7. Position of the Court in economic theory

Colignatus (1990a) forecasted a revival of institutional economics. We see this happening in the literature indeed. This current book belongs to that development. An Economic Surpreme Court, or the lack of it, is a topic in institutional economics, and thus has a natural position in the proposed new synthesis. [22]

There have been precursors to this approach indeed. Galbraith (1998:199) correctly quotes Michael Kalecki (“Political aspects of full employment”):

“The assumption that a Government will maintain full employment if only it knows how to do it is fallacious.”

8. The record of economics itself

A joke is that there are as many theories as economists, and five for Keynes. Krugman (1994ab, 1996a) describes eloquently how Western economies came from full employment and a period of great expectations to a period with unemployment and inflation and a productivity slowdown, and as a result diminished expectations. He is even more eloquent in describing the different fashions in economics and economic policy making. He gives a brilliant discussion of Keynesians, Monetarists, Supply-siders, Business-cyclists, Post-Keynesians, Strategic Policy Adepts. Krugman also makes an apt distinction between serious economists and the policy entrepreneurs who abuse economics for schemes of their own. [23]

The discussion by Galbraith (1998) is also very useful to understand the history of economic schools in the last decades. I discuss this book in the final chapters.

There also is ample reason to be humble about econometric testing of theories or identifying regularities (see Hendry (1995)), and then we haven’t started yet on the quality of national statistical data. [24]

If we regard the role of economic theory itself, then we cannot overlook the error that economists made with respect to Arrow’s Theorem in the theory of Social Choice.

First of all, there has been a stagnation in theory development:

“Tullock sees public choice as a subject in which there was a burst of interest from the 1950s to the 1970s, but which has now ‘died out’ (p39). The cause of death was the set of unremittingly negative conclusions that issued from the analysis of the Condorcet and Arrow paradoxes.” Sugden (1999).

Secondly, it turns out that economists and Arrow himself gave a wrong interpretation to the mathematics. Below we will present a novel analysis with respect to the Arrow problem, and show that economists have run astray indeed. This gives another reason to be humble.

But, our discussion also provides clarity that social choice can be based on reasonable and morally attractive axioms. And thus there is a logical basis for a Court too.

Evaluating in general:

·         Looking at this circus, it would be wrong to be only entertained. The proper point to see - the real upshot of Krugman’s books - is that the current government structure has little protection against this circus, the fads and fashions, the David Stockmans: and that this protection would be larger with a well selected Court. Note that the word ‘court’ has been chosen judicially: the job of this body is to make a judicious choice, a wise selection of all competing theories and approaches.

·         It is useful to realise that the academia basically write for the journals, i.e. each other, and do not necessarily have the focus of analysing or predicting the national economy. Van Bergeijk c.s. (1997) point to these different focusses and the ‘dangers’ thereof. [25]  The academic job also is to generate and test new ideas, not only the implementation of accepted theory.

·         Another aspect of the distinction between the academia and practical policy advice is that only the first have the luxury of saying that they ‘don’t know it’. In policy advice this luxury basically lacks, and a decision has to be supported with the best information available. Much academic criticism on economic policy advice is overdone, since it does not take this condition into account.

·         Also, economics has come far, and many economic models show similarities. So there is a body of ‘existing economics’ or ‘accepted theory’ and a rather firm scientific base. Let me indicate as such: the textbooks of Dornbusch & Fischer (1994), Mankiw (1992), Blanchard & Fischer (1989), Mueller (1989), research like Bruno & Sachs (1985), Layard, Nickell & Jackman (1991), Phelps (1994), and the practical work such as of the Dutch Central Planning Bureau (1990) (in which I participated) and Gelauff (1992). [26]  [27] As Montesquieu for his Trias Politica referred to the existing example of England, we can point to Holland, where the Dutch Central Planning Bureau has earned itself a strong position, even to the extent that political parties have their programmes evaluated before elections. One can be severely critical of that CPB, precisely since it is no real Economic Supreme Court, but the current achievement is there, and is an argument for ‘promotion’.

If we regard the arguments for a court again, in the light of this evaluation of the record of economics itself, then:

·         The issue is not quite the difference between unfinished science and finished science. Even if economics were to be like engineering with some finished science - like Keynes’s famous dentistry, where it would be easy to switch from one economist to another - then still there are always decisions to be made. How to interprete the data ? Is factor X now crucial or not ? Even if a science is finished, then its application to reality still is an art, and there are differences in the artists. One should realise that choices are made nowadays too, albeit hidden and not in the open, and with less scientific scrutiny as is advisable. Currently we have the President and Parliament deciding what will be the ‘information’ on which policy is based: and only too often they select that kind of presentation that suit their goals rather than the truth. The only suggestion here is to make procedures such that the result better serves democracy.

·         It is important to see that we are dealing with a natural monopoly here. When the government has to establish its budget and thereby wants to rely on science, then there has to be an instance at which it is decided what the current state of science is. Even if one would ‘privatise’ forecasting, and have universities compete in bids for the contract, then there still is the decision which university to take for this year. By definition there is a monopolistic situation for that decision maker at that moment.You cannot compete that away. My analysis and advice is to embed that authority in the Constitution, and provide warrants that the critical decisions are taken in scientific manner.

·         Thus crucially: If the government on the one hand would desire to use the results of scientific advice for its budget process, and on the other hand would not opt for an Economic Supreme Court, then its definitions would be logically inconsistent, and it would thereby tend to create a cause for dishonesty and improper manoeuvreing and thereby corrupt its processes. [28]

·         We should realise that also law is no ‘finished business’. Our ancestors have opted for an independent judiciary, even though there is no unanimity about formulations and interpretations. But precisely since there is no unanimity, we need an institute to make a decision - a court.

·         It will also be useful here to recall one of the key aspects of being a scientist: namely the responsibility to make up one’s own mind. The scientist is in this respect as a judge. He or she has to balance all pro’s and contra’s, to review theories and facts, to replay all opinions of the colleagues, and then make a decision as to what he or she believes is the right thing to think. For example, to let one’s opinion to be swayed by the opinions of others is unscientific. Now, in the light of the enormous complexity of an economy, and the additional complexity of human made theories about the economy, many academics have the liberty to choose not to ‘believe’ anything - except the logical consistency of the paper that they read or write. But in policy advice, this luxury, as said, is lacking, and much more scrutiny of what one really believes, in terms of probable effects and such, is required.

9. Economics ‘as usual’ and its inadequacy

Figure 1: Isoquants of national income

Figure 1 shows how national income is produced. Capital and labour combine in a production function and give national income. Capital is aggregated in dollars, labour in personyears. [29]

Let labour supply be LS and the unemployment rate be u. In the unemployment regime 0 only LS (1 - u) work, producing a national income of Y₀ in wages and profits. The slope of the tangent gives the price ratio of wages and rents. In regime 1 LS work, producing Y₁. The rise of national income from regime 0 to 1 is the increase in efficiency from going from the lower to the higher isoquant. The graph clarifies about the improvement in efficiency that: (a) more people work, (b) total income is higher, (c) average wage costs are lower, indicating lower pressure on prices, (d) hence, when there is unemployment, then there is a possible improvement, that benefits some while it needn’t hurt others.

The story of course doesn’t stop with Figure 1, and is a bit more difficult. Some points need to be developed - just indicative, not extensive:

1.       We have to show that (current) unemployment is inefficient indeed, and that it is not caused by technology or globalisation or labour market inflexibility (which would cause it to be a form of efficient unemployment).

2.       Wages may fall on average, but the story for each individual is different. We have to deal with heterogeneous labour. And we have to develop the impact on inflation.

3.       An econometric problem is that observations are based on observations of LS (1 - u), i.e. on the inefficient area, so that extrapolations towards the true efficiency frontier are difficult, especially when labour is heterogenous.

4.       Policy makers tend to see the decision process as a clash of preferences. When a tax reduction is proposed, to tackle unemployment, then this is translated in their minds into terms of the (re-) distribution of income - and then it is quickly opposed. So we have to deal with this source of misunderstanding too.

5.       Though above uses a Bergson-Samuelson social welfare function, many economists are hesitant about that approach and refer to Arrow’s theorem. This matter then needs clarification too.

Indeed, I might present much of the argument along these ‘economics as usual’ lines.

But doing that makes part of the problem go away. We no longer see the dead of the two World Wars, the hungry of the Great Depression, the ruined lives of the Great Stagflation. We no longer see the devastation in Russia and many of the Eastern European Countries in the first decade after the Fall of the Berlin Wall. Closing our eyes to these issues, would be closing our eyes to the evidence for the need for an Economic Supreme Court.

The critical observation is: If economics would not confront the serious problems of mankind, it would lose it relevance to democratic policy making, and would rather become disinformation and a veil for anti-democratic policy making. It would become an accomplice in economic policy stagnation.

10. Four empirical cases

Interestingly, Frank Sulloway’s (1996) “Born to rebel” argues, roughly put, that first-borns tend to be more conservative and that later-borns are more open to new scientific findings. Van den Berg (2004) calls this finding into question. But an Economic Supreme Court packed with conservatives could be a recipe for stagnation anyway. [30]

To be sure: my question of ‘would it not have been better if…’ is not intended to be rhetoric, and I grant that a Court at times will be slow to take up a challenge.

There however is a proper analogy: In the same way, occasionally, a fireman is caught causing fires himself. But this does not cause us to abolish the whole fire-department. As said, the appendix contains an example constitutional amendment that tries to find the middle ground, something that is workable and a huge improvement compared to the current situation.

11. The moral imperative

The modern economist entertains a sharp distinction between science and values. This indeed is a proper attitude, and also a crucial instance of the division of labour. It is up to Parliament and the President to set the course and make the value judgements - and once the ship’s course has been set, economists will build the ship, rig the sails and do whatever necessary to get there. [31]

It is interesting to observe however that economists regularly express values. It is well-known that Marshall and Tinbergen were drawn to the subject out of a desire to understand the causes of poverty and ‘do’ something about it. Less well known may be this quote of Pigou:

“I would add one word for any student beginning economic study who may be discouraged by the severity of the effort which the study, as he will find it exemplified here, seems to require of him. The complicated analyses which economists endeavour to carry through are not mere gymnastic. They are instruments for the bettering of human life. The misery and squalor that surround us, the injurious luxury of some wealthy families, the terrible uncertainty overshadowing many families of the poor---these are evils too plain to be ignored. By the knowledge that our science seeks it is possible that they may be restrained. Out of darkness light! To search for it is the task, to find it perhaps the prize, which the “dismal science of Political Economy” offers to those who face its discipline.” --- A. C. Pigou [32]

Keynes wrote the General Theory not only motivated by the beauty of economic theory itself but also against the backdrop of the Great Depression and the threat of communism and facism, and war. He even presented the GT somewhat in the fashion of ‘either you accept my theory or there will be a world revolution’:

“The authoritarian state systems of to-day seem to solve the problem of unemployment at the expense of efficiency and freedom. It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated - and, in my opinion, inevitably associated - with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.” - GT:381

What do we make of these value judgements ? Do these economists cross the line ? Do they wander in the perk reserved for politics ?

The answer is no. They only emphasise that society may be well willing to do something decent about unemployment and poverty, if only people had the knowledge. If the knowledge is lacking, then society faces a tough choice, and people in power will tend to look after themselves first. But with the knowledge, the situation is entirely different, and even those in power will be quite ready to help create the new prosperity. By doing so, they may also become popular, and gain or retain power. Note that it is not obvious or self-evident that the powerful will allow such change, but they might be persuaded to it.

Of course, in a sense, it could be considered a political act, when one provides crucial knowledge that changes a situation. But properly seen, this is just the definition of a scientist: to provide knowledge. Scientists can be knowledge (power) brokers - see also Throgmorton (1991). If one does not like this role of scientists, then throw out Montesquieu too.

In the same manner the economist can, with his or her knowledge, elucidate the moral problems of society. People may not be aware of certain choices that they implicitly make, and they will be grateful - though not necessarily happy at the first instance when responsibility dawns on them - when these choices are pointed out. The economist then again is only helpful in clarification. Though of course it is often wise to only try to clarify matters if one can predict that this will cause a change - otherwise much discussion and sweat will have been for nothing.

But clearly, the economist has to be protected by the Constitution to be able to perform his or her task of clarification, since new or seemingly contrary ideas always run the risk of misunderstanding and disproportional reaction.

My analysis in 1990 was, vide Colignatus (1990a), and the first edition of this book in 2000 stated:

“In my analysis the moral imperative for the Western nations since the Fall of the Berlin Wall is to help the Russian and Eastern European peoples to recover from the brutal communist oppression that they have suffered. The best way to help is to allow trade. But the West is afraid for cheap products, and thus its own unemployment. And hence there are barriers to trade again. But the true cause of unemployment is not external, but internal to the West, internal in our system of economic policy making. It is the West’s own stupidity that causes hurt to others.”

The second edition of this book in 2005 witnesses the Enlargement of the European Union on May 1 2004. This is a great step in the right direction. There are still obstacles, however, if not internally to the EU then externally to the other nations.

The argument thus has not changed fundamentally.

Hence, the moral imperative for Western nations is to reconsider the Trias Politica structure of economic policy making. [33]

Book III
Economics ‘as usual’

12. Introduction

Many people accept these days that Western economies have a problem with jobs with a low level of productivity and thus a low level of market-earned income. The United States tolerate more poverty while Europe sets its minimum wage much higher so that Europa has more unemployment. This problem with low productivity jobs finds various explanations, notably those of technology, globalisation and labour market inflexibility - or ‘welfare state sclerosis’. Policies based on these explanations have been enacted for some time now. For quite some time, in fact; while little is being achieved. It is proper that we pose the question: why is it that we don’t achieve much ? [34]

The novel analysis presented in these pages finds the problem and answer in taxes. [35] As noted, benefits have to be financed, and the tax arrangements have a key impact on incentives and costs. We will focus on the influence of taxes that runs via the labour market, both directly by ‘labour taxes’ and indirectly by ‘consumption taxes’ that also affect the cost of labour. The emphasis in our study is on dynamics where interactions have more time to take hold. The idea of this present study is that by proper management of tax dynamics, the economy could become more efficient, in both the EU and US alike, so that ultimately the drawbacks of a welfare state can find a better balance with its advantages.

Obviously, when this analysis is new, then it has not been recognised before, and then it has likely been missing in policy. And policy that was based on a wrong analysis, is likely to have been the cause of the very problem that it wanted to solve.

The emphasis on taxes does not mean that technology, international trade and labour market inflexibilities are irrelevant. It does not mean that we can throw away the current macro-economic models. On the contrary: the emphasis on taxes is only an amendment to the current models. The tax analysis would be meaningless without these current models. I myself participated in the construction of the CPB (1990) Athena model, a sectoral model of the Dutch economy with 7000 variables, and I would be the last one to suggest that only taxes matter !

Though the amendment sounds simple, there still are grounds to cover. Unemployment obviously has a much longer history than the current problem. Also, the Western track record on unemployment can only be understood when the record on inflation is taken into account too. A wrong diagnosis of the cause of unemployment would also have its effects via the anti-inflation policy of the monetary authorities.

Stylized history

One sees a certain “trade-off” between unemployment and inflation. Figure 2 reviews the official data for the United States and Figure 3 for the Netherlands for 1950-2001. [36] For both countries, the official values for the 1950s and 2000s are in the same lower left and favourable region, but they have been far outside of it during the years in-between. [37] Since the official statistics in the 2000s have returned to the favourable lower left region, the natural question to ask is whether stagflation has been defeated. Figure 4 reviews the situation in the Netherlands, where the official values have been extended with those on the labour force ‘not working’. [38] One can suspect that Welfare State programmes can hide unemployment.

In macro-economics, the relation between unemployment and inflation is expressed in the Phillipscurve. Next to the standard (wage-) Phillipscurve there is the (price-) Phillipscurve that gives the relationship between unemployment and (consumer) prices (and that relies upon a dependence of prices on wage-costs). A more extensive (participation-) Phillipscurve links the development of wages and prices to unemployment or ‘not-working in general’. Understanding the relationships of the curves is subtle: it is not just the inclusion of the numbers, but rather the effect on the market. Notably, when ‘disability’ means a reduction of the workforce, the remaining workers face less competition and might raise their wage demands (see Figure 4).

Figure 2. The unemployment - inflation space 1950-2001, United States

Figure 3. The unemployment - inflation space 1950-2001, Holland

Figure 4. The Netherlands, ‘official unemployment’ (drawn) and ‘not working’ (dashed)

“The contemporaneous correlation between innovations in wage inflation and GNP is, however, positive and significant: it is this correlation that underlies the Phillips curve, which plays a central role in theories of the business cycle that allow aggregate demand disturbances to affect output.” (p19). [39]

Their discussion is critical and enlightening, but does not involve the role of the minimum wage. On p551 they discuss the high European unemployment, but then refer to the Layard & Nickell 1986 & 1987 model, concluding, a bit non-committingly:

“The Layard-Nickell model provides an example of how to relate the theories developed in this book to the data. It suggests a complex set of causes for high unemployment in which both demand and supply factors play a role and the labor market’s own dynamics explain the persistence of high unemployment with nearly stable inflation.” (p555).

Our analysis will allow a stronger conclusion. From the 1950s till the beginning of the 1990s the common view among economists and policy makers tended to be that the unemployment in the trade-off was “general” unemployment. This is not quite true for all economists, but many made this simplifying assumption. Nowadays we tend to link unemployment to lowly productive labour. For us it may be obvious, but compared to the earlier view of many it is a change of perspective that the once-thought-to-be “general” unemployment now turns up as a rather specific type. To make this change specific: we will hold that the unemployment in the trade-off has always been related to the distribution of productivity across labour.

Structure of the argument

The crucial insight is that the people who can demand pay rises need not be the people who run the risk of unemployment thereof. High productivity workers run less risk of unemployment and can more easily demand pay rises, while low productivity workers run the larger risk of unemployment. High productivity workers are more versatile and are able to shift the risk of unemployment to the lower income groups. When jobs are scarce, the high productivity workers even crowd out others from the labour market. [40]

The policy rule on taxes is: don’t tax low productivity labour. Why ? To keep it employed so that more productive labour will meet more competition and will not demand inflationary pay rises. In Europe, taxes on low productive labour are still high, causing a high minimum wage that causes unemployment. These taxes could be abolished, and without costs, since these workers are unemployed anyway. Similarly, marginal tax rates are less a problem than often said. The proposed alternative policy provides an improvement on both unemployment and inflation, exactly the kind of policy measure required for in the current situation.

This analysis is not common knowledge. It is missing in the economic journals, it is missing for example in Borjas’s (1996) much used textbook for undergraduates. Borjas (1996:441) states: “The minimum wage, however, affects mainly less-skilled young workers, so it is difficult to attribute much of the unemployment problem to minimum wage legislation.”  [41] For policy makers, the OECD (1998) reports: “The cross-country evidence suggests that the minimum wage has no significant impact on overall adult employment.”  though OECD (2000) is more guarded, see chapter 44. We will show however that a minimum wage can have huge ‘multipliers’.

The difference that it means

Table 2: Differences between current and possible policy

13. Unemployment via taxes and minimum wage

Figure 5: Earnings distribution

The earnings distribution

Figure 5 gives an earnings distribution of a standard lognormal shape. The figure approximates the situation in Holland 2002, though without parttimers. With each level of income there is a number of ‘personsyears’ of people who earn that level. The earnings distribution can be used to compute how large unemployment will be below the minimum wage. Figure 6 gives the situation for the Dutch minimum wage of about € 18.3 thousand. Since Dutch unemployment is about 25% of a potential labour force of 8 million people, the graph conforms to the facts. [42]

Figure 6: Unemployment below the minimum wage

Analysing the minimum wage

Malthus has subsistence B enforced by nature. Under current rules of (European) welfare states, B can be higher, since people who cannot earn subsistence B are entitled to a benefit of that level. [46] Table 3 gives the Dutch example.

Table 3: Tax wedge at subsistence (single person)