Ebenstein’s “Chicagonomics: The Evolution of Chicago Market Economics [Book Review]

chicagonomicsReview of Lanny Ebenstein’s “Chicagonomics: The Evolution of Chicago Market Economics”, New York: St. Martin’s Press, 2015.

This book tells the story of the University of Chicago’s economists, from the university’s founding in 1891 with a large grant from John D. Rockefeller to the present day. Apparently it started recruiting by using its riches to hire a strong faculty, which was originally headed by James Laurence Laughlin. It portrays the interwar Chicago as full of classical liberals, who also had a program for combating the Great Depression that some of us would be tempted to call Keynesian, though without such theoretical structure as Keynes managed to create. (It embraced fiscal expansion.)

The author is very emphatic in distinguishing classical liberalism, which he insists has ample room for government, from libertarianism, defined as hostility to all government. Ebenstein clearly thinks of himself as a classical liberal, and—despite his affiliation to the Cato Institute—has only contempt for libertarians. Jacob Viner, who along with Frank Knight dominated the inter war period, was a prime example of a classical liberal. He advocated “use of the market, but recommended redistributive taxes and transfers to mitigate the worst inequalities of the laissez-faire system” (p.39), as well as the use of fiscal-monetary policy for stabilization.

1946 marked the transition between the old Chicago and the modern Chicago, with the departure of Viner to Princeton, the death of Henry Simons, and the arrival of Milton Friedman to the Economics Department. The first four years were mainly devoted by him to the battle with the Cowles Commission, but after 1950, with the arrival of Friedrich Hayek in Chicago (at the Committee on Social Thought), the “Chicago School” really took off. (The book debates whether there had been a prewar “Chicago School”, and concludes negatively.)

The book’s main claim is that in their younger days (defined as pre-retirement in 1976 in the case of Friedman and prior to being Nobelled in 1974 in the case of Hayek) both Friedman and Hayek should be considered classical liberals rather than libertarians. This is because their writings in this period, unlike their writings later in life, contain positive references to government. One may endorse this as the critical distinguishing feature between classical liberals, on the one hand, and libertarians in the contemporary sense, on the other, and yet wonder whether Ebenstein is not too generous to Chicago. This is said not because of the trivial point that any abrupt cut-off point is likely to have the odd reference that does not fit, but because Friedman and the Chicago School were already considered pretty reactionary when I was a graduate student (1960-63). The point is that classical liberalism as defined by Ebenstein is a fairly broad church, which can contain both Milton Friedman and myself, despite the fact that I would prefer vastly more redistributive taxation than Friedman. It is wrong to say that one has to be a conservative in all dimensions to be labeled as conservative in any: the fact that Hayek (and Friedman) criticized some conservative attitudes, like the opposition to science and the sympathy for evangelicals (p.166), does not make their attitude to income equality progressive. If one had to define a single criterion for deciding whether someone is “left” or “right” on the political spectrum, there is surely a strong case for choosing the attitude to equality (which is not, despite what Ebenstein says on pp.150-51, the same as uniformity). There is also the point that, as Ebenstein confesses, Friedman (and Hayek) described themselves as libertarians at one point. He argues that the meaning of the word has changed, and that now it simply means opposition to government; he does not tell us what Friedman and Hayek thought it meant when they used the term. Both favored low taxes and small government, even if they did not go as far as the Tea Party does today. Friedman and Hayek are hardly unique in having become more conservative (in the non-Hayekian sense, as meaning less sympathetic to government) as they aged, but that does not mean that formerly they were progressives.

The other weakness of the book strikes me as uncritical acceptance of the Chicago school’s claims as to their innovations. The ones listed are: their opposition to monopolistic and imperfect competition; the dominance of monetary over fiscal policy; the methodological precept that a theory should be judged by the validity of its predictions rather than the realism of its assumptions; and the criticism of Keynesian economics. On the first, we are told that Aaron “Director’s key insight was that monopolistic competition did not characterize the American economy” (p. 142). No reason for describing this as an “insight” rather than an “assertion” is given. There was a long, and rather pointless, dispute as to the relative potency of monetary and fiscal policy. With the benefit of hindsight, I think we can say that even though fiscal policy has a role in a recession as deep as that of 2008-09, the profession was deeply impressed by Friedman’s analysis of the (monetary) causes of the Great Depression, and has concluded that above all else we need to make sure that monetary policy avoids causing shocks. On methodology, Friedman’s victory was total. On Keynesian economics, I have never understood the reasons for the hostility; one can perfectly well draw monetarist conclusions from a Keynesian framework by introducing monetarist assumptions (as David Laidler used to do when he was temporarily exiled back to the UK by the Vietnam War), and Friedman’s attempt to provide an alternative framework (“A Theoretical Framework for Monetary Analysis”, April 1970 and “A Monetary Theory of Nominal Income”, April 1971, both in the Journal of Political Economy) was distinctly unimpressive. Meanwhile there are some outstanding contributions of the Chicago School, such as Gary Becker’s analysis of the family, that are overlooked.

Ebenstein writes that “prices, profits, and property….are the three essential knowledge-bestowing institutions that allow productive economic activity to occur” (p.147). It is easy to agree that all three are essential to the operation of a market economy, but if one thinks of a socialist economy, it is surely not true. Presumably one does not include consumer goods as property, in which case a fully socialized economy would not have private property. Or is he claiming that socialism just is not feasible? If prices are a guide to scarcity as in a market economy, then a socialist economy ought to keep a track of profits as a guide to whether to expand or contract activity in particular lines of business, although what it would do with net profits earned is a good question. But perhaps it is claiming too much for the rationality of socialist planners to imagine that prices might reflect scarcity, the usual socialist logic seems to be that they reflect costs.

Despite these criticisms, the book gives a sense of the magnitude of the debt that we all owe to Milton Friedman and his followers in Chicago. It is easy to forget it now, but we would be a lot poorer without their writings. One does not have to be an adherent of the Chicago School to appreciate its contributions.

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Taxation of Multinationals

The OECD has just produced a report on “Base Erosion and Profit Shifting” (BEPS) which sets forth a set of proposals for tightening taxation of companies which operate across national boundaries to curb the abuses of “tax planning”, in response to a request from the G20. It remains to be seen how successful these will be in terms of increasing the tax take, although one can certainly hope for much to be accomplished in this direction, but it is clear from the nature of the proposals that they will not succeed in the broader objective of abolishing tax planning.

VAT?That this is feasible, without also abolishing the taxation of profits, is clear. One would treat “companies as single entities, rather than clusters of supposedly independent parties, and then carv[e] up taxing rights over the firms’ global profits according to an internationally agreed formula based on sales, assets, and other measures” (The Economist, 10-16 October 2015, p. 64). This will be referred to as the “single-entity system”. A mechanism of this type is employed in determining the distribution by state of profits in a federal system, inter alia in the United States. It has been found satisfactory.

Instead, what the OECD is proposing is a set of measures designed to ensure that companies actually pay what is their moral obligation under the present system, which was designed to secure the absence of double taxation of profits (but has the incidental effect of enabling many corporations to almost completely avoid paying taxes). Perhaps the most important proposed change is the shift to country-by-country reporting. This is a change that has long been sought by NGOs such as the Tax Justice Network which have the interests of developing countries at heart, and should result in a greater share of profits being taxed in the countries where they are earned, which is certain to benefit most developing countries, among others. It will become that much more difficult for a multinational to impute most of its profit to a low-tax jurisdiction where it neither raises capital nor employs labour nor sells its product. But it will still pay profits tax on the sum that it is estimated to have made in a particular jurisdiction, after paying for inputs bought from other members of the group, and selling outputs to other associated companies, at transfer prices that leave substantial room for disagreement. However, while firms are to be obliged to provide details of their national production and sales to the taxman, this information is not to be made public, thus impeding independent entities checking on the extent to which profit-shifting is really ended.

Another change is that companies will be obliged to provide details of “comfort letters” that they have received from some national tax authorities to other national tax authorities. (A “comfort letter” is a letter from one tax authority stating that it is satisfied with a particular company’s tax arrangements.) This will increase transparency.

Already some of the conservative powers are indicating their support. For example, the UK’s George Osborne is reported to have welcomed the proposals in his speech to the Annual Meeting of the IMF and World Bank in Lima. Certainly OECD is fully behind them. Since the USA apparently worked hard to prevent the OECD playing with more radical proposals, it is reasonable to infer that US support will also be forthcoming. The path thus seems clear for this, the biggest revision of the rules governing the taxation of direct investment since the 1920s, to be approved by the G20 in November.

It is worthwhile examining the case for more radical change. The alternative is spelt out in the second paragraph above, where it was termed “the single-entity system”. The case in favour of this more radical change is that it would abolish tax planning and save the real resources tied up in attacking and defending transfer prices; and that it would permit an increase in the rate of profits tax without the fear that this would undermine national competitiveness. The case against is that it would erode national sovereignty; that it would require international agreement on the parameters of a tax plan; and (conversely to the second pro argument) that it would make it too easy to tax profits.

Corporations would still need transfer prices in a world with the single-entity system, for the purpose of calculating the profitability of their subsidiaries in various countries. These transfer prices would, however, have no bearing on the company’s overall financial results. They could therefore be safely left to an individual company to determine; a company which made realistic choices would have a competitive advantage in deciding which subsidiaries to expand, but no more. It is my impression that this would avoid most of the costs of transfer prices, though it would be good to have some quantitative estimates of the saving.

Whether one regards an easing of the difficulty of taxing profits as an advantage or disadvantage of the single-entity system depends on one’s attitude to raising money via a tax on capital. Those concerned about the recent tendency to concentrate taxation on immobile factors of production, notably unskilled labour, will welcome increased opportunities of taxing capital. But there are those who welcome the threat of corporations migrating in response to increased capital taxes as a potent safeguard against high capital taxes, and who would therefore regard the increased ability to raise taxes provided by the single-entity system as a negative factor.

The factors on which it would be necessary to secure international agreement in order to introduce the “single-entity system” would be the rate of profits tax and the formula specifying the variables that would be used to divide up countries’ entitlements to the profit tax and the weights to be attached to each variable. Consider first the rate of profits tax. One of the objections to the single-entity system is that it would mean losing national sovereignty to decide the rate of profit tax, instead of which one would be obliged to accept whatever the international decision might be. (Can one contemplate a system in which the international agreement extends only to agreement on the formula by which taxes are to be raised, and individual countries are free to impose whatever tax rate they choose? No; there is no disincentive in such a system to prevent a small country from imposing an indefinitely high tax rate.) Sovereignty fetishists will doubtless take this loss far more tragically than some of us; the fear of losing firms to other countries already serves to deprive countries of meaningful choice.

The other question on which international agreement would be required is the variables, and weights, with which one would calculate a country’s entitlement to a share of a firm’s taxable profits. There is no doubt that the location of a firm’s customers is highly relevant. But clearly one wants to include the location of production as well as consumption, and here there is a choice (as well as the choice of the weight to be given to consumption versus production). At one extreme, one could look only at a firm’s employment of labour. At the other extreme, one could take a measure of the assets employed, which would require a rule for dividing assets among the several countries where a given firm operates. This is likely to be particularly problematic in the case of patents and other intangible property that the firm employs, since its use in one location does not preclude its use elsewhere. A possible solution is to attribute all capital, including intangible capital, to a corporation’s home country, except to the extent that physical capital is located elsewhere or capital was raised elsewhere. In general, one would measure a company’s production in a given location by a weighted average of the labour that it employs there and the assets that it utilizes there. This would result in country A being entitled to a share of corporation B’s profit of

                  αSA/∑Si + ßLA/∑Li + (1 – α – ß)KA/∑Ki

where   α = the share of sales in determining the allocation of profits to different countries (α < 1)

                  SA = sales of corporation B in country A

                  ∑Si = total sales of corporation B (= sum of sales in each country i)

                  ß = the share of labour in determining the allocation of profits to different countries (α + ß < 1)

                  LA = the labour force employed by corporation B in country A

                  ∑Li = total labour force employed by corporation B

                  KA = stock of B’s assets deployed to country A

                  ∑Ki = stock of assets deployed in all countries by corporation B.

The international decision variables would be merely α and ß (in addition to the rate of profits tax). This determines, as a residual, the share of assets in determining the allocation of profits to different countries. However, it might be that imposing the same value of α and/or ß on all firms would be unfair to firms in industries with abnormal production processes, which would point to a need for an international mechanism for negotiating α and/or ß by industry (not by firm).

Unless we are to take it for granted that the G20’s endorsement of this proposal closes the argument for the next 90 years or so, it is worth asking what can be learned from existing experiences about some of the crucial issues, such as whether some firms would be gravely penalized by using the same values of α and ß, as well as the value attributed to those variables in existing federal systems. It would also be desirable to have more knowledge of how large the savings would be in getting rid of tax planning and the dependence of profits on transfer prices.

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Prospects for International Monetary Reform*

currenciesAs I see it, international monetary reform has two essential elements.

The first of these is a system for disciplining excessive current account surpluses, such as Keynes sought to introduce at Bretton Woods. There is an important constraint on what is available, caused by the popularity of floating exchange rates with the G20 (in particular, with the US). I take it that we agree that exchange rates are best set by the interaction of governments and markets, and I hope we also regard the adjustable peg as a false solution to this dilemma (on account of its susceptibility to speculative crises).

The G20 has adopted the nihilistic policy of forbidding thought on where the exchange rate ought to be, which foregoes the benefits of government influence entirely. The Palais Royal report suggests as an alternative a practice forbidding countries from intervening  (or otherwise seeking to influence the exchange rate) so as to push it away from its equilibrium value. This, of course, presupposes that we can agree on equilibrium exchange rates. In the world as it now is, defining these is clearly a task for the IMF. The Palais Royal report suggests that the set of exchange rates chosen need to be (a) mutually consistent and (b) consistent with “each country’s internal and external macroeconomic balance”. Elucidating what that implies is precisely the task that I set myself in a forthcoming book (Williamson, International Monetary Reform, Routledge, 2015). Allowing countries to pick their own targets, but limiting the targets countries are entitled to aim for within the range of +/- 3% of GDP, one gets well-defined values for equilibrium real effective exchange rates (REERs).

A rule forbidding countries intervening to push or hold the exchange rate away from equilibrium would prevent countries running sustained current account surpluses greater than 3% of GDP when they had no capital outflow (formerly China), but not when the exchange rate is held down by large capital outflows (formerly Germany). If the private sector repatriates its holdings and they are taken over by the public sector (including in the form of TARGET 2 balances), then Germany also would become subject to IMF discipline. The fear of this occurring at some future date would presumably make a country more reluctant in running a large current account surplus.

I favor replacing the Palais Royal’s emphasis on strengthened surveillance with requirements to follow certain rules. In terms of disciplining current accounts, what I have suggested is that normal countries (special rules apply to members of currency unions) should be disciplined by exchange rate policies.

The second element of international monetary reform may be summarized as

“enthroning the SDR”. By this is meant making the SDR the principal (ideally, the only) reserve asset; establishing the SDR as the intervention medium; and establishing a vibrant private international market in SDRs, in place of the Eurodollar market. In other words, one would realize the dream expressed in the IMF Articles. What are the reasons for desiring to see this reform? (1) To spread the “seigniorage” involved in reserve creation more broadly: IMF quotas are not an ideal mechanism for this purpose, but they are already better than any conceivable alternative, and anyway one expects them to be progressively changed in the future, to match the growing importance of developing countries in the world economy. (2) To put paid once-for-all to the Triffin Dilemma. Since the whole world is the debtor, it is impossible for an increasing demand for reserves to undermine creditworthiness. (3) To provide a bait for the Chinese, who would have to make a major sacrifice to approve the first change, which is central to US interests. But while they are clearly uncomfortable at living in a system dependent on the US dollar and unhappy to see the yuan labeled as inferior to the dollar, they have no desire to see the RMB supplant the dollar.

Replacing the US dollar as the main (or making it the only, if a substitution account can be agreed) reserve asset, making it the intervention medium, and establishing a private market in SDRs are clearly interdependent. One cannot have intervention in SDRs without private holdings of SDRs because intervention inherently involves a transaction between official and private sectors, and if the SDR were used in intervention that would add to the desirability of holding reserves in SDRs. While establishing a private SDR market is essentially up to the private sector, there is much that the public sector could do to nurture the SDR as an “infant currency”, as well as to provide the link between official and private sectors by changing the IMF Articles and nominating one or several commercial banks as SDR holders.

There is a long-running dispute as to whether dollar intervention precludes widespread dollar devaluation. In the run-up to the dollar devaluation of Aug 1971, it was widely assumed by American economists that a dollar devaluation would have no effects on exchange rates because European countries would have maintained their dollar intervention margins unchanged (e.g. Gottfried Haberler and Thomas D. Willett, “A Strategy for US Balance of Payments Policy”, American Enterprise Institute, 1971), although this would have been in direct contravention of their obligations. This view appears to be shared by Mr Zhou, the Governor of the People’s Bank of China, who, in his famous comment on the inadequacies of the international monetary system in 2008, wrote:

When a national currency… is adopted as a reserve currency globally, efforts of the monetary authority issuing such a currency to address its economic imbalances by adjusting exchange rate would be made in vain, as its currency serves as a benchmark for many other currencies.

In the current international monetary “system”, unlike Bretton Woods, countries are perfectly entitled to declare their exchange rates in terms of the dollar, and therefore Mr Zhou’s concerns appear to be solidly based. Only by replacing the dollar as the intervention medium could one ensure that a legal ability to devalue the dollar would be matched with a practical ability, and could one reasonably hold the US to the same standards for managing its payments as other countries.

There are no reforms that could be expected to benefit all countries in the short run. The intent of the above reform program is to respect the vital interests of all parties, and to offer each of them the prospect of long-run gains. Sadly, one has to acknowledge that since a willingness to seek long-run gains irrespective of the short-run is the characteristic of a statesman rather than politician, the prospects of imminent reform do not appear good.

I conceive the essential interests of each of the main parties today to be:

The United States. I regard the overwhelming interest of the US to be establishment of a system that imposes a discipline on surplus countries. Admittedly the system is not ideal from a US standpoint, since a surplus country that exports an equivalent amount of capital escapes the discipline—as it succeeds in exporting capital.

Western Europe. There is neither a gain nor a loss in the short run. But insofar as most of those worried by the Triffin Dilemma tend to be Europeans, there would be a long-run gain.

China. I do not believe that China benefited itself or anyone else by running large surpluses. Instead, insofar as China wants to build a world economy without a dominant role for the dollar (my interpretation of China’s motives), they have a strong interest in enthroning the SDR.

Other developing and emerging market countries. I believe that their primary interest is in gaining a part of the seigniorage that accrues from reserve creation.

Why then am I pessimistic about the chances of real reform? First, because the powers that be, the G20, focus on the short run, which is what one should expect of a body dominated by politicians rather than statesmen. Second, because some countries, like China and Germany, are against disciplining surpluses (which they equate with virtue). There is no reason to regard their surpluses as permanent, but if we postpone reform until they have developed deficits we may he in for a long wait. Third, Europe has no short-run gain (or loss) by replacing the dollar by the SDR, so why go to the trouble? Fourth, the EMs/LDCs (dominated by the big ones)

have turned anti-SDR as a mark of their virility (in contrast to their attitude in the C20), despite this being against their long-run interests.

*  Text of a speech that John Williamson gave at a conference on “The International Monetary System 70 Years after Bretton Woods” in Turin in Nov 2014.

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Thoughts on Social Welfare Functions

The way that most economists visualize the objective function of economic policy is in terms of the maximization of a social welfare function. This is a mathematical expression that summarizes the weight which society places on the preferences expressed by each member of society. A typical social welfare function today would be:

W (Ui) where W’ > 0, W’’ < 0 and i = 1…n where n is the number of individuals considered to be members of society.

Historically, there have been three great controversies about the nature of the social welfare function. The one on which economists have got most excited is the issue of whether utility is cardinally measurable. In the wake of Pareto, it is generally assumed that it is not possible to measure welfare cardinally, but only ordinally.

The second controversy is about an issue that makes sense only if utility is cardinally measurable and interpersonal comparisons are possible. The issue is inequality. Many of us feel it so important to recognize that equality should enter into the SWF that we take this as an important argument for abandoning the classical position that utility is only ordinal and that interpersonal comparisons are impossible. There is still the question of the weight to be assigned to inequality in comparison to an increase in total output. No one sensible (with due respect to Rawls) believes that only equality, or the income of the poorest, matters: the serious arguments are about trade-offs. The most satisfactory formalization of this is due to A.B. Atkinson (1970, 1975), who postulated that the marginal social value of the income of an individual i was equal to (Yi) where ε is a distribution parameter that varies from 0 (for those who subscribe to the economist’s de facto traditional view that distribution is unimportant) to ∞ (for those who subscribe to Rawls’ view that only the income of the poorest counts).

The third issue, which has been mainly debated in the political rather than the economic realm, concerns the domain of the welfare function: who are the i whose welfare is considered to matter? Initially society was organized in a way that implied that the only people who mattered were the king and maybe other aristocrats. The franchise was gradually broadened in England in the nineteenth century: first to the whole middle class, then to the urban working class, then to the rural working class, and finally (in the twentieth century) to women. And there it has remained, for almost a century. It would be unthinkable to deny economic rights (a role in the welfare function) to those accorded political rights, which implies that the i today are: all citizens.

Two categories of being are still denied a place in the social welfare function: foreigners, and animals. The exclusion of foreigners does not automatically mean that they are denied consideration: presumably they enter into the SWF of their home country, and then it is presumed that the political authorities of their respective countries enter into a bargaining process with the aim of maximizing the joint welfare of the two countries. The ideal end result may be to place individual foreigners in a comparable situation to nationals. (Consider ITO, or the arrangements for mutual provision of benefits under national health systems.)

There is no such reassurance for animals. They receive consideration only insofar as some of the people included in the SWF care about the continued existence of animals, or the lack of cruelty imposed on them. In Paul Collier’s book The Plundered Planet: Why We Must—and How We Can—Manage Nature for Global Prosperity, despite its main title, the analysis is all about the benefits that humans may enjoy from the policies recommended; there is no consideration of the consequences for nature per se. One may seriously doubt whether this provides a basis for meeting environmentalists halfway, as he seeks. Organized religion has long taught that animals are placed here for humanity’s benefit; we have no obligation to consider their interests. Even conservationists emphasize concepts like “existence value” to justify expenditure of resources on animal preservation.

It is high time for this arrogance, speciesism, to give way to a broad-based concern for the animal kingdom. Consider the following thought-experiment. Suppose that the human race ceases, for whatever reason, to exist. Would we want a SWF that declares itself indifferent between an incinerated world in which no advanced life survives and a world with an abundance of life-forms similar to that which existed prior to mankind’s advent? (In neither event are there any human beings, so that a SWF restricted to human preferences would have nothing to say about which state is preferable.) Another thought-experiment: would we really consider the crash of a couple of jumbo jets with total loss of life a greater tragedy than the extinction of, say, the mountain gorilla? To an economist, the implication of such thought-experiments is the necessity of placing the interests of animals in the SWF.

How to do this raises all the problems of interpersonal comparisons to the nth degree. But it can be argued that it is preferable to be forced to make such judgments explicitly rather than having them made implicitly, which typically involves completely ignoring animal interests (except maybe for pets), with the consequence that farm animals are treated quite atrociously (particularly in the United States). Personally I would give an equal weighting to humanity versus the millions of other life-forms. I would also be prepared to place a value on human life (which is how we behave). Presumably the death of any other life-form would not be weighed comparably heavily, though the extinction of a species (or subspecies) would carry a major cost. How large a cost would surely depend upon the uniqueness of the species or subspecies. It would be interesting to see if these judgments are widely shared.

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If Development Succeeds

Let us assume that development succeeds, to the point where living standards are similar in all countries. (This does not seem to me to be terribly unrealistic; it is a logical consequence of the hypothesis that less-developed countries tend to grow more rapidly, which is in turn explained primarily by the fact that knowledge is in large part a public good so that latecomers do not have to reinvent the wheel. Of course, it is quite inconsistent with some economic model-building, specifically with those models that postulate that countries tend to reach the same equilibrium growth rate but differ in their trajectories. So far as I am aware these models have not been subjected to empirical testing.)

The question is: what does this imply about future world events?

Consider first what are the implications for strategic events. I see no obvious reason why this should impinge on relations among the great powers: the competition among them is not economically motivated. Countries do not engage in a competition with the objective of catching up, nor would they cease to act in competitive ways if there were no commercial motivation. Where I would anticipate a benefit is in eliminating the widespread tendency of poor countries to engage in civil warfare: whether one attributes that to an increased opportunity cost of warfare, or to greater contentment of the population, it appears there is a strong tendency for poor countries to be the ones that have civil wars. If one abolishes poverty, the leading countries may have difficulty in using small countries as agents in their contest, which would be a gain, but it is unlikely to resolve the tensions among the leading countries.

Where I would anticipate far greater impact is on the economic relations among states, in particular, with regard to migration and trade.

So far as migration is concerned, it would surely relieve the tensions that are so evident at the present time. There would be an end to the desperate search to enter richer countries that is motivated primarily by the poverty at home. Instead, migration would become far more similar to that which presently takes place among the developed countries: migration that is often temporary, more balanced, and therefore does not generate great social tensions.

Consider trade. At the present time, trade is fundamentally of three types. First, there is trade of the sort first analyzed so brilliantly by David Ricardo: trade that ultimately is based on different factor proportions and therefore leads to differences in comparative advantage. This explains most trade in primary products: country X imports a commodity because it lacks the resources to produce it domestically. Obviously there are shades of grey here: at more expense a country could produce some of the commodities currently being imported, while others demand a factor of production (say, iron ore) that it totally lacks. But when a country imports commodities for this reason, it must export an (approximately) equal value of products. A second type of trade is the inter-industrial trade that was first extensively analyzed in explaining the early success of the European Common Market (as it was then called). It is well known that this trade cannot be explained by differences in factor endowments, but reflects instead differences in demand preferences, with each country tending to make products that satisfy majority demands at home, and then satisfying minority preferences by importing goods. Today there is a third great category of trade: that which consists of the import of goods that were formerly produced at home. Like trade in primary products, this trade will also be explained by differences in factor proportions, but differences that will tend to erode as countries become more equal.

Let us call the first motivation for trade Category A. We make the strong assumption that all trade in primary products is explained this way. Inter-industrial trade is labeled Category B. We make the strong assumptions that all manufactured exports of advanced countries and all industrial intra-trade of emerging markets consist of Category B. We label the third motivation for trade Category C. We make the very strong assumption that all industrial exports of emerging markets to advanced countries consist of Category C at the present time: in practice they surely include Category B too, and indeed one expects that the proportion of Category B will progressively increase as countries approach maturity, but the assumption is essential to permit identification of Category C.

The first two categories are liable to persist indefinitely. In contrast, the third is a temporary phenomenon, which arose after the “third world” mastered the techniques of the first world but had not achieved their living standards. It is destined to disappear if and as living standards catch up with those in the advanced countries.

Some facts about the value of trade in 1995 and 2013 are shown in Table 1. Trade is disaggregated merely into primary products and manufactures, and countries are disaggregated merely into the “advanced” (OECD less Mexico) and the Emerging Markets (all other countries). The data come from the World Bank, courtesy of Tyler Moran.


It is a well-known fact that trade has grown more rapidly than GDP since the Second World War. This is no doubt partly because trade was unnaturally repressed at the end of the war, and has since bounced back to a more natural relationship. Inter-industrial trade was the primary victim of the anti-trade bias of policy inherited at the end of the war, and was progressively eliminated during the postwar period, which explains why it was inter-industrial trade that first accelerated markedly. But the rapid growth of trade relative to GDP is also due to the fact that Category C has been coming on stream. This is a new phenomenon in the postwar period: there was previously virtually no trade of this type.

Is the phenomenon of trade growing more rapidly than output likely to go into reverse as this type of trade disappears, which it will do as incomes become more equalized? For that one needs an estimate of the current breakdown of trade, along with extrapolations of the growth rates of the first two categories. It is easy to get figures for the level and growth of trade in primary products, since this simply involves extracting the relevant figures from the SITC classification of trade, as is done above. This shows that trade in primary products, defined as SITC 0-5 and 67 and 68, has grown at an average rate of 9.0 percent per annum over the 18-year period 1995-2013. However, a part of the primary product trade is a reflection of the new trade in products that were previously manufactured domestically. If one assumes that emerging markets spent 20% (31%) of their export earnings on primary products, as they did in 1995 (2013), one should deduct 20% (31%) of the estimated value of “new” trade from the exports of primary products to get the trend estimate of primary product trade. (The increase in 2013 over 1995 presumably reflects the recent boom in the prices of primary products.) The figure for the trend in 1995 was 766 – 276/5 = 711, and the relevant figure for 2013 is 3637 – (0.31)(1903) = 3046. Thus primary product trade would have increased from 711 to 3046 over the 18 years from 1995 to 2013 in the absence of manufactured exports by emerging markets, so our estimate of the trend rate of growth of primary product trade is 8.4 % per annum.

Unfortunately it is more difficult to make a similar breakdown between the remaining two categories, since this refers to alternative motivations for trade in industrial products, and no sub-division of industrial products is likely to approximate the desired division. (For example finished cars are a single SITC code, even at a finely disaggregated level; but a developing country may well export cars to an advanced country that represent Category C, while much of the trade in cars represents Category B.)

The sub division of trade in industrial products between Categories B and C is thus bound to be rough and ready, which is reflected in the fact that the assumptions previously listed were described as “strong”. However, let us assume that industrial exports of advanced countries are entirely accounted for by category B as are the exports of emerging markets to other emerging markets, while the industrial exports of emerging markets to advanced countries consist entirely of category C. In that case inter-industry exports amounted to $2340b in 1995 and to $6744b in 2013, which is an increase of 6744/2340 = 2.882 over the 18-year period, or 6.06 percent per year. Since both 6.1% and 8.4% are in excess of any likely growth of GDP, one may conclude that the growth in trade is likely to exceed the growth in GDP even after Category C disappears.

There is, however, a fundamental problem in the preceding calculations. The fact is that both Category A and Category C are exported with a view to being able to import. It therefore makes no sense to consider the trade motivated by comparative advantage as merely the export of primary commodities; one needs also to include the imports (other countries’ exports) they permit. Consider primary products. They are typically exported with a view to being able to import industrial products, so to the extent that this occurs one should increase the weight of comparative advantage trade (Category A) and decrease that of inter-industry trade (Category B).

It is in principle simple to calculate the extent to which the three categories change as a result of trade in primary products, on the assumption that “expenditure patterns” in a particular year – the division of spending between primary products and manufactures, and the division of spending between goods made in the EMs versus the advanced countries – is constant. Then, labeling as follows:


we can say that the primary product exports of EMs amount to (a1 + a2). The money they earned is divided in the proportion (a1 + a3)/(b1 + b3) between primary products and manufactures; (b1 + b3)/(a1 + a3 + b1 + b3) is therefore the proportion of spending on manufactures. So the size of “induced” manufactured imports (some other country’s exports) is (a1 + a2) (b1 + b3)/(a1 + a3 + b1 + b3). A part of the counterpart of EM primary product exports is exports of manufactures, and to this extent it is clearly appropriate to reallocate the value of B, to A.

The primary product exports of advanced countries amount to (a3 + a4). They can be analyzed in exactly the same way, which results in “induced” manufactured exports that reduce B by (a3 + a4)(b2 + b4)/(a2 + a4 + b2 + b4). This is added to the result for the EMs.

It is less clear that it is appropriate to make a similar adjustment in the value of A for the induced component of primary product exports. They are already included as reflecting comparative advantage; the logical procedure would therefore be to first deduct them and then add them back, leaving the value of A unchanged.

Consider next the export of manufactures by the EMs, b2. These were classified as Category C. The purpose of exporting is to be able to import, so that we need to include (in Category A) an estimate of the additional exports that result from EM exports of manufactures. Insofar as the imports (= exports) are of industrial goods, there is a further diminution of B. Once again, the reduction in B is b2(b1 + b3)/ (a1 + a3 + b1 + b3). Again, it is unclear whether we should change A, so we don’t. Note that in this case we do not add a term for the advanced countries, since (by definition) they do not export Category C.

Substituting in the above formulae for 1995 and 2013, one concludes that A95 = 776 + 174 + 629 +265 = 1844, B95 = 2606 – 174 – 629 – 265 = 1538, C95 = 276. Similarly, A13 = 7498, B13 = 2883, C13 = 1903.

During the 18-year period 1995-2013, Category A increased 7498/1844 = 4.066 times, an annual rate of growth of 8.1 percent. Category B increased from 1538 to 2883, i.e. by 1.875 times, an annual growth rate of 3.6 percent. Combining the two, using the 2013 weights of 7498 and 2883, yields a growth rate of 6.9 percent per year. Since this is well above any plausible growth rate of GDP, one may conclude that the phenomenon of trade growing more rapidly than “World GDP” is still likely to outlast the end of Category C trade under this expanded concept of Category A trade.

If and as the emerging markets catch up with the advanced countries, rather than get caught in a “middle-income trap”, the growth of trade is likely to slow down. There is, however, no reason to suppose, on the basis of recent experience, that it will cease to grow more rapidly than output.

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Raise Taxes to Cure the Recession

Political debate in the United States is currently strangled by the failure of anyone to advocate raising taxes, however strong the arguments in favor. This is presumably the ultimate tribute to the genius of Grover Norquist, who has made it political suicide to even mention the possibility. The likely result is economic catastrophe, but that is of no consequence to the low-tax brigade.

In the long term, the consequence of a refusal to raise taxes will be to present the American people with a choice between the preservation of such elements of a welfare state (notably social security) as it has in the past built and continuing increases in the national debt. The CBO projects government spending on present trends at just over 22% of GDP in the first half of the 2020s and the tax take as slightly over 18% of GDP.

Insofar as growth occurs, one can run a secular deficit without an increase in the debt/GDP ratio, but that allows only for at most a 2% real gap. There is no way that discretionary expenditures can be cut enough (even if one is prepared to ignore the case for increasing some of them), since they are projected to amount to only about 5.5% of GDP (including defense). A reduction in mandatory expenditure (such as social security expenditure) would be needed, despite the increase in the number of claimants that is in prospect.

There is a second baleful long-term consequence of the refusal to consider tax increases. This is the need to achieve equality between debt and equity. At present debt is subsidized by being tax-free, with the result that corporations and banks (like governments) have far too much debt and far too little equity. Since we cannot afford yet more give-aways of tax revenue, the only way to square the circle is to tax debt. Logically tax reform, if it ever happens, should include the abolition of mortgage interest relief. But these reforms are also precluded by a refusal to raise taxes.

In the short term, I have long held that a switch in the composition of taxes could be helpful, but this also is precluded by the slogan of no new taxes. The particular switch that seems to me called for is to institute progressively a heavy tax on conventional energy, in return for a progressive reduction in taxes on things that we want to encourage, like income. The reason for believing that it could be helpful in the present situation in that it would provide a concrete incentive to undertake investment in the new energy industries; if it were done so as to be fiscally neutral, there would be no adverse impact on aggregate demand. The idea of a “carbon tax” has been around for many years, and was indeed considered (and rejected) by Congress at the start of the Clinton Administration. Politically, opponents of the carbon tax presented it as implying a tax increase; if instead it were presented as the price of an income tax reduction, it might be less unpopular with the general public. Of course, there is no hope of persuading Grover Norquist or the Exxons of this world.

What is new, at least to me, is an additional short-term case. This arises from an argument persuasively advanced by Andrew Smithers[1]: that the shift in managerial compensation from salary to bonus distorts management incentives in such a way as to bias managerial incentives toward the short-term. The argument is that managers are now largely compensated by bonuses, that most bonuses depend on recorded profit per share being higher than in the preceding period, and that it is therefore in their personal interest to risk the long-term future of the firm where there is a conflict with its short-term interest. 

Where do such conflicts arise? In regard to investment, where long-term a firm may need to expand its capacity by investing more, while in the short term it can make do with its existing facilities. And with regard to its price mark-up; short-term profits can typically be increased by charging more than is good for the firm in the long run. So one has an explanation of why firms are sitting on oodles of cash instead of investing as past experience suggests they can be expected to. Similarly, we suffer from more inflation than past experience would lead us to expect, given the extreme weakness of demand.

Changing these outcomes is essential to achieving a real recovery. The most straightforward way I can see of achieving this is to reverse the fact that managerial returns now come overwhelmingly from bonuses. And how to achieve that? How about using the tax system? Ideally one would want to impose a tax rate of about 98% on bonuses, as opposed to the present top rate of 39.6% plus state taxes, so that bonuses cease to be worthwhile.

A good approximation would be to raise the income tax rate on incomes over (say) $1 million to a rate of about 90%, which (combined with state taxes) would typically give a marginal rate of about 98% for those with incomes of over a million dollars a year. We were sold tax reductions with the argument that they are good for incentives, and there are high-earning individuals for whom this is surely true. But they earn over $1 million? The only persons who earn in that range are those with large assets and company CEOs on bonuses; the former do not need incentivizing and for the latter we have just argued that the incentives have a perverse outcome.

So it would be easy to design a program that would both promise to end the recession and improve the fiscal outlook. Of course, it won’t happen. For that we have to thank Grover Norquist and the low-tax brigade. 

[1] The Road to Recovery, Wiley, Chichester (UK), 2013.

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Should One Worry about the Prospect of Deflation?

It seems that there is now virtual unanimity in regarding deflation as a threat to be avoided at all costs, comparable in severity to the problem of inflation in the 1970s. This is despite the fact that my suggestion of many years ago to define deflation as referring to declining output was not adopted: it would be neater for all if one spoke of price changes in terms of inflation versus disinflation, and of output changes in terms of reflation versus deflation, instead of using the terms “deflation” as the opposite of inflation. But there can be no doubt that what people are concerned about is the possibility that prices will fall. 

How did such a concern come to dominate economists, despite the fact that (gently, and/or temporarily) falling prices were as common as (gently, and/or temporarily) rising prices over many centuries prior to 1914 in a period that people do not generally equate with disaster in the Western economies? As with so many of the propositions in economics, it seems to have originated with no less than John Maynard Keynes. In chaps. 19 to 21 of the General Theory, Keynes was mainly concerned to refute the notion that falling prices provide a simple antidote to unemployment, pointing out that the then-traditional analysis neglected the impact of lower prices on aggregate demand. Once this is done, the net effect is equal to that which operates by increasing the real value of the money stock; and this could be achieved more readily by monetary expansion than by price deflation. Ergo, declining prices had no role to play in rational demand management policy.

One can agree with this proposition without going overboard, as most contemporary economists do, regarding mild price declines as a social evil to be avoided at all costs. How one moved from the consensual position that it makes no sense to seek reflation via price declines to the dominant contemporary view that price declines represent a threat to the possibility of managing demand is far from evident, but it seems that this is what happened.

It has been customary to buttress this view with a reference to Japan. In fact, Japan has not suffered anything like a catastrophic decline during the supposed lost decades; living standards continued to improve (as measured by the rate of growth of real GDP per employed person) at a rate of about 0.8 percent per year. Admittedly this is distinctly less than in the previous 20, 30, or 40 years, but this is mainly because the opportunities of rapid growth were distinctly less, because by 1990 Japan had more or less caught up with the world technological frontier. It is also less than the 1.6 percent per year that the US enjoyed, but the income distribution deteriorated far less and the labor force participation rate improved by almost 5 percent, as opposed to the decline of over 4 percent in the US. (A “cheap” way of improving measured productivity is to reduce employment per capita.) There are difficulties in making a comparison with the Euro Area, because of its changing composition and the earlier absorption of East Germany by West Germany and its consequent entry into the Euro Area, but it seems that the rate of productivity increase there was broadly comparable to that in Japan.

The important thing to appreciate is that it is the real growth rate per capita that is the relevant determinant of the improvement in living standards, and not the growth rate of the total economy in real terms (still less is it the growth rate in nominal terms). The major determinant of the faster growth in the US has been faster population growth (of about 27 percent rather than 2 percent), which has almost zero welfare significance.[1] Admittedly the US enjoyed faster per capita real growth, but since – as is well-known – the benefits of this went almost exclusively to “the 1 percent”, even this is of minimal welfare significance.

Let us ask analytically what is the effect of a negative rate of inflation. It is a problem that is caused by the zero lower bound to the nominal interest rate. If this constraint is in operation, this makes it impossible to use monetary policy to reduce the real rate of interest when desired, which has an effect in reducing aggregate demand. But note (1) That under many circumstances it is possible to offset this undesired effect through a more expansionary fiscal policy; (2) That when this is not possible (because, for example, of constraints on fiscal policy) it may still be possible to use “unorthodox” monetary policy (like quantitative easing) and (3) That in the worst analysis the effect is confined to the interest elastic component of aggregate demand. Even when it cannot be offset, the effect on demand is thus likely to be modest. It is hardly comparable to the problem of stopping inflation in the early 1970s.

Since there is no empirical evidence that disinflation is likely to be disastrous, nor convincing theoretical reasons for fearing modest and/or temporary price declines, one is bound to conclude that the present fevered attempts to prevent “deflation” are misguided.

[1]  Until recently I would have said zero welfare significance, but then I read Thomas Piketty’s book Capital in the Twenty-first Century. This shows that the concentration of capital tends to approach s/g, where s is the propensity to save and g is the growth rate of population and growth due to invention. It follows that high population growth tends to retard the concentration of capital, which some of us would regard as a benefit. This is the only benefit I can see in fast population growth.

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