The Need to Challenge Conventional Economic Wisdom: Part II

We know from economic history that the only examples of fully planned economies have been failures. They have failed to achieve sustained and continuous or indeed environmentally sustainable growth, with initial growth spurts atrophying into inefficiency and corruption. But beyond that, economic history does not support the contention that there is one best model of economic growth.

As Ha Joon Chang points out in his book, 23 Things They Don’t Tell You About Capitalism, is that very few countries in the early stages of successful economic take-off achieved growth through the classic liberal combination of free markets, limited state intervention, free trade and free capital flows.

Indeed, there is really only just one example of that, which is Britain in the 19th century. Elsewhere in the historic record we find tariffs, state industrial sponsorship, capital controls and financial repression of various degrees and mixes.

And as for rich developed economies seeking to grow from positions of already attained prosperity, it is simply not empirically clear that the record of the last 30 years of deregulation and freer markets, and in particular freer and more active financial markets, has been superior to that achieved in the postwar period of more regulated markets and more repressed finance.

Now there is, I still believe, a strong case for several of the deregulations of the 1980s and 1990s — in telecommunications, for instance. But it is a case which needs to be made by reference to specific beneficial impacts in specific markets, not by reference to a generalized theory that market completion and liberalization will everywhere take us closer to a general equilibrium nirvana. And the starting point of good economics is surely to recognize how different markets are. Tolstoy’s opening sentence of Anna Karenina says that “all happy families are happy in the same way, all unhappy families are unhappy in their own specific way.”

Paul Krugman suggested the neat adaptation that “all perfect markets are perfect in the same way, and all imperfect markets imperfect in their own particular way.” That captures a crucial insight. We need to understand the different degrees and different types of imperfection to which different markets are subject.

Some markets actually work pretty well left to themselves. They are not perfect, but the prescription of liberalization is still a fairly good one. If we want good restaurants, offering variety, good service and attractive ambience, the best way we have found so far is to let competition rip, let entrepreneurial flowers bloom, some to flourish and some to wither. Anyone who doesn’t believe that didn’t visit a restaurant in the Soviet bloc before the fall of the Wall.

But some other markets — in particular financial markets which link the present to the future under conditions of inherently reducible uncertainty — work pretty badly when left entirely to themselves. They have strong tendencies towards financial instability and to the proliferation of purely distributive rather than creative activities, rent extraction rather than value added — but with those rent-extracting activities potentially showing up as apparent value added in measures of GDP. And to that, we must add Anat Admati’s suggestion that rent extraction probably drives non-trivial misallocation of resources.

So even if we were sure that increased economic value added was the appropriate objective, it is very unclear that ever freer and more complete financial markets are an effective means to achieve it.

Finally, within the holy trinity of the conventional wisdom, what about issues of income distribution, of inequality? Inequality within developed countries, but also within several developing countries, has increased quite dramatically in the last few decades — both between the bottom of the income distribution and the median, but even more dramatically between the median and the top (and indeed between the top 1% and the rest of the top decile, and between the top 0.1% and the poor old only quite rich rest of the top percentile).

And the predominant response to this has been that we should not do anything about it via, for instance, progressive income redistribution, because low income tax rates produce necessary incentives for hard work, innovation and creativity. We should vote for low taxes for the rich, because it will increase the size of the economic cake available for all. And that resulting inequality does not matter as long as average income is increasing, because absolute income matters — not relative income.

What should we think of these assertions? Obviously, incentives must matter to a degree. If tax rates were 100%, people would not work. But beyond that, what do we really know? Most of the analysis focuses on incentives at the middle and bottom of the income distribution — asking whether, if we vary tax rates, people enter or leave the workforce, or work more or less hours.

Very little analysis actually throws any light on the issue of how levels of pay or taxes affect the work ethic or the effectiveness of top earners, because that’s a very difficult question to answer. In fact, any belief that increased incentives are powerful and growth-inducing at the top end, is largely an assertion of belief, not an empirical observation.

And it is a belief that can certainly be challenged. Empirically, it is simply unclear that top executives worked less or less effectively in the higher taxed and lower paid 1950s and 1960s, before the explosion of top banker and CEO pay. And even if the war for talent has been accompanied by a more ferocious devotion to the short-term competitive success of each firm, the extent to which this has driven superior economic growth at the socially aggregate level is even more unclear.

And theoretically, if the motivation of high income earners is heavily driven by relative income status competition, then higher income taxes which reduce absolute but leave relative income distribution unchanged should not be expected to make all that much difference.

So of course there are sensible limits to the progressivity of tax rates. But I suspect that they are essentially political and social, not economic — related to notions of what is a fair division between private benefits and social contributions.

As for whether inequality matters, clearly it does if the increase in inequality is so great as to deny the median or the bottom of the distribution any share in rising prosperity, and the United States has been fairly close to that over the last few decades.

So we cannot avoid questions about the drivers of increasing inequality — and what if anything we can do about it. But to do that, we have to move beyond some of our standard analytical assumptions — such as individual utility preference schedules which can be assumed to be independently given.

To sum up:

  Beyond some level of income, further growth probably becomes less important and less necessarily conducive to increased human well being;

  Freer markets do not always deliver faster growth and increased economic efficiency;

  And the degree of inequality which has arisen may be unnecessary to achieve growth, and may impose welfare costs not offset by any level of absolute income growth.

So, both in respect to incentives and means, the dominant belief system is deeply flawed.

These flaws, in part, reflect not academic economics itself, but the translation of ideas into ideologies, and the influence of economic interests as well as ideas, and the simplifications made by practical men and women in turning ideas into policy prescriptions.

But it is fair also to say that they reflect biases within the dominant strain of academic economics — a tendency to shy away from questions about end objectives, about human nature or about the empirical historic record. In its place, the tendency has been to build mathematical models on the basis of assumptions which make models tractable, but which do not reflect the complex reality of human behavior and preferences.

But if the three tenets are flawed, what follows for policymakers?

This series of articles was adapted from the author’s presentation at the Institute for New Economic Thinking’s conference at Bretton Woods, New Hampshire, on April 8, 2011. Published with the consent of the author.

Part I | Part II | Part III