Keywords: History of Ideas, Methodology & Philosophy; Social Policy;
Keynes remarked that practical men (he meant politicians, bureaucrats and businessmen) are but the slaves of some defunct economist, a sentiment that will have been all too apparent over the last few years. Today I want to focus upon some of these defunct economists, to show how economic analysis which is too narrowly directed results in policies for economic change which generate social costs far in excess of any ‘economic’ benefits.
Pareto, Kaldor: Welfare and Income
The first defunct economists are Vilfredo Pareto and Nicholas Kaldor. To understand their role we need to look at welfare economics as it had developed in the late 1920s, particularly by Arthur Pigou, which involved comparing the welfare of different people. Economists were uneasy about making these interpersonal comparisons, since there is no scientific means of verifying to what extent one person is better off than another.
Then the notion of a Pareto improvement was developed. This so-called ‘new welfare economics’ observed that under some circumstances a policy change would result in some people being better off, and no-one being worse off. If this were to occur an economist could say, without severe value judgements, that there had undoubtedly been an improvement in the welfare of society.
This is not a lecture in welfare economics, so let me skip through the subtleties, and go on to Kaldor’s extension of the notion of a Pareto criterion for social welfare.
Kaldor pointed out that if, under some policy changes, the winners could compensate the losers, losers and the winners would still be ahead. If this compensation were to occur then, of course, we would have Pareto improvement, because some people would be better off and nobody would be worse off. But what Kaldor was seeking was a notion of social welfare or social income which was independent of whether the compensation actually took place. Again I skip through a series of delicate steps, and report to you that an increase in real national income, one of the statistics a government statistician calculates each quarter as a part of the national accounts, is equivalent to a Kaldor improvement. That is, an increase in real national income could result in compensation payments by the winners, so the losers were no worse off than before the increase, and some people were better off. However, what is crucial is that an increased national income need not mean there has been a Pareto improvement. That is, the compensation need not happen. An increase in national income may be associated with some people being worse off.
You can see now how Kaldor and Pareto are defunct economists. Precise ideas that they and their successors developed have been used by practical men in ways that were never intended. An increase in national income does not mean there is an increase in the nation’s welfare, only that there is the potential for an increase in the nation’s welfare.
Indeed, the distinction between efficiency and equity, which economics undergraduates worry about, is now seen to be a construct of economics rather than something inherent. In order to avoid making value judgements, economists constructed the notion of Pareto efficiency. This proved to be too limited, but Kaldor’s extension reintroduced the issue of value judgements so that economic efficiency and equity were no longer distinct. And for almost all practical purposes they are not.
This issue becomes even more pertinent when it is realized that very often the gains from a policy change are small, but the winners’ gains are very much greater, as are the losers’ losses. Let me give two cases, both using very orthodox economics, which illustrate this proposition.
Dr Michael Pickford of the Economics Department of Massey University calculated the welfare effects of the tariff cuts of 19 December 1985. The cuts were basically on products which were not produced in New Zealand, the largest three items being videos, other motor vehicle parts and accessories, and microwave ovens.
Pickford found that the national income gain from the tariff cuts was just under $11 million a year. However, the loss of tariff revenue to the exchequer was almost $72 millon a year. That means the general taxpayer was $72 million worse off, while purchasers of these tariff-cut items were $83 million better off. Since not all taxpayers will purchase the tariff-cut items, they will be worse off. Correspondingly, purchasers will be much better off. Pickford concludes that “the distributional effects of the package may have been significant”. Indeed, one might conjecture that the poor who on the whole cannot afford the tariff cut items could be worse off by paying more taxes, while the rich who purchase the now cheaper items will be better off. The tariff cuts may have increased national income, but it is not evident that they increased social welfare.
The second example comes from some of my own work on wage flexibility. I use a simple example to illustrate the issue. In March 1981 unemployment among professional people was 1.6%. According to some simulations on an applied general equilibrium model, it would require a 4.9% drop m the real wage of professional workers to reduce this unemployment to zero. Among the benefits to the economy of this fall would be real output (say measured by national income) which would increase by 0.1%. In today’s terms that would mean that output would increase by $50 million. However, wages and salaries of the professional workers would be down $132, so the winners – that is everyone but the professional workers – would have a gain of $182m. Thus once more the gains and the losses far exceed the net gain.
I want to draw three conclusions from this. The first conclusion is that while there are gains from a properly managed programme of economic liberalisation, and the gains of the winners and the losses of the losers are far larger than net gain measured on the Kaldor criterion, there are people who will over-sell the liberalisation measures, confusing the improvement in their circumstances with the improvement to the nation.
My second conclusion is that economic policy advice cannot be value free. When economic advisers, I mean of course grandstanding amateurs as well as professional advisers, advance some policy options they are not offering some scientific analysis independent of ethical considerations. Competent advisers will know they are making, explicitly or implicitly, value judgements in which, in their opinions, the welfare improvements of the gainers outweigh the welfare decreases of the losers. Honest, competent advisers will be willing and able to explain and analyse these judgements. It seems to me that the community should demand from economists who proffer policy advice the underlying value judgements they are using. Perhaps the Royal Commission on Social Policy could carry out an investigation into some past policy decisions to identify the value basis of each decision. By doing so it would establish in the public’s mind forever that economic policy was not value free, and that good advice requires that the social and moral foundations be explicit.
The third conclusion is that the sequence of policy changes is important, since the order in which they are implemented affects who will gain and who will lose. I will not pursue this conclusion any further, except to draw to your attention that unless the policy is explicit, one is left with a feeling that the actual sequence is anomalous. For instance, given the major changes in government economic administration which have taken place, why was there not first a reform of the control system, including agencies such as the Audit Department, the State Services Commission, and the Treasury? The Maori loans affair is a good illustration of the potential dangers of a change in the operating activities of departments without an earlier change in the control systems. As a further illustration I draw attention to the emphasis on labour market resources, while little attention is being paid to reforming the erratic incidence of tax on income from capital, which is almost certainly one of the reasons for our appallingly low return from new investment, and the ineffectiveness of monetary control.
Samuelson and Hicks: Comparative Statics and Transition
If Pareto and Kaldor are my first illustrations of the pervasiveness of defunct economists, I guess my second illustration involves Paul Samuelson and John Hicks, -and indeed that long, honourable line of economists who developed comparative static analysis. This involves assessing the state of the economy in one equilibrium, then changing one variable, say a policy instrument, so that the state of the economy is in a second equilibrium, and comparing the economic states before and after the change. This is what Pickford did when he evaluated the tariff cuts, comparing the economy with the old and the new tariff and calculating that national income would be hiked by almost $11 million in the second case.
The problem with this approach is that it says nothing about the transition between the two equilibria. If the transition is almost instantaneous, as in the case of Pickford’s example, this problem hardly matters. If, as is much more common, the economy takes time to adjust, then the transition is important.
To give you a simple example, consider the situation where a set of measures boosts the growth role of real national income, but where the immediate effect of the measures is to stagnate the economy for a period.
Unfortunately nobody has quantified the impact-on the long run growth role of current government measures, but some recent work I have done suggests that the New Zealand economy could be growing as much as 0.5% per annum slower than the OECD average when other factors are taken into account. So let us assume that a set of measures increases real national income growth by 0.5% per annum. Let us also assume that the stagnation is a period of zero growth, rather than the contraction we are currently experiencing. Finally, I use the official Treasury 10% per annum discount rate in order to evaluate the changing patterns of national income.
Using these assumptions, simple arithmetic shows that if the economy stagnates for three years and then grows at the faster rate, discounted national income would be lower than if the measures had not been introduced. (If the measures had boosted the national income growth rate by 1% per annum, five years’ stagnation would wipe out the benefits as valued by discounted national income.)
Practically, what this tells us is that if someone came along with a proposal which would stagnate the economy for three years and then increase its growth rate by 0.5% a year, a rather optimistic interpretation of the current policies, then Treasury would do a cost benefit analysis and reject the proposal.
Let me illustrate the issue at a more human level by a debate which took place in the 19608 and which still has contemporary relevance. The debate was over the question as to whether the government should intervene to ensure that economic growth was not concentrated in a few regions, but measures were taken to ensure that there was some evening out of the national growth throughout all regions.
An important contribution to this debate was a report by Kerry McDonald on regional development  in which he argued that the growth of national income would be inhibited if measures were taken to stimulate the weaker regions. The model he was using was a comparative static analysis, that is a comparison between the national income when the regions were in equilibrium with government intervention, and the higher national income in the equilibrium with no government intervention.
For the purposes of this illustration I shall take McDonald’s analysis as being correct, and not pursue my earlier point that an increase in national income may nevertheless mean that there could be severe losers. What I want to focus on is that if intervention is withdrawn, the switch to the higher national income equilibrium will not be immediate.
In particular the transition path requires resources, labour and capital, to move out of the regions which are contracting as a result of the removal of the interventions. Not only will it take time for the resources to move, but some will move more quickly than others.
This differential mobility of resources, particularly people, was seen as a major reason for a conscious regional policy, particularly by many economists who otherwise accepted the broad outline. of McDonald’s comparative static analysis. They thought that the long run national income gains would be more than outweighed by the short term losses and social distresses of regions rapidly contracting, with the young and skilled workers and capital quickly moving out, and the old, the poor and families with children remaining. The depressed economy would be compounded by the resulting social imbalance.
More recently, in a slightly different context, David Mayes expanded the argument when he pointed out these are asymmetries in change. It is much easier to close down a factory or make obsolete a human skill than it is to invest in new buildings and equipment and people, even if the macro-economy is more prosperous and dynamic than m today’s New Zealand.
Thus we cannot rely upon comparative static analysis to give sound policy prescriptions unless the adjustments are quick, the resources mobile. In many circumstances they are not, and so transition paths become important. And that means there will be unemployment of people.
Hobbes and Mill: Rational Economic Man and the Human Condition
The way which a lot of economic policy handles the issue of unemployment is far from satisfactory. Basically it arises from a tradition which could be said to commence with Thomas Hobbes, which leads to utilitarianism but ignores the insights of John Stuart Mill, successor to that tradition, and yet in some ways one of its greatest critics.
Hobbes, the social pessimist, viewed man as by nature selfish and egotistic, and his modelling of man with such behaviour is the precursor to the ‘rational economic man’ which underlies the analysis of many policy prescriptions. Such rational economic men pursue only self-interest, as they consume, produce, and trade goods and services, without reference to the behaviour of others except insofar as the others affect market prices.
Like many other parts of economics, including the measuring of social income and the use of static analysis, the model of rational economic man is a powerful tool for economic analysis. But it has severe limitations. John Stuart Mill was aware of these limitations, even as he attempted to maintain and extend utilitarianism. There is a view that his attempt to support the approach ultimately undermines it. Mill identified the existence of higher and .lower forms of pleasure. He argued that there is a need for enlightenment, and he saw that each person’s happiness was directly dependent upon the happiness of others. He wrote that there was
“no inherent necessity that any human being should be a selfish egotist, devoid of every feeling or care but those centred on his own miserable individuality. Something far superior to this is sufficiently common even now. ..Genuine private affections and a sincere interest in the public good are possible, though in unequal degrees, to every rightly brought up human being.”
Neither for his personal behaviour nor in theory would one mistake John Stuart Mill for Hobbes’ characterisation of man as solitary, poor, nasty, brutish and short (lived).
The introduction of Mill’s additional sentiments into the vocabulary of rational economic man radically transforms him (and now of course ‘him’ may be a ‘her’) from a selfish egotist. It also transforms human interaction from a series of market transactions into a rich spectrum of social behaviour.
Practically, this change has major implications for the analysis of market economics. It is no longer possible to show that the market mechanism produces social efficiency, because there exist superior outcomes which involve co-operation over competition. Thus we cannot rely upon utilitarian/rational economic man models of social behaviour to underpin economic policy. Mill, among others, would have been much happier with the approach of the 1972 Royal Commission on Social Security, which specified that the aims of social policy should be:
– to enable everyone to sustain life and health;
– to ensure … that everyone is able to enjoy a standard of living much like the rest of the community, and thus is able to feel a sense of participation in and belonging to the community;
– to improve … as far as possible the quality of life available.
Elsewhere I have pursued many of the ramifications of the objectives. Here I report briefly on the conclusions with respect to employment.
Rational economic man does not include having a job as a positive element in this utility function. However, for most men and women, having a job is an integral part of their participation in and belonging to the community. Because it pursues this goal, and because extra employment generally means additional output, a high level of employment is the foundation of good social policy and performance. However, in order to attain this goal there has to be redeployment of labour, and typically, redeployment of labour means some unemployment is inevitable, although we should attempt to minimise it, and the resulting social hardship.
Once we extend rational economic man to a human being capable of sentiment, of social intercourse, and in need of a job, the benefits from the sort of economic liberalisation we are going through become even more fragile. For instance, rising national income associated with falling employment may no longer mean an increase in political social welfare.
The Rise of Inequality
This may all seem a bit irrelevant given that the economy is experiencing falling per capita national income and rising unemployment. But it explains why we are also getting risky inequality in New Zealand. In everyday terms the rich appear to be getting richer while the poor are getting poorer.
As it happens, no New Zealand government has had the guts to commission indepehdent research on this issue, and thus each can blandly state that there is no evidence. In fact there is evidence about recent distributional shifts, but we use it with care.
I know of three statistical indicators which point to, or are consistent with, a picture of increasing inequality. First, there is evidence of registered unemployment by region. In recent years regional dispersion has increased to a pattern similar to that of Britain – quite contrary to our post war experience. Second, there are the political opinion polls which show the rich switching in favour of the Labour Government and the poor switching against it. This is consistent with the analysis I d~cribed earlier where the winners from economic liberalisation favour the government, and the losers reject the government. Third, there are the Government Statistician’s real disposable income indices which show that the top quintile of wage and salary earners is doing better than the bottom quintile. We know that if they measured deciles or half deciles rather than quintiles the indices would show even greater gains for the top, that is, professionals and managers, because of their favourable tax treatment. Moreover, the indices do not include the rising investment incomes of the rich, nor allow for rising unemployment among the poor. In addition high interest rates on housing are pressing on poor and middle income earners.
There are a couple of caveats. Clearly farmers, who traditionally have been among the affluent, have been among the losers rather than the winners, as have some middle income superannuitants. But in general we may safely conclude that there is a widening gap of inequality, primarily as a result of the economic liberalisation measures.
A further conclusion is that we should not expect any major benefits to the poor from a ‘trickle down’ effect. The allegations that policies which make the rich richer will also benefit the poor have been more a matter of wishful thinking by the rich than the conclusions of any rigorous analysis, even by a defunct economist. It is time that those who made claims for the ‘trickle down’ effect of the present economic policies articulated the processes which they are involving, including, perhaps, some quantitative indications of when and by how much the poor will be better off. It would be well for them to recall some of the welfare economics I mentioned earlier, which say that a growth in real national income need not be a growth in social welfare.
I guess what I am most concerned with is an increasing intellectual confusion over the relationship between economic and social activities. It was well captured by a headline alleging that a cabinet minister said that “The nation’s overseas debt is … a fundamental social problem.” I suspect the minister meant that the debt was a national problem – hardly worthy of a headline.
But the notion that debt, that is, a property right, is a social issue illustrates what is sometimes described as the ‘neutron bomb’ approach to economic policy. Recall that neutron bombs were advocated on the basis that they would destroy people but keep property intact. There appears to be a similar view that economic policy should be concerned only with property and with capital, and to hell with its consequences on people. Such a view arises from a misunderstanding of the great economists whose theories are implicitly involved to justify today’s economic policies. Such economists would be appalled by the misuses of their analyses. They would not see any contradiction with the conclusions of our oldest philosophers, the Maoris, who must look at today’s economic policies and wonder where their people fit in.
As the proverb asks:
Ki mai ki au, he aha te mea nui o’ te au?
(Tell me, what is the most important thing in the world?)
And the reply is:
Makue ki atu, he tangata, he tangata, he tangata.
(Well, I’ll tell you, it is people, it is people, it is people.)
Those so dependent upon defunct economists would do well to remember those who came before.
 Pickford, M., “Measuring the Effects of the Tariff Cuts of 19 December 1985,” Massey Economic Papers, B8605 (1986).
 Easton, B.H., Labour Flexibility, Wages and Free Lunches, University of Melbourne Department of Economics Research Paper No.180 (1987).
 McDonald, T .K., Regional Development in New Zealand, Contract Research Unit, New Zealand Institute of Economic Research (1969).
4. Mayes, D., Changes, New Zealand Institute of Economic Research Discussion Paper No.30 (1987).
5. Mill, J.S., Utilitarianism (1981), Fontana Library Edition (1962), p.265.
6. Social Security in New Zealand, Report of the Royal Commission of Inquiry (March 972), p.65.
7. “Debt ‘social problem’ “, The Evening Post, 30 May 1987, p.2.
Simon Litten (Department of Internal Affairs)
Am I correct in my understanding of your analysis, that with salary cuts that increase the income of the community the income goes to the investor?
No, it’s slightly more complicated than that. What happens is that as any particular group in the community cuts its wage rate or salary rate, the general price in the community is lowered enabling us to export better. That’s the actual mechanism, and that creates more jobs not only among the group whose wages are cut, but also for the group (also workers) which benefits from extra jobs. So there are two groups which benefit from the wage cut or the salary cut in this case. One is all other workers, because it actually generates more jobs for them at the current wage rate. Indeed, they get a benefit from lower inflation, but that’s not important in this model. Secondly, you’re quite right-investors also benefit. Now I gave a very quick illustration from that piece of work I’ve done. I actually have a more complicated version of it. What if all workers were to drop their wages? Well, the answer is that they’d all take home less pay, national income would go up, and since the workers are worse off with ‘in aggregate’ less pay, and the nation is better off with ‘in aggregate’ more output, it follows that the investors are much better off. You can now understand the enthusiasm of some people who are all in favour of getting other people to cut their wage rates.
Tom Berthold (The Treasury)
I understood you to have suggested that the economy has been in recession, a period of stagnation for three years. That is quite counter to my impression. My impression is that the economy was in a period of significant growth until about twelve months ago, and has subsequently turned down. So for us to invest, if you like, in a period of stagnation in order to achieve an increase in the rate of increase of national income, one should really start counting that three years from the period at which stagnation commenced, not from the change of government?
I apologise – I was ad libbing, but I actually had a slightly more complex story. Tom is correct. The economy turned down in September 1985, and we are now in our seventh quarter of recession. Most of the forecasts suggest that we’re going to be in another four or five quarters of recession. Just to give you background I think I could elaborate Tom’s argument a little further. The typical recession length in the New Zealand economy is three to four quarters. Since we’ve had business cycle analysis of New Zealand which goes back to the mid-fifties, we’ve never had a recession longer than four quarters-until this one. I have to eat a bit of humble pie on another matter. I always said that the politicians couldn’t influence the business cycle. Current policies actually demonstrate they can, by making a business recession of record length which looks as though it will be about ten, tw.ye, or fourteen quarters. Politicians can damage an economy!