalism.

         Marx developed a theory of business cycles based on exploitation, alienation, capital accumulation and economic growth (see Marxian Economics). With every boom and bust, with every capitalist crisis, thought Marx, tension and conflict between the increasingly polarized classes of capitalists and workers would heighten. Ultimately, led by the Communist party, Marx envisaged a revolution and the creation of a classless society.

In 1917 Russia crumbled into revolution led by Vladimir Lenin. Lenin promoted Marxist theory and collectivized the means of production (History of economic thought, Wikipedia).

From now on there was a concrete example, how the Marxist theory could be implemented (respectively abused) in practice. Lenin’s centrally planned economy also marked the beginning of an endless competition between liberal and (partly) state-run economies. An attempt to reconcile Marxian economics with free markets was made in the 1920s in the context of market socialism. Market socialism combines the public, cooperative, or social ownership of the means of production with the framework of a market economy (see chapter 3.3).

 

 

 

 

3. Neoclassical Economics (since ca.1870)

 

 

3.1 Definition

 

Neoclassical economics is a set of solutions to economics focusing on the determination of goods, outputs, and income distributions in markets through supply and demand (Neoclassical economics, Wikipedia).

 

 

Origin

Neoclassical economics is conventionally dated from

1.      William Stanley Jevons's Theory of Political Economy (1871)

2.      Carl Menger's Principles of Economics (1871), and

3.      Leon Walras's Elements of Pure Economics (1874 – 1877).

 

These three economists have been said to have promulgated the marginal utility revolution or Neoclassical Revolution (…).

1.      Walras was more interested in the interaction of markets than in explaining the individual psyche through a hedonistic psychology.

2.      Jevons saw his economics as an application and development of Jeremy Bentham's utilitarianism and never had a fully developed general equilibrium theory.

3.      Menger emphasized disequilibrium and the discrete. Menger had a philosophical objection to the use of mathematics in economics, while the other two modeled their theories after 19th century mechanics.

(Neoclassical economics, Wikipedia)

 

 

Comparison with classical economics

 

Rational behavior

         Classical economists (…) accounted for economic phenomena like output, consumption, value of commodities, distribution of income.

         Neoclassical economists defined economics as a science which additionally could be capable of studying all human rational actions. All humans can be modeled as agents who search for getting the maximal satisfaction from their actions. The marginalist neoclassicals tried to develop general economic laws, imitating the rigorous methods used in physics (History of Economic Thought, Wikipedia).

 

Marginal utility is a consequence of rational behavior:

         Instead of the price of a good or service reflecting the labor that has produced it (as in classical economics)

         the price reflects the marginal usefulness (utility) of the last purchase. This meant that in equilibrium, people's preferences determined prices, including, indirectly the price of labor (…).

Consumers act rationally by seeking to maximize satisfaction of all their preferences. People allocate their spending so that the last unit of a commodity bought creates no more satisfaction than a last unit bought of something else (History of economic thought, Wikipedia)

 

 

 

3.2      Old welfare economics

 

Jevons, Menger and Walras promulgated the concept of marginal utility, but did not invent it:

 

Daniel Bernoulli (1700-1782) published a formalization of marginal utility in 1738 (Expected Utility Hypothesis, Wikipedia)

 

Hermann Heinrich Gossen (1810-1858) was a Prussian economist who is often regarded as the first to elaborate a general theory of marginal utility (Gossen, Wikipedia)

 

As long as utility functions are assumed to be linear it does not matter, if the welfare of the most or the least wealthy is increased. But if we assume a diminishing marginal utility of welfare, then it makes sense to increase the welfare of the least wealthy. Under the influence of Gossen’s laws a part of the welfare economists turned towards egalitarianism without being particularly compassionate. The normative force of fraternity is not required to justify redistribution, as long as Gossen’s laws are seen as a kind of “natural” laws. Under the given premises redistribution is simply a consequence of the common goal to maximize the welfare of the community.

One of the major representatives of the Gossen-type of economics was the English economist Arthur Cecil Pigou (1877-1959). According to his theory the welfare of a society can be measured by the Gross Domestic Product (GDP) and the distribution of GDP [Kleinewefers, 40-42].

Since the marginal value of income decreases, the total of utility can be increased by transferring income from the rich to the poor. Pigous ideas are still effective in the actual discussions on

1.      Egalitarian utilitarianism (Pigouvian redistribution)

2.      Protection of the environment (Pigovian tax for pollution etc.)

The weakness of his theory lies in the assumptions that the utility functions of all individuals are equal [Herbener, 80] and that the society’s total income isn’t affected by the redistribution.

 

 

 

3.3      New Welfare Economics

 

 

Definition

Old welfare economics used the following assumptions:

1.      Utility can be measured in terms of money and is a measure for social welfare

2.      Utility is interpersonally comparable and summable.

These two assumptions were given up in new welfare economics [Clarenbach, chapt.2.6] [Herbener]. Pareto proved that utility is immeasurable from observations of behavior. Economists who accepted this proof (like Hicks) attempted to revise the theory of consumer behavior by excluding immeasurable concepts of utility. The analytical framework remained individualistic. All social phenomena (in particular market prices and the law of demand) had to be explained in terms of individual behavior.

 

 

Ordinal utility

Ordinal instead of cardinal utility is the major difference between old and new welfare economics [Kleinewefers, 42]. For a comparison see Cardinal Utility, Wikipedia.

When cardinal utility is used, the magnitude of utility differences is treated as an ethically or behaviorally significant quantity. On the other hand, ordinal utility captures only ranking and not strength of preferences (…). It would e.g. be possible to say that juice is preferred to tea to water, but no more. Neoclassical economics has largely retreated from using cardinal utility functions as the basic objects of economic analysis, in favor of considering agent preferences over choice sets (Utility, Wikipedia).

 

The first usage of ordinal utility is attributed to Vilfredo Pareto (1848-1923).

         Giving up cardinality (classical utilitarianism, assumption 9) means giving up the cardinal hedonistic scale.

         Utility is now defined by a set of individual preferences and cannot be interpersonally compared (classical utilitarianism, assumption 6).

         Without a common hedonistic scale utilities cannot be added (classical utilitarianism, assumption 4).

As a consequence there is no variable like “welfare” which could be maximized and distributed. Distributive justice was cancelled from the economist’s agenda.

 

 

Allocative efficiency

From now on economics concentrated on the search for allocative efficiency under the conditions of a given initial allocation and limited resources. These are the characteristics of an optimization problem.

 

Given a set of alternative allocations of goods or outcomes for a set of individuals, a change from one allocation to another that can make at least one individual better off without making any other individual worse off is called a "Pareto improvement". An allocation is defined as "Pareto efficient" or "Pareto optimal" when no further Pareto improvements can be made (Pareto efficiency, Wikipedia).

 

Two fundamental theorems of welfare economics are the following:

1.      A perfectly competitive general equilibrium is Pareto optimal [Arrow, 97]

         The theorem captures the logic of Adam Smith’s invisible hand (Welfare Economics, Wikipedia)

         A corollary is that free trade is Pareto optimal among countries.

2.      Any Pareto optimal allocation can be attained by a competitive general equilibrium.

For a more detailed description see General Equilibrium Theory

 

Pareto efficiency was criticized for two reasons:

1.      It does not require a "just" or equitable distribution of wealth. A simple example is dividing a pie into pieces to distribute among three people. The most equitable distribution is each person getting one third. However, the solution of two people getting half a pie and the third person getting none is also Pareto optimal despite not being equitable, because the only way for the person with no piece to get a piece is for one or both of the other two to get less, which is not a Pareto improvement (Pareto efficiency, Wikipedia)

2.      Varying initial allocations lead to varying optima, and there is no criterion to compare these optima. It is not even possible to compare the optimal solution for a specific initial allocation with the non-optimal solution of a different initial allocation. The only normative goal is to realize perfect competition in a perfect market in order to reach a pareto optimum [Kleinewefers, 43-44]. Obviously the Pareto optimization cannot be applied to practical politics because political decisions normally produce winners and losers. As a consequence, economics developed new optimization criteria which could be applied to cases with winners and losers.

Using Kaldor-Hicks efficiency, an outcome is more efficient if those that are made better off could in theory compensate those that are made worse off, so that a Pareto improving outcome results. For example, a voluntary exchange that creates pollution would be a Kaldor-Hicks improvement if the buyers and sellers are still willing to carry out the transaction even if they have to fully compensate the victims of the pollution.

(Kaldor-Hicks efficiency, Wikipedia)

Using the new efficiency criteria it was possible to compare a new situation with the status quo, but it was not possible to compare several alternatives and find the best one. The need to compare and rank a larger number of alternatives led to the development of new social welfare functions. There was, however, a competing movement in economics, which radically questioned the value of economic planning.

 

 

The economic calculation problem

The economic calculation problem is a criticism of using economic planning as a substitute for market-based allocation of the factors of production. It was first proposed by Ludwig von Mises in his 1920 article "Economic Calculation in the Socialist Commonwealth" and later expanded upon by Friedrich Hayek. In his first article, Mises describes the nature of the price system under capitalism and describes how individual subjective values are translated into the objective information necessary for rational allocation of resources in society. In market exchanges, prices reflect the supply and demand of resources, labor and products. In his first article, Mises focused his criticism on the inevitable deficiencies of the socialization of capital goods, but Mises later went on to elaborate on various different forms of socialism in his book, Socialism. Mises and Hayek argued that economic calculation is only possible by information provided through market prices, and that bureaucratic or technocratic methods of allocation lack methods to rationally allocate resources (see Austrian School).

The debate raged in the 1920s and 1930s, and that specific period of the debate has come to be known by economic historians as the Socialist Calculation Debate. Mises' initial criticism received multiple reactions and led to the conception of trial-and-error market socialism (Economic Calculation Problem, Wikipedia).

The theory of Market Socialism combines Marxian Economics with neoclassical economics after dumping the labor theory of value (History of economic thought, Wikipedia).

In response to the Economic Calculation Problem, Abram Bergson formally demonstrated that competitive outcomes may not lead to the best result. In the following he reconsidered the concept of a social welfare function and reintroduced distributive justice to the economist’s agenda.

 

 

New social welfare functions

Bentham and Pigou already defined social welfare functions (see Negative Utilitarianism and Justice), but these functions were cardinal and restricted to the consumption of goods. Pareto’s social welfare function, on the other hand, was ordinal, but focused on efficiency.

 

Furthermore it turned out that it is not possible to evaluate a change which makes some persons better-off and some worse-off without making some implicit value judgment about the deservingness of an individual or a group. Recognizing the inevitability of value judgment, Bergson suggested that the only way to solve this problem is to formulate a set of explicit value judgments about the distribution of income [Dwivedi].

 

In a 1938 article Abram Bergson introduced a new type of social welfare function. The object was "to state in precise form the value judgments required for the derivation of the conditions of maximum economic welfare" set out by earlier writers, including Pigou, Pareto and others (Social welfare function, Wikipedia)

It is important to note, however, that Bergson defined value judgments in the form of parameters or variables and not in the form of fixed values.

 

According to Bergson a social welfare function should include all arguments which influence the members of the society in a positive or negative way.

Pareto efficiency could characterize one dimension of a particular social welfare function, distribution of commodities among individuals another dimension. Samuelson stressed the flexibility of the social welfare function to characterize any one ethical belief, Pareto-bound or not, consistent with a complete and transitive ranking (an ethically "better", "worse", or "indifferent" ranking) of all social alternatives (Social welfare function, Wikipedia).

 

Neither Bergson nor Samuelson precisely defined their social welfare functions. It remained unclear

         how the arguments of these functions should be measured, respectively (if there is no cardinal measure)

         how ordinal utilities should be aggregated

[Kleinewefers, 45-48].

 

These questions are the main topic of social choice theory:

 

 

 

3.4      Social Choice Theory

 

Neoclassical economics is closely tied to decision theory and social choice theory:

1.      Neoclassical microeconomics is nothing but the theory of individual economic decisions, under the side constraint of limited resources.

2.      Kenneth Arrow realized that the aggregation of individual preferences has to be treated as a collective decision process (social choice)

 

Social choice theory depends upon the ability to aggregate, or sum up, individual preferences into a combined social welfare function.

         Individual preference can be modeled in terms of an economic utility function.

         The ability to sum utility functions of different individuals depends on the utility functions being comparable to each other; informally, individuals' preferences must be measured with the same yardstick. Then the ability to create a social welfare function depends crucially on the ability to compare utility functions. This is called interpersonal utility comparison (Social Choice Theory, Wikipedia)

 

In his dissertation Social Choice and Individual Values Arrow proved that there is no democratic decision process which aggregates individual preferences into an unambiguous result [Kleinewefers, 48-52].

Because of welfare economics' close ties to social choice theory, Arrow's impossibility theorem is sometimes listed as a third fundamental theorem of welfare economics [Welfare economics, Wikipedia].

The difficulties in the aggregation are caused by the assumption that individual preferences are not comparable and therefore not cardinally measurable. Following the major attempts to find a way out of this trap:

 

 

1.      Harsanyi’s utilitarianism

Individual preferences are made comparable by a normative act. They are subjected to the judgment of an impartial observer, who makes a distinction between comparable preferences (those which correspond to the Conditio Humana) and individual extravagances. The former are relevant and therefore considered in the aggregation, whereas the latter are neglected. The most important representatives of this approach are John Harsanyi and Serge-Christoph Kolm.

         Harsanyi calls the comparable preferences basic psychological laws or extended preferences [Adler]

         Kolm calls them fundamental preferences or human nature.

In other words: The problem of incomparable preferences is circumvented by constructing a “representative” individual.

 

Economic theory assumes that an individual acts rational and attempts to maximize utility under given side constraints. Utility can be maximized by means of the expected utility theorem. The concept of the utility function – which builds on the expected utility theorem – is sufficiently flexible in order to address all relevant problems of individual rationality. It allows taking account of

         social interdependencies

         external effects

         public goods

On this basis Harsanyi constructed an axiomatic version of utilitarianism and embedded it in a theory of rationality. The theory assumes that – after every decision influencing or changing society – the decision-maker can find him-/herself with equal probability in every possible position in the changed society (Gleichwahrscheinlichkeitsmodell, see Negative Utilitarianism and Justice).

 

The problem with utility functions, however, is not a theoretical one, it is a practical one. There is no complete utility function for an individual [Kleinewefers, 277] and no estimation for the cardinal values. Approximations used so far are:

1.      income for the welfare of the individual

2.      GDP (calculated by the income approach) for the welfare of society.

But welfare cannot be reduced to income and the measurement of the GDP has its pitfalls [Coyle]

 

 

 

 

The Gross Domestic Product measures everything

except that which makes life worthwhile.

 

Robert F.Kennedy

 

 

 

 

2.      Broome’s utilitarianism

In John Broome’s theory individual preferences are given up as a criterion for the valuation of social welfare. Interpersonal comparisons are achieved by means of a different, non-preferencist theory of the good [Broome]. On this (cardinal) basis Broome constructs a modern form of hedonistic utilitarianism. Let us assume that the summum bonum (the highest good) is life satisfaction or quality-adjusted life years. The utility functions are then restricted to

o  The aggregation of the individual good in different time periods into the individual’s total.

o  The aggregation of the individual good of different persons into the community’s total.

Life satisfaction or quality-adjusted life years have to be measured by means of surveys. For an example see Negative Utilitarianism and Justice.

 

 

3.      The capability approach

Individual preferences are replaced by capabilities. Capabilities are defined in constitutions and laws. Social situations are valuated according to potentials (resources) which are offered to individuals. The usage of these potentials is then a concern of the individuals and not of society. Similar to Harsanyi’s attempt to find morally relevant preferences, an attempt was made to find morally relevant potentials by subjecting them to the judgment of an impartial and empathic observer. The most important representatives of this approach are John Rawls (1921-2002) and Amartya Sen (1933- ).

 

The capability approach runs across the aggregation problem on a constitutional level. Resources, goods, rights etc. are not measured according to the same cardinal scale and cannot be accumulated into a single value called “social welfare” [Kleinewefers, 53-54]. There are, however, two ways to circumvent the problem:

         John Rawls’ arranges his most important values (liberty rights, equality of opportunity and economic welfare) on a priority scale.

         Amartya Sen and other social choice theorists make their most important values comparable by a normative act and aggregate them into an index.

In this paper we concentrate on Sen’s capability approach (chapter 4.3). For more information on Rawls’ concept see Negative Utilitarianism and Justice.

 

 

 

3.5      Micro- and Macroeconomics

 

With the neoclassical researchers economics started to split up into microeconomics and macroeconomics. Whereas Jevons concentrated on microeconomics, Walras and Menger worked on equilibrium theory which became the cornerstone of macroeconomics.

 

 

Microeconomics

         Neoclassical economists were above all involved in the development of microeconomics, a science they have founded, even if the idea that all human pursued their self-interest was already mentioned in Smith, Ricardo and Mill’s works (History of Economic Thought, Wikipedia).

         Microeconomics is a branch of economics that studies the behavior of individuals and firms in making decisions regarding the allocation of limited resources.

One goal of microeconomics is to analyze the market mechanisms that establish relative prices among goods and services and allocate limited resources among alternative uses. Microeconomics also analyzes market failure, where markets fail to produce efficient results, and describes the theoretical conditions needed for perfect competition (Microeconomics, Wikipedia)

 

 

Macroeconomics

         Macroeconomics deals with the performance, structure, behavior, and decision-making of an economy as a whole.

         Léon Walras first formalized the idea of a one-period economic equilibrium, but it was French economist Antoine Augustin Cournot and English political economist Alfred Marshall who developed tractable models to analyze an economic system (Partial Equilibrium, Wikipedia)

         Early macroeconomic researchers explained broad aggregates and their interactions “top down,” that is, using a simplified form of general-equilibrium theory.

         Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices. They develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance (Macroeconomics, Wikipedia)

 

 

Relation to welfare economics

Welfare economics used microeconomic knowledge to develop social welfare functions. As mentioned in the previous chapter it remained unclear how the arguments of these functions should be measured, respectively aggregated. Whereas social choice theory developed various ideas how to circumvent the problem, the predecessors of mainstream economics pursued a radically different approach:

o   Consumer theory, which is a branch of microeconomics, solves the measuring problem by means of the market. New Welfare economists struggled in vain for several decades to show how ordinal ranks relate to cardinal numbers and were useful for welfare analysis. Had they not been wedded to their mathematical formulations, perhaps they could have accepted the solution given by Mises. From his development of the concept of ordinal marginal utility in 1912 Mises went on to explain how ordinal utility can be the basis for socially-meaningful cardinal comparisons of value. Money is a common denominator in which ordinal preferences can be expressed. Exchanges of private property for and against money (supply and demand) result in cardinal numbers, namely money prices, for all goods and factors traded on the market [Herbener, 81].

o   Macroeconomics circumvents the aggregation problem by working with macro parameters

o   The neoclassical synthesis solves both, the measuring and aggregation problem, by combining micro- and macroeconomics (chapter 3.6)

Mises’ approach implied, however, that welfare is driven by the market and cannot be optimized by means of mathematical methods.

 

 

The Great Depression (1930s)

Until the Great Depression economists implicitly assumed that either markets were in equilibrium—such that prices would adjust to equalize supply and demand—or that in the event of a transient shock, such as a financial crisis or a famine, markets would quickly return to equilibrium. In other words, economists believed that the study of individual markets would adequately explain the behavior of what we now call aggregate variables, such as unemployment and output.

The severe and prolonged global collapse in economic activity that occurred during the Great Depression changed that. It was not that economists were unaware that aggregate variables could be unstable. They studied business cycles—as economies regularly changed from a condition of rising output and employment to reduced or falling growth and rising unemployment, frequently punctuated by severe changes or economic crises. Economists also studied money and its role in the economy. But the economics of the time could not explain the Great Depression [Rodrigo].

 

 

Keynes’ critique

Some of the notions of modern macroeconomics are rooted in the work of scholars such as Irving Fisher and Knut Wicksell in the late 19th and early 20th centuries, but the major change of the discipline began with Keynes’s masterpiece, The General Theory of Employment, Interest and Money, in 1936. Its main concern is the instability of aggregate variables. Keynes introduced the simultaneous consideration of equilibrium in three interrelated sets of markets—for goods, labor, and finance. He also introduced “disequilibrium economics,” which is the explicit study of departures from general equilibrium [Rodrigo]

 

Keynesian economists argue that private sector decisions sometimes lead to inefficient macroeconomic outcomes which require active policy responses by the public sector, in particular, monetary policy actions by the central bank and fiscal policy actions by the government, in order to stabilize output over the business cycle. Keynesian economics advocates a mixed economy – predominantly private sector, but with a role for government intervention during recessions (Keynesian Economics, Wikipedia)

 

 

 

This picture was taken from the internet

 

 

Keynes had trained at Cambridge University as a mathematician (…). When he turned his attention to economics, he was shocked by the way mathematical economists abused mathematics (…) and he made no secret of his professional contempt for their empty pretentiousness. But these economists were soon to have their revenge. Led by Paul Samuelson in the US and John Hicks in the UK, they set about mathematicising Keynes’ theory [Fullbrook].

 

 

 

3.6          Neoclassical Synthesis

 

Definition

Neoclassical synthesis is a postwar academic movement in economics that attempts to absorb the macroeconomic thought of John Maynard Keynes into the thought of neoclassical economics. Mainstream economics is largely dominated by the resulting synthesis, being  

         Keynesian in macroeconomics and

         neoclassical in microeconomics.

The theory was mainly developed by John Hicks, and popularized by the mathematical economist Paul Samuelson (Neoclassical Synthesis, Wikipedia)

 

 

Criticism of Keynesian macroeconomics

As inflation increased in the late 1960s, the empirical success and, in turn, the theoretical foundations of the synthesis were more and more widely questioned. The more serious blow was, however, the stagflation of the mid-1970s in response to the increases in the price of oil: it was clear that policy was not able to maintain steady growth and low inflation. In a clarion call against the neoclassical synthesis, Lucas and Sargent (1978) judged its predictions to have been an ‘econometric failure on a grand scale’ [Blanchard, 4].

         In the 1960s Milton Friedman’s published his monetarist critique of Keynesian macroeconomics.

         In the 1970’s Robert E. Lucas, Jr. refuted the idea that government intervention can or should stabilize the economy (History of Economic Thought, Wikipedia).

The Lucas critique, named for Robert Lucas’s work on macroeconomic policymaking, says that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data (Lucas critique, Wikipedia).

 

 

New Neoclassical Synthesis

In the wake of the Lucas critique, much of modern macroeconomic theory has been built upon microfoundations, in particular the so-called New Neoclassical Synthesis (1990s) which is used by the Federal Reserve and many other central banks (Microeconomics, Wikipedia):

         The rational behavior or individuals, households or firms is the basis for simulating individual markets

         Individual markets are integrated into a model of aggregate economy.

[Woodford, 4].

The new synthesis did not expect full employment to occur under laissez-faire; it believed, however, that, by proper use of monetary and fiscal policy, the old classical truths would come back into relevance [Blanchard, 1]

1.      The “old classical truths” say that free markets are the best means of inducing rapid and successful development (Development Economics, Wikipedia).

2.      The new synthesis believes that the “proper use of monetary and fiscal policy” is able to avoid crises. Financial and economic crises are closely interconnected. A financial crisis can lead to an economic crisis (stagflation, recession, depression) and vice-versa. Traditionally the research focused on macroeconomic phenomena like the change in interest rates, business cycles and debt ratios. The new research, in contrast, includes the microstructure of financial markets and institutions [Straumann] [Eichengreen].

 

 

Relation to welfare economics

Welfare economics does not represent mainstream economic theory. Present mainstream economics, like welfare economics, has its roots in neoclassical economics. But, unlike welfare economics, it focuses on how markets work. Mainstream economic policies in Western countries (and in a growing number of non-Western countries) focus on how to improve the working of free markets. These policies were not dominant during the 1950s-70s when Keynesian policies prevailed. And those policies prevailed too long, leading to the combination of inflation and stagnation called stagflation. Neoclassical free market oriented policies became the mainstream in the 1980s. The collapse of the centrally planned Eastern European economics systems reinforced the dominance of present mainstream economics [OECD, 268].

 

         There are instances in mainstream analysis outside standard consumer theory that make explicit use of cardinal utility. In fact, the important field of welfare economics has never fully recovered from the demise of cardinal utility [Selikoff, 43].

Welfare cannot be maximized and distributive justice cannot be reintroduced to the economist’s agenda, as long as there is no consent on the parameter values within the social welfare functions. Only a social system of unanimous consent (on these parameters) can generate the greatest benefit for society.

         The neoclassical synthesis claims that the free market – which creates this consent – is the economic condition for generating the greatest benefit [Herbener, 85]. This claim stands clearly in the tradition of Adam Smith’s invisible hand and Pareto’s theorems. However, the neoclassical synthesis is restricted to the investigation of economic welfare, and happiness (life satisfaction, well-being) cannot be reduced to economic welfare. For many determinants of happiness there is no market and no price (fortunately).

 

Given this diagnosis: What happened to the classical utilitarian goal to maximize happiness? The most promising strategies are probably those, which have given up the idea to derive happiness exclusively from economic welfare:

         The Capability Approach (chapter 4.3)

         Happiness Economics (chapter 5)

The research on micro- and macroeconomics continued during and after the emergence of these new branches of welfare economics. The goal was – and still is – to dispose of simulation models, which could realistically forecast the outcome of competing economic policies.

 

 

 

 

4. Modern Development Economics (since ca.1950)

 

 

4.1      Definition

 

Development economics is a branch of economics which deals with economic aspects of the development process in low-income countries. Its focus is not only on methods of promoting economic development, economic growth and structural change but also on improving the potential for the mass of the population, for example, through health, education and workplace conditions. Unlike in many other fields of economics, approaches in development economics may incorporate social and political factors to devise particular plans (Development Economics, Wikipedia).

 

The origins of modern development economics are often traced to the need for, and likely problems with the industrialization of Eastern Europe in the aftermath of World War II (Development Economics, Wikipedia).

In the following we only address (newer) theories which are related to welfare economics:

 

 

4.2          Neoclassical Theory

 

The neoclassical theory is a consequence of Pareto’s theorems (chapter 3.3) and Robert Lucas‘critique of government intervention (chapter 3.4).

 

Neoclassical theory gained prominence with the rise of several conservative governments in the developed world during the 1980s. These theories represent a radical shift away from international dependence theories. Neoclassical theories argue that governments should not intervene in the economy and that an unobstructed free market is the best means of inducing rapid and successful development. Competitive free markets unrestrained by excessive government regulation are seen as being able to naturally ensure that the allocation of resources occurs with the greatest efficiency possible.

 

It is important to note that there are several different approaches within the realm of neoclassical theory, each with subtle, but important, differences in their views regarding the extent to which the market should be left unregulated. These different takes on neoclassical theory are the free market approach, public-choice theory, and the market-friendly approach.

         Of the three, both the free-market approach and public-choice theory contend that the market should be totally free, meaning that any intervention by the government is necessarily bad. Public-choice theory is arguably the more radical of the two with its view, closely associated with libertarianism, that governments themselves are rarely good and therefore should be as minimal as possible.

         The market-friendly approach, unlike the other two, is a more recent development and is often associated with the World Bank. This approach still advocates free markets but recognizes that there are many imperfections in the markets of many developing nations and thus argues that some government intervention is an effective means of fixing such imperfections.

(Development Economics, Wikipedia).

 

Above theories do not question the (classical utilitarian) assumption that economic growth improves general welfare. A fundamental critic of orthodox welfare economics, however, says that social welfare shouldn’t be restricted to economic indicators. Social indicators like material security, political liberty, social justice, legal security and health care are essential for welfare [Kleinewefers, 56-58] (Welfare Economics, Wikipedia). All these indicators question the List of Countries by GDP per Capita. The most prominent development economist promoting social indicators is the Nobel laureate, Amartya Sen. His name is associated with the term capability approach:

 

 

 

4.3      Capability Approach

 

Indian economist Amartya Sen expressed considerable skepticism about the validity of neoclassical assumptions, and was highly critical of rational expectations theory, devoting his work to Development Economics and human rights (History of Economic Thought, Wikipedia)

 

 

Definition

The Capability Approach emphasizes functional capabilities (such as the ability to live to old age, engage in economic transactions, or participate in political activities); these are construed in terms of the substantive freedoms people have reason to value (…). Someone could be deprived of such capabilities in many ways, e.g. by ignorance, government oppression, lack of financial resources, or false consciousness (Capability Approach, Wikipedia)

Economic and social progress – as understood by the capability approach – can be measured by indices.

 

Examples:

1.      The Human Development Index (HDI) published by the United Nations Development Program combines the standard of living (as measured by the natural logarithm of gross domestic product per capita) with life expectancy, adult literacy rate and the gross enrollment ratio.

2.      The Social Progress Index was developed based on extensive discussions with stakeholders around the world about what has been missed when policymakers focus on GDP to the exclusion of social performance.

3.      A list which combines the indicators political liberty, legal security and social justice is the Democracy Ranking.

4.      Traditional economic indicators (like GDP) don’t account for the exploitation of natural resources and therefore allow consumption at the cost of future generations. A recently proposed alternative for GDP is the Genuine Progress Indicator (GPI).

 

 

Correlation with the GDP

A recent (2014) IMF project investigated the correlation between the Social Progress Index and the GDP. One of the interesting results was the following:

         Costa Rica reaches almost the same level of social progress as the United States, although the GDP per capita is only a quarter.

         Costa Rica has a substantially higher social progress than Saudi Arabia, although the GDP per capita is less than half.

This seems to confirm Kennedy’s claim (chapter 3.5) that there is no correlation between the GDP and life satisfaction. In countries with a lower GDP per capita than Costa Rica, however, things look different:

 

 

 

 

 

The overall picture suggests that social progress improves roughly with the logarithm of the GDP. A logarithmic function is reminiscent of Gossen’s observation of the diminishing marginal utility of economic welfare. (Besides: the standard of living within the Human Development Index is measured by the natural logarithm of the GDP per capita).

The correlation between economic progress and democracy is of special interest:

         As long as physical survival remains uncertain, the desire for physical and economic security tends to take higher priority than democracy.

         When basic needs are fulfilled, however, there is a growing emphasis on self-expression [World Values Survey]. Life satisfaction then correlates stronger with the democracy-index than with any other of the current indices [Schwarz].

 

 

Development aid

Can social progress be accelerated by development aid?

         The quality of development aid is criticized insofar, as donors may give with one hand, through large amounts of development aid, yet take away with the other, through strict trade or migration policies, or by getting a foothold for foreign corporations. The Commitment to Development Index measures the overall policies of donors and evaluates the quality of their development aid, instead of just comparing the quantity of official development assistance given.

         The effectiveness of development aid is criticized as well. Many econometric studies in recent years have supported the view that development aid has no effect on the speed with which countries develop. Negative side effects of aid can include an unbalanced appreciation of the recipient's currency (known as Dutch Disease), increasing corruption, and adverse political effects such as postponements of necessary economic and democratic reforms.

Nobel Prize winner Angus Deaton suggests in his recent book The Great Escape [Deaton] that development aid does not work, and that it can increase corruption and keep bad leaders in power.

The Massachusetts Institute of Technology started a rigorous study [Banerjee] of the relatively few independent evaluations of aid program successes and failures (Development Aid, Wikipedia).

 

 

 

 

5. Happiness Economics (since ca.2005)

 

The idea that happiness is important to a society is not new. Thomas Jefferson put the “pursuit of happiness” on the same level as life and liberty in the United States. Jeremy Bentham believed that public policy should attempt to maximize happiness, and he even attempted to estimate a "hedonic calculus". Many other prominent economists and philosophers throughout history – including Aristotle – incorporated happiness into their work (Happiness Economics, Wikipedia).

Happiness economics – in today’s understanding – may have started with the introduction of the Gross National Happiness (GNH) in Bhutan. At this time, however, there was no exact quantitative definition of GNH. The first GNH Index – also known as Gross National Well-being – was introduced in 2005.

(For the purpose of this paper we can use the terms happiness, general welfare, well-being and life satisfaction as synonyms).

 

 

5.1      Definition

 

Happiness economics is the study of a country's well-being by combining economists' and psychologists' techniques. The goal is to determine from what source people derive their well-being (Happiness Economics, Wikipedia)

 

Happiness economics examines the determinants of life satisfaction by means of surveys, thereby connecting micro- and macroeconomics. The result is an average or “representative” utility function [Kleinewefers, 278] with subjective life satisfaction on one side and the statistical determinants on the other side. Determinants are those social indicators which are relevant for the life satisfaction of the majority [Kleinewefers, 58].

Happiness economists hope to change the way governments view well-being and allocate resources in the light of empirical data. They challenge conventional economic theory on two accounts:

1)      They question the rational utility maximization principle of the homo oeconomicus (chapter 5.2)

2)      They question the definition of social indicators by bureaucratic elites and the use of untested assumptions about the determinants of happiness (chapter 5.3)

Obviously, after a long detour, welfare economics returned to its classical target, which was the greatest happiness for the greatest number of people [Hirata, 21].

 

 

 

5.2      Criticism of Neoclassical Economics

 

Following a summary of the empirical findings:

1.      On the biological level people have their preferences, but on the cultural level people rather make than have their preferences.

2.      Behavior systematically deviates from happiness maximization, both intentionally and erroneously. People sometimes account for moral considerations at the cost of subjective well-being; and sometimes they take decisions mindlessly. Consequently the assumption that everyone is the best judge of what will make him/her happy is by no means unchallenged. This conclusion should not come as a surprise. After all, economic decision theory is built upon psychological ad hoc assumptions which qualified primarily on formal, rather than substantive grounds. They were convenient because they warrant internal consistency and analytical versatility, making them amenable to quantitative analyses. Similarly in the context of consumption, welfare economics relies on an uncritical generalization of the casual observation of individual consumption decisions and their motivations.

The Homo Oeconomicus is an inadequate description of human behavior. Neoclassical economics will have to be reassessed in the light of empirical findings. All the important theories in this field (in particular the general equilibrium theory) depend on the relation between behavior and welfare through the intermediary of preferences [Hirata, 26]. Adherents of happiness economics replace individual welfare functions by surveys on subjective life satisfaction.

 

 

 

 

 It is better to be roughly right than precisely wrong.

 

John Maynard Keynes

 

 

 

 

 

5.3      Surveys

 

 

Elementary indices

Social indicators (chapter 4.3) as well as the GDP are based on objective data. The basic new idea of happiness economics consists in relating objective data to subjective happiness. Social indicators are often defined by bureaucratic elites and rely on untested assumptions [Kleinewefers, 277]. Indicators, once they are established, develop a normative force and influence politics. It is therefore necessary to check the relation between indicators and subjective well-being by means of surveys. Examples:

1.      The Satisfaction with Life Index is an attempt to show the average self-reported happiness (subjective life satisfaction) in different nations. This is an example of a recent trend to use direct measures of happiness, such as surveys asking people how happy they are, as an alternative to traditional measures of policy success to GDP or GNP (…) (Happiness Economics, Wikipedia)

2.      The World Happiness Report is the result of a UN General Assembly resolution, inviting member countries to measure the happiness of their people and to use this to help guide their public policies.

An interesting experiment is taking place in Bhutan, the only country that replaced the GDP by the Gross National Happiness.

 

 

Combined indices

1)      Happy Life Years, a concept brought by Dutch sociologist Ruut Veenhoven, combines self-reported happiness with life expectancy (…). Veenhoven is one of the chief critics of (…) the Human Development Index published by the United Nations Development Programme (…). Happy Life Years may be a better indicator of happiness as it relies on subjective measures of happiness (Happy Life Years, Wikipedia)

2)      The Happy Planet Index combines self-reported happiness with life expectancy and ecological footprint. The HPI is based on general utilitarian principles — that most people want to live long and fulfilling lives, and the country which is doing the best is the one that allows its citizens to do so, whilst avoiding infringing on the opportunity of future people and people in other countries to do the same (Happy Planet Index, Wikipedia).

 

 

Minorities

In the established indices, the worst cases of suffering disappear in the average, suggesting that they can easily be compensated. An index of global suffering [Anderson] could be used as additional information, challenging (relativizing) established indices. Such an index strengthens the awareness that the suffering minority pays (in a statistical sense) the price for the happiness of the majority. It can reveal cases in particular, where the average improves and the situation of the suffering minority worsens (see Negative Utilitarianism and Justice).

 

For more information on happiness economics see Moral Relativism and the Search for Happiness.

 

 

 

 

6. On the Philosophy of Economics

 

 

6.1 Positive Economics

 

 

Definition

Positive economics (as opposed to normative economics) is the branch of economics that concerns the description and explanation of economic phenomena. Positive economics concerns the analysis of economic behavior and avoids value judgements. For example, a positive economic theory might describe how money supply growth affects inflation, but it does not provide any instruction on what policy ought to be followed. Positive economics is sometimes defined as the economics of "what is", whereas normative economics discusses "what ought to be" (Positive Economics, Wikipedia)

Historically positive economics has two sources:

1.      Critical rationalism

2.      Econometrics

 

 

Critical rationalism

         The critics of old welfare economics was connected with the dispute on values in economics. Classical economics did not clearly distinguish between normative and descriptive statements. In the context of Popper’s critical rationalism (1934 The Logic of Scientific Discovery) economics attempted to become a science, i.e. a theory that is based on logic and empirical data.

         The marginalist neoclassicals tried to develop general economic laws, imitating the rigorous methods used in physics (History of Economic Thought, Wikipedia).

         New welfare economics abstains from value judgments. The values within Bergson’s social welfare function, for example, are treated as variables or parameters. But by investigating the conditions for optimum welfare (Pareto) or maximum welfare (Bergson), new welfare economics clearly aimed at delivering input for normative economics.

 

 

Econometrics

Besides Popper’s critical rationalism it was the emergence of econometrics in the 1930s, which encouraged positive economics. Simulation models were supposed to support normative economics

         by estimating the outcomes of competing economic policies and

         by predicting economic crises.

The simulation models (so far) did not live up to their promises:

A cover story in BusinessWeek magazine in April 2009 claimed that economists mostly failed to predict the worst economic crises since the Great Depression of the 1930s (Financial crisis of 2007-08, Wikipedia)

 

 

Comparison with physics

The following joke circulates on theoretical physics:

 

“Theoretical physics has basically nothing to do with reality or similar nonsense.”

 

In theoretical physics this sentence is an expression of self-irony, in economics the analogous sentence is less amusing. A growing part of economic theory is characterized by mathematical models, statistics and computer simulations. There is nothing wrong with this development as long as we do not forget the difference between physics and economics: A market is not a laboratory where phenomena can be repeated and investigated under controlled conditions. Mainstream economists often seem to forget a platitude: The map is not the terrain; the model is not reality. Sometimes the model becomes even more important than reality – a phenomenon which is called “model-fetishism” [Kaeser]:

 

 

 

 

 If the model does not coincide with reality

so much the worse for reality.

 

(Author unknown)

 

 

 

 

Neoclassical economics is based on strong assumptions which are often transformed into axioms – in particular the rational behaviour of the Homo Oeconomicus (see e.g. Unlearning Economics). The actors in a market, however, are much more willful than the molecules of a gas. Economics is closer to the social sciences than to physics and chemistry. The Dutch journalist Joris Luyendijk recently (11.Okt.2015) wrote an article in The Guardian with the provocative title: “Don’t let the Nobel prize fool you. Economics is not a science” (meaning: not a natural science). He maintains that the award glorifies economists as tellers of timeless truths, fostering hubris and leading to disaster. A Nobel Prize in economics suggests that economics is a natural science comparable to physics, a science which is able to make reliable forecasts. But the fact is that, in recent times, the forecasts of much respected economists have often driven us into the dirt. Alan Greenspan – one of the architects of the financial market deregulation and lover of mathematical models – commented after the financial crisis of 2007-08 [Kaeser]:

 

"I made a mistake in thinking that the self-interest of organizations, specifically banks, is of such a nature that it can protect best their shareholders."

 

In other words: Greenspan's simulation models could not imagine that bankers would ground their own banks. Obviously Greenspan ignored anthropological field studies which revealed that – for decades – the financial business was characterized by a "culture" of hire and fire and zero loyalty. Karen Ho documented this mentality impressively in her book on the anthropology of Wall Street. A similar study is available from the financial sociologist Vincent Lépinay.

 

Similarly the insight that there is a herd instinct among exchange traders does not require complex simulation models – it can be attained by simple field studies on trading platforms. That is why Luyendijk justly asks: Would it not be appropriate to extend the Nobel Prize for economics to the social sciences? That would hopefully open the mind for the heterodox and creative approaches in economics, which are usually overlooked by the mainstream. So far only two heterodox researchers were awarded:

         1969 Daniel Kahneman for his unconventional insights into human behavior

         1998 Amartya Sen for his novel introduction of ethical issues in economics

Why not, for example, ennoble the work of Richard Sennett, Zygmunt Bauman or Bruno S.Frey?

[Kaeser]

 

 

Nobel Prizes in welfare economics

As of 2014 Nobel Prizes in Economic Sciences have been given to seventy-five individuals. In the rationale for awarding the price the term welfare only appears in three instances:

o   1972 John Hicks and Kenneth Arrow for their pioneering contributions to general economic equilibrium theory and welfare theory.

o   1998 Amartya Sen for his contributions to welfare economics

o   2015 Angus Deaton for his analysis of consumption, poverty, and welfare.

(Nobel Memorial Prize laureates in Economics, Wikipedia).

 

 

 

6.2 Normative Economics

 

 

Definition

Normative economics (as opposed to positive economics) is a part of economics that expresses value or normative judgments about economic fairness or what the outcome of the economy or goals of public policy ought to be. (Normative economics, Wikipedia)

Examples:

         Welfare economics is normative, because it attempts to maximize total welfare.

         Keynesianism is normative, because it promotes a specific policy for macroeconomic stabilization.

         Robert Lucas‘ work is normative, because he denies that government intervention should stabilize the economy.

Given the economic crises since Lucas’ normative claim, macroeconomic stabilization is still a big issue.

In the following we have a look at the current economic situation and contemporary policies for macroeconomic stabilization.

 

 

Impending debt deflation

The financial crisis of 2007-08 was the worst crisis since the Great Depression and induced – among others – the European debt crisis (2009). This crisis, however, was not impressive enough to change the politician’s mentality. In the period from 2007 to 2015 the worldwide debt – measured relative to the economic power – increased by 17 percent [Rasch]. With a continuing expansion of the debt-bubble the next financial crisis could trigger a debt-deflation.

Debt deflation is a theory of economic cycles that holds that recessions and depressions are due to the overall level of debt shrinking (deflating): the credit cycle is the cause of the economic cycle. The theory was developed by Irving Fisher following the Wall Street Crash of 1929 and the ensuing Great Depression. Assuming, that, at some point in time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both (Debt-deflation, Wikipedia).

In view of this danger national banks pursue new strategies of debt relief: financial repression and quantitative easing.

 

 

Financial repression

Financial repression refers to "policies that result in savers earning returns below the rate of inflation" in order to allow banks to "provide cheap loans to companies and governments, reducing the burden of repayments”. It can be particularly effective at liquidating government debt denominated in domestic currency.

Financial repression has been called a “stealth tax” that "rewards debtors and punishes savers—especially retirees" because their investments will no longer generate the expected return, which is income for retirees. "One of the main goals of financial repression is to keep nominal interest rates lower than they would be in more competitive markets. Other things equal, this reduces the government’s interest expenses for a given stock of debt and contributes to deficit reduction. However, when financial repression produces negative real interest rates (nominal rates below the inflation rate), it reduces or liquidates existing debts and becomes the equivalent of a tax—a transfer from creditors (savers) to borrowers, including the government.” (Financial Repression, Wikipedia)

 

 

Quantitative easing

Quantitative easing is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. Standard monetary policy to stimulate the economy typically involves the central bank buying short-term government bonds to lower short-term market interest rates or keep interbank interest rates at a specified target value. However, when short-term interest rates reach or approach zero, this method can no longer work. In such circumstances monetary authorities may then use quantitative easing to further stimulate the economy by buying assets of longer maturity, thereby lowering longer-term interest rates on the yield curve. A central bank implements quantitative easing by buying financial assets from commercial banks and other financial institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the money supply. Quantitative easing can help ensure that inflation does not fall below a target (Quantitative Easing, Wikipedia)

Quantitative easing can be seen as a form of monetizing debt:

If government bonds that have come due are held by the central bank, the central bank will return any funds paid to it back to the treasury. Thus, the treasury may 'borrow' money without needing to repay it. This process of financing government spending is called monetizing debt (Monetization, Wikipedia).

 

 

Risk and benefit

According to the International Monetary Fund, the US Federal Reserve, and various other economists, quantitative easing undertaken since the global financial crisis of 2007-08 has mitigated some of the economic problems since the crisis (Quantitative easing, Wikipedia).

The alleged benefits of financial repression and quantitative easing are not without risk:

1.      Both strategies decrease the value of the currency - potentially stimulating exports and decreasing imports. In times of economic crisis governments strive to save the jobs in the export industry. If all countries devaluate their currencies, it can lead to a general decline in international trade, harming all countries (currency war). The risk of a competitive devaluation is mitigated by institutions like the G7 and G20.

2.      If quantitative easing induces inflation, then it leads to a similar transfer of wealth from creditors to debtors (stealth tax) as in the financial repression.

3.      The stimulation of the economy may be more effective than intended, leading to hyperinflation and a collapse of the monetary system.

A stealth tax on retirees is the smaller evil compared to a crash of the debt-bubble, but a hyperinflation is similarly disastrous. Consequently there is an increasing demand to stabilize the monetary system:

 

 

Monetary reform

Two concepts have been proposed to stabilize the monetary system [Rasch]:

1.      Privatize the creation of currencies and create a corresponding free market. The competition between public and private currencies would exert a permanent pressure to keep quality high. An interesting new idea is the virtual currency Bitcoin which has no central repository and no single administrator. Rather than relying on confidence in a central authority, it depends instead on a distributed system of trust (Blockchain).

2.      Another concept is the full-reserve banking, which bans commercial banks from creating money. Full-reserve banking was already promoted at the time of the Great Depression by Irving Fisher:

During the last two and a half years there has been a fast growing interest in the plan to put and keep a 100% cash reserve behind all demand deposits. Why is it that at various times for over a century there has been a recurrence of the suggestion to put a full cash reserve behind demand deposits instead of a partial one? And why, in particular, is there now so sudden and striking a display of interest in the proposal? The chief answer is: depressions. Independently, many writers thought of the 100% money plan as a solution. As I have stated elsewhere I have come to believe that the plan, "properly worked out and applied, is incomparably the best proposal ever offered for speedily and permanently solving the problem of depressions; for it would remove the chief cause of both booms and depressions, namely the instability of demand deposits, tied as they are now, to bank loans." [Fisher, 8]

 

As Luyendijk said, economics is not a natural science. This seeming inferiority turns out to be a huge advantage. We cannot change the laws of physics, but we can change the political and legal framework of economy.

 

 

 

8.  Conclusion

 

The history of welfare economics seems to confirm the following suspicion:

 

 

The mathematical maximization of welfare is extremely useful –  

as a form of employment for economists.

                      

Author unknown

 

 

Whereas many branches and techniques of economics are indispensable, the mathematical maximization of welfare cannot live up to its promise.

Newer strategies have given up the idea to derive happiness exclusively from economic welfare:

         The Capability Approach emphasizes that – once a decent level of economic welfare is reached – human rights become a major determinant of happiness.

         Happiness Economics builds on empirical data about individual happiness instead of mathematical functions and bureaucratic indicators like the GDP and GNI.

With regard to economic welfare the hope rests on simulation models, which forecast the outcome of competing economic policies. Unfortunately, however, these models did not foresee the worst economic crises since the Great Depression.

 

 

 

References

 

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