What Are Our Economic Priorities?

Fabian Society, Wellington, 20 October, 2011

(Note that this is a revised version of the paper at http://www.eastonbh.ac.nz/?p=1524.

Keywords: History of Ideas, Methodology & Philosophy; Macroeconomics & Money;

Tonight I want to talk about our economic priorities. I’m going to differ from the conventional wisdom by arguing we should pay less attention to the growth of material output and more attention to employment, to social coherence and to the quality of life. While that may leave the conventional wisdom uneasy, I want to insist that my approach is within orthodox economic thinking, albeit a little ahead of much of the profession.

Before doing this I have to say something about the economic context – about the past, the current, and the possible future state of the economy.

Since New Zealand became a market economy it has experienced five great stagnations, long periods – five and more years – when per capita real income did not rise. In all but the Rogernomics Recession of 1984 to 1993, the stagnation was caused by an unfavourable world economy. The indications are that the world economy is once more in a period of a long stagnation which began in the United States in 2007; about the same time and quite independently New Zealand also went into a recession, which turned into a long stagnation when the world economy stagnated.

We dont know when the stagnation will end, although it is unlikely to in the near future, despite some economists promising that there will soon be an upturn. I am reminded of the wife of an economist who sued for divorce on the basis of the non-consummation of the marriage. She explained that her economist-husband just stood at the end of the bed, beating his chest, and saying things were going to get better; ‘but they never did’.

Not all economists are so inept, although they get less media coverage. Many of those I respect – those who warned that a global financial crisis was likely to happen – are saying that the world is in a long recession and there will be no early recovery – that is, a return to sustained economic growth. They are not saying we are in a double or triple dip recession, they are saying we are in the same one. They cannot tell the exact date it will come to an end, but they can say something about the conditions necessary to end it.

To understand their argument, you need to recall Joseph Schumpeter’s theory that the function of a depression is to eliminate various weaknesses that build up during a boom. Schumpeter talked of ‘creative destruction’, where inefficient firms go out of business during the cyclical downturn, releasing resources for firms that will thrive during the following upswing. A financial crisis involves a slightly different form of creative destruction.

During a boom, households, firms and financial institutions borrow to acquire assets which prove to be overvalued; as a result much of the apparent value of such assets is fictitious. That means they have too much debt relative to the true value of their assets or, to put it another way, the owners have much less equity than they desire or is desirable. Until they get a better balance sheet – a better balance between their assets, their liabilities and their equity – they typically have to reduce their liabilities. For instance, a household may cut back, by spending less and paying off their consumer debt or some of their mortgage. If a lot of people do this, then there is a drop in spending, a fall in production and there follows a rise in unemployment.

There are a numerous ways which balance sheets can be rebalanced. A particularly vicious form is when a finance company simply announces it will no longer – it can no longer – honour its debts, even those to its depositors. So it goes bankrupt with zero assets and zero liabilities. But its liabilities are other people’s assets, so the weakness of the finance company (or whatever ) gets pushed onto depositors and shareholders because their assets in it also become valueless; their balance sheet gets screwed up, and they have to cut back their spending.

Whether the balance sheets are rebalanced by saving more or through bankruptcy, there is economic disruption. The worst such experience, thus far, was the Great Depression of the 1930s. More commonly there is a stagnation, or recession, which will last as long as it takes to get those balance sheets right. That is the current international situation, as best we can judge. Far too many balance sheets are out of kilter – not only in households and the finance sector. The balance sheets of some governments are weak, and deteriorating because the governments are still borrowing, and/or because they are taking over private sector liabilities.

This is all a bit complicated, but there are two simple lessons. First, policies which do not address the balance sheet problems are not going to resolve the underlying economic problem; they may worsen it.

Second, it will take quite a while to work through these imbalances. That’s why those who predicted the global financial crisis expect a long stagnation. They cant tell you how long because no one knows how the imbalances will be resolved. Some talk about most of the world being in a recession for another five years – that is, to 2016; nobody whose judgement you would value has said that such a forecast is crazy, although some are more cautious. .

There is one further complication which I dont think anyone thought much about in 2008 when the crisis really began. The conventional wisdom had been complacent about the soundness of the economy. You might think that the crisis would have led them to revise their smug theories; instead many keep on with a belief that the theories are right and revise the facts. Unfortunately by doing this, the complacent are encouraging policy responses which inhibit the required balance sheet adjustment, and prolong the recession they keep promising will end. So the recession also has to purge out their bad theories as much as it has to purge out bad liabilities.

This raises a very serious issue. How do you get people to abandon faulty theories? Some will hold them till death, but people of goodwill who latch on to a bad theory may take a long time to give it up. It was over a decade before the conventional wisdom recognised how stupid were the extremes of Rogernomics; what convinced them was that ten years on the promises – the chest beatings at the end of the marital bed – of better economic performance had still not happened. Instead, – despite regular claims the economy would recover the next year, we had a ten-year stagnation under Rogernomics while the rest of the world prospered.

The current reluctance to abandon bad theories in the face of contradicting facts suggests that the recession will have to be quite long to get rid of the bad theories – even longer than the balance sheet analysis might suggest. Alternatively there may have to be a cataclysmic event – like the Great Depression – to dump them. I hope not, but as long as the existing conventional wisdom predominates, we are not going to get easily out of the mess.

Now I have been discussing here the world economic situation. New Zealand’s balance sheets – be they of household, farm, finance sector, corporate or government – are not among the worst in the world, although many are a bit shonky. (We could say the same about our conventional wisdom.) But what goes on in the rest of the world has a major impact on us; how we cope with what the world deals us is our responsibility.

I shall not give further detail of the context tonight. Instead, given the prospect of a long stagnation I ask what is to be done. I am not foolish enough to argue here for policies which will boost New Zealand’s economy – dragging the rest of the world out of recovery behind it. Rather I want to consider that, if we are in for a period of stagnation, whether we should despair.

Many think GDP – market production – equates with the welfare of the population. So if per capita GDP remains the same, as it does during a stagnation, they think there is no increase in welfare, or even that it is declining. However in recent years economists have been evolving a more sophisticated account of what determines wellbeing.

This account has been possible because of growing data bases. In the past economists did not have them. They knew their understanding of the determinants of wellbeing was limited, but lacking the empirical evidence, they were unsure how to modify their theories. Recently accumulated data enables some progress.

We ask individuals about their wellbeing, with questions like ‘how happy are you?’ The response is subjective, but there is evidence that individuals’ responses are consistent with the objective evidence. These surveys usually involve thousands of people and have been carried out in many different countries. The conclusions are pretty consistent across cultures; including for New Zealand.

We use the responses to identify regularities. For instance, women tend to say they are happier than men, although the difference has been converging over the years. The young are happier than the middle-aged, but after about the age of forty the decline reverses and the elderly are as happy as the young. Being married is, on average, associated with being happier than not being married.

All the results I report assume all other things are equal. If you dont do that you can end up with weird results. A market research firm concluded widows were happier. There are not a lot of 40-year-old widows but a lot of elderly ones and the age effect outweighs the marriage effect; dont bump off your husband to make yourself happier, but you are welcome to outlive him.

Economists and government cannot do much about age, gender or marital status, but we claim to be able to influence incomes. What is the evidence about the impact of incomes on happiness? There are three salient results which require a little care to reconcile.

The first result comes from looking at the data over time. More than 60 years of survey data from America shows no rise in average happiness, despite real incomes more than doubling. The implication is that raising national income does not increase happiness.

The second result comes from looking at the data between countries. It shows that happiness among rich countries does not seem to be affected by relative income. For instance, New Zealanders are typically happier than Australians even though our income is lower.

However, those in poor countries are on average less happy than those in rich ones. It is not hard to see that an increase in income improves the lives of the desperately poor. But once the basics of food, clothing and shelter are met, it appears that rises in average income do not directly lift wellbeing. This level is well below New Zealand’s standard of living, so the phenomenon does not generally apply to us.

The third result comes from looking within a country. It shows that those on higher incomes are happier than those on lower incomes. The effect is small; for instance, compared to the non-married the married on about half the equivalent income are happier. But the effect is definitely there; research I have been involved with confirms it is here in New Zealand too.

How to reconcile that a rise in income for everyone does not increase happiness, but for one person it does? Instead of thinking of income as facilitating what you can buy, think of it as indicating what you can buy relative to others.

Economists describe this phenomenon by a theory of positional goods, but it comes from a much older tradition developed by an American economist and sociologist Thorstein Veblen of ‘conspicuous consumption’, where goods and services are acquired mainly for the purpose of displaying income or wealth and power.

You will be aware this is widespread in a modern affluent society. Particular products – homes, cars, clothes, extravagant parties – are used to display the holders’ wealth, and to upgrade their position in society. Underneath this is the notion that’s one social status is determined largely – or importantly – by one’s income. But only income relative to others’. What is happening appears to be the additional income does not in itself generate happiness, but the social status which may go with it does. But if everyone can buy more, the average ranking does not change, and people dont get happier.

So what is the point of raising incomes since nobody, on average, is any better off? We have an economic system based on each of us seeking to raise our income; on the whole it succeeds, and yet it does not make us individually happier. That leads to the deep philosophical question of the purpose of it all – I am not going to answer that tonight. But to progress it, let’s think about the differences between me and my father, who was born about a quarter of a century before I was.

It is a matter of record that, on the whole, my income has been higher than my Dad’s. It is a reasonable conjecture, on the basis of the research I have just reported, that I am no happier than Dad. So am I really better off than he was (except I have the better son)?

What strikes me is that despite all his achievements Dad did not have the opportunity to go to university – he had the ability – and pursue the career for which he was naturally qualified – he would have been a superb general practitioner (as his final career as a psychopaedic nurse well demonstrated.)

That is the difference between Dad and me. I can look back at my father and regret that he missed his natural vocation; I doubt my son will think that I missed mine in the same way. Dad did not have the choices that I did. Economic and social development – and the support from Dad and Mum – meant I had opportunities that they could only dream of.

(Arguably my mother did worse than my father, because she was a woman. Following a series of changes, later generations of women will not suffer as much as her generation did. That is true for other minorities. They may not yet have attained the same opportunities but the gap has narrowed. Of course many of the policies which reduced those gaps have little to do with economics.)

What I have been describing is a simplified account of objectives set out by the great Indian economist and philosopher, Amartya Sen, who emphasises the importance of life opportunities and choice: not the choice we have when we go into a supermarket and select between brands of baked beans, but the real choice of being able to select a life style consistent with one’s potential.

On the whole, the development of the economy improves those opportunities. From this perspective higher incomes are a collateral consequence of rising opportunities but they are not the social purpose of the economy, for there is an imperfect correlation between rising incomes and increased opportunity; sometimes the relationship may even be negative with higher incomes and lower opportunities. That means we should not focus on income as the sole policy target.

Consider the argument that higher taxation reduces the efficiency of the economy and lowers income. Suppose it were true. Having broken away from the fallacy that social purpose is about rising income, we can instead ask whether the additional income advances opportunity and achievement. It might not, if the consequence is a drop in the wrong public spending.

Some public spending – that which cannot be delivered effectively in any other way except through the public purse – contributes to the wellbeing of some individuals. This is a treacherous area because it involves supply-side and distributional issues, which I have not time to reflect upon tonight. So let me just list some salient examples of public spending which can increase wellbeing in non-economic ways: culture and heritage, the environment, recreation, safety and security. In each of these the private sector has manifestly failed to supply sufficiently for our needs. Reduce taxes and cutting them back may reduce wellbeing.

Education which creates fundamental opportunities and enlightenment is another area where it is difficult to envisage adequate private sector provision. That is why so much education is publicly funded. (But we should treat vocational training differently; that is about economic development.)

An even bigger public spending item is healthcare. While income may not really add to one’s happiness, effective healthcare may by prolonging the period when one is happy. Privately driven healthcare is ineffective and expensive – the American failure is a salient example – so it makes sense for the public sector to be involved. How to design that involvement is complicated – let’s leave that for another day too.

Observe then that my support for public spending is pragmatic rather than ideological. Its need arises when the private sector does not supply it well; taxation is a consequence. The economist’s task is primarily about evaluating the trade-off between more public spending less private spending (although economists get sucked into managing the expenditures, if others do not try to use the resources the economy supplies them efficiently).

However there are some aspects of the economy, other than the level of public spending, which directly impact on welfare and where economists have some expertise. One is the degree of inequality in a society.

Recently there has been a lot of excitement about the book The Spirit Level, published a couple of years ago, although there was a precursor The Impact of Inequality published four years earlier by the senior author, Richard Wilkinson. Another key player in this research is Ichiro Kawachi, who did his doctorate in New Zealand. His and Wilkinson’s work goes back to the 1990s, so what I am to tell you is not as new to the profession as it is to the public.

What this work shows is that there is a correlation between the degree of inequality and various measures of poor social performance. The strongest and longest established correlation is that a larger gap between the rich and the poor is associated with poorer health status; poorer mental health, greater drug use, more suicide, poorer physical health, lower life expectancy, greater obesity and earlier pregnancy. More recently, violence and criminality has been shown to be associated with greater inequality. Inequality is also associated with unequal life chance opportunities, but that has been long known.

While there have been challenges to the conclusion that income inequality is associated with poor social performance, the empirical evidence has been too strong to dismiss the relationship out of hand. More controversial is what the underlying causal processes are.

Social inequality is a complex phenomenon. Consider a society which pays insufficient attention to its elderly; contrast it with another that does not support its children and with yet another which has high unemployment which severely disadvantages its young adults. Each could generate exactly the same measure of income inequality, yet each is likely to malfunction differently. Ignoring the elderly is unlikely to increase criminality, disadvantaging adolescents may.

Wilkinson and his co-author Kate Pickett argue that neuro-endocrinological stress, provoked by a perception that others enjoy a higher status than oneself, undermines self-esteem and generates these malfunctions. Can a single channel explain so much, even if it seems consistent with my earlier discussion about the importance of social status in the economy? I think it better to treat their explanation as a hypothesis and look for further supporting evidence and alternative explanations.

But whatever a research scientist may think, for practical policy purposes the material the authors bring together counsels that it is sensible to try to reduce income inequality and unwise to increase inequality except for a very good reason.

Increasing income in order to accelerate economic growth is not a good reason. Some vigorously advocate cutting taxes on the rich to do so. The empirical evidence is that lower taxes would not have much effect on the growth rate; some contradicts it suggesting lower taxes may even reduce GDP. If there is any effect, it is very, very small; so small that we cannot measure it with any certainty. In any case higher incomes do not in themselves promote greater wellbeing or happiness.

The rich are quite right when they say the tax cuts will benefit them. It increases their self-esteem. But Wilkinson and Pickett warn that not only may this be at the expense of those lower in the income distribution, but also at the expense of the nation in terms of poorer health, more criminality and loss of opportunity.

The second directly economic issue is the level of employment and unemployment. The survey evidence is that the unemployed are not as happy as the employed; that would be true even if they had the same income as they could earn, rather than the much leaner unemployment benefit. That is because work is a socially valuable experience. It does not just pay us, but it also provides what are called the latent social functions of work:

* Employment imposes a time structure on the working day:

* It involves regularly shared experiences and contacts with people outside the nuclear family:

* It links an individual to goals and purposes which transcend her or his own:

* It enforces activity.

A quick summary is that we because we are social animals we are happy to work, for it gives us more than just income. (However let us acknowledge that the last few hours of each week – say Friday afternoon – are a bit of a burden.)

The implication of work having these values to a social animal is that we can enhance wellbeing by keeping unemployment to a minimum. Now while it might seem to be easy to guarantee everyone a job, it is actually hard. Work and Income would love to get the unemployed off their books, they put a lot of effort into doing this, but they are not that successful. More subtly, we cannot guarantee everybody a job for life, other than by having a totally stagnant economy, which would reduce the opportunities which enhance wellbeing.

If people do not have a job for life, that means sometimes individuals will be in transition between jobs: they will be unemployed. Some unemployment is not avoidable, but we can handle it poorly or badly. We sometimes talk about a pool of unemployment; a little limnology can be helpful. The pool may be stagnant with the water sitting there full of rotting detritus. Or the pool may consist of freshwater flowing in and flowing out quickly the other side. Far too much of our pool of unemployed is of the first sort; we need to extend the second, especially so a person who becomes unemployed has some confidence that the stay in the pool will be short and not too unpleasant. A first step would be to stop pouring the acid of contempt onto the unemployed. Their pool is an integral part of a dynamic economy.

Observe that I am sneaking in a case for economic progress. Its aim is not to lift incomes but to generate jobs and opportunities. Because of technological change, because of physical shocks like earthquakes, because of changing overseas conditions, the economy has to be dynamic and changing, even if aggregate real income is not increasing. We need to direct the dynamism so it contributes to wellbeing.

For instance, I support the development of a strong urban Auckland. If we fail there, New Zealanders will go offshore for the opportunities a big urban centre generates. That may, or may not, be a bad thing for the migrants personally – there is no way Rutherford could have thrived here had he stayed. But the rest of us may be worse off. By promoting Auckland, New Zealanders will find more of their children and grandchildren are here rather than Australia. Your family offshore means a loss of wellbeing, even though it is not measured in your income.

Yet I am not arguing we should try to catch up to Australian income levels at all costs. That is what some people want to do, although they are silent on just how the policies they advocate would do this. After all the same policies, when implemented a quarter of a century ago, got us well behind Australia. Moreover the policies will increase income inequality – did you know that we had the largest increase in inequality in the OECD between the mid 1980s and 2010? Didnt help us to catch up with Australia much. Our inequality is about seventh highest in the OECD. Is that really where we want to be? If Wilkinson and Pickett are right, we would be heading for poorer health, more crime and less opportunity.

Did you know our secondary schooling system is doing better than the OECD average and slightly better than Australia on the PISA scores? It is true that we have a brown tail of poor achievers where we need to do better. But will cutting back on educational spending and even privatisation – the inevitable consequence of tax cuts – mean we will do better?

New Zealand life satisfaction is not only higher than Australia’s, it is higher than for most OECD countries. On some measures we do well relative to Australia, on others we do worse. Will tax cuts address those we do badly in? I doubt it. Will it make those we do well in worse? Often.

Forgive the tone of irritation in the last few sentences but it captures the central theme of this presentation. The empirical evidence cautions against the obsession of equating income with wellbeing or of pursuing income growth at all costs. There are other things which contribute as well, and some things – even economic things – may contribute much more: certain sorts of collective spending, better health and education, lower income inequality, less stressful unemployment. The economy can contribute to much of this, but we would be unwise to sacrifice them for the pursuit of income. It should be our servant, not our master; the same applies for economists.

Instead, as Socrates advised us, we should be promoting the good life well lived. Which is what happened with my Mum and Dad. With Amartya Sen’s addition that we should be enhancing people’s life opportunities. Beside that goal, income maximisation is trivial; in any case the economy is going to be stagnant for a while.