John Kenneth Galbraith and the Future of Economics

John Kenneth Galbraith and the Future of Economics Edited by Blandine Laperche and Dimitri Uzunidis John Kenneth Galbr...

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John Kenneth Galbraith and the Future of Economics Edited by Blandine Laperche and Dimitri Uzunidis

John Kenneth Galbraith and the Future of Economics

Also by Blandine Laperche LA FIRME ET L’INFORMATION, INNOVER POUR CONQUÉRIR L’INNOVATION ORCHESTRÉE (Edited) PROPRIÉTÉ INDUSTRIELLE ET INNOVATION (Edited)

Also by Dimitri Uzunidis COMMENT ONT-ILS RÉUSSI? L’HISTOIRE DES ENTREPRENEURS DU XVIIIE SIÈCLE À NOS JOURS (with S. Boutillier) LA LÉGENDE DE L’ENTREPRENEUR (with S. Boutillier) LE TRAVAIL BRADÉ, AUTOMATISATION, MONDIALISATION, FLEXIBILITÉ (with S. Boutillier) L’INNOVATION ET L’ÉCONOMIE CONTEMPORAINE: Espaces Cognitifs et Territoriaux (Edited) MONDIALISATION ET CITOYENNETÉ (Edited with J.- P. Michels)

John Kenneth Galbraith and the Future of Economics Edited by

Blandine Laperche and

Dimitri Uzunidis

Selection and editorial matter © Blandine Laperche and Dimitri Uzunidis 2005 Individual chapters © Contributors 2005 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published in 2005 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world. PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN-13: 978–1–4039–9616–9 ISBN-10: 1–4039–9616–4 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data John Kenneth Galbraith and the future of economics / edited by Blandine Laperche and Dimitri Uzunidis. p. cm. “Papers from the International Symposium honoring John Kenneth Galbraith held in Paris in September 2004”—Pref. Includes bibliographical references and index. ISBN 1–4039–9616–4 (cloth) 1. Galbraith, John Kenneth, 1908– 2. Economists – United States. 3. Economics. I. Galbraith, John Kenneth, 1908– II. Laperche, Blandine. III. Uzunidis, Dimitri. HB119.G33J64 2005 330.092—dc22 10 9 8 7 6 5 4 3 2 1 14 13 12 11 10 09 08 07 06 05 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

2005048689

Contents List of Figures

vii

List of Tables

viii

Acknowledgements

ix

List of Contributors

x xi

Preface by James K. Galbraith Introduction Blandine Laperche and Dimitri Uzunidis

1

Part I Back to John Kenneth Galbraith 1. Galbraith: a Partisan Appraisal James K. Galbraith 2. Where Do Galbraith’s Ideas Come From? Richard Parker 3. Galbraith and the Post Keynesians Paul Davidson 4. J.K. Galbraith: Economist of the Peace Jacques Fontanel and Fanny Coulomb 5. John Kenneth Galbraith and the Uncompleted Task of Progress Norman Birnbaum

15 25 34 40 52

Part II The Trouble with Economists and Policies 6. The Bias in Academic Economics: the Economics Salon Jeff Madrick 7. Reframing Capitalism James E. Sawyer 8. Power and Institutions in Macroeconomic Theory John Cornwall and Wendy Cornwall 9. Reinventing Fiscal Policy Philip Arestis and Malcolm Sawyer 10. Alternatives for the Policy Framework of the Euro Philip Arestis and Malcolm Sawyer 11. Promoting Growth and Welfare in a Changing Europe: Economic Analysis and Policy Jean-Luc Gaffard v

65 77 87 105 126

142

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Contents

Part III Economies in a Global Context: a Programme of Action 12. The Future of the International Financial System Paul Davidson 13. John Kenneth Galbraith and the Anatomy of Russian Capitalism Stanislav Menshikov 14. Escaping the Squeeze: Lessons from East Asia on how Middle-income Countries can Grow Faster Robert Hunter Wade 15. The Third World’s Debt Problem Kunibert Raffer 16. Global Organization and Developing Countries: Current Aspects of Neo-mercantilism and the Global Framework of Accumulation Dimitri Uzunidis Index

165 180

196 214

230

241

List of Figures 8.1 Optimizing political preferences 8.2 Alternative political preferences

vii

96 97

List of Tables 8.1 8.2 8.3 8.4 10.1 13.1 13.2 14.1 16.1 16.2

Annual average standardized unemployment rates and rates of consumer price inflation for 18 OECD countries Average days lost to strikes, per thousand workers, 1960–89 Definitions of the variables used in the unemployment equation Regression results for the reduced form unemployment equation Recent macroeconomic data for the eurozone Dynamic proportions of Russian and US economies Macroeconomic proportions in the US, 1929–99 Trade regimes, incentives to sell on domestic market or to sell abroad, developing countries around 1969 Share of manufacturing production in GDP per region, 1960–2000 Patterns of development

viii

89 94 99 100 127 188 193 201 237 239

Acknowledgements There are many people and institutions we would like to thank for their input into making this book possible. The IGS Group (Institut de Gestion Sociale) in Paris was the co-organizer with the Industry and Innovation Research Unit, University of Littoral Côte d’Opale (Lab.RII), of the first Forum The Spirit of Innovation, International Symposium John Kenneth Galbraith, in September 2004. The papers included in this volume were all presented at the conference. Our first thanks go to Roger Serre, head of the IGS Group and all the staff who took part in the organization of this conference. We are most particularly grateful to Yves Enrègle, Claude Treyer, Christine Lancesseur, Michèle Crost, François Diquero and Claire Jeuffrain. We extend our thanks to Jarlath Dillon, head of the IGS international MBA and his students for the compilation of the debates during the International Symposium John Kenneth Galbraith. Many institutions supported the organization of this event and the publication of this volume. We would like especially to thank the French Ministry of Education and Research, the National Centre for Scientific Research (CNRS), The Embassy of the United States in Paris, the French Senate, the French National Institute on Industrial Property (INPI), the French Region Nord/Pas-de-Calais Council and the University of Littoral Côte d’Opale. We offer our deep appreciation to all the members of the scientific committee of this symposium, for their help in the selection of papers, in the construction and in the publication of this book. We especially thank Philip Arestis (University of Cambridge) for his help with the publication of this book. We also express our thanks to James K. Galbraith who, from the very beginning of this project offered time, advice and help to make this event and this book possible. We also thank our colleagues of Lab.RII–ULCO, for their precious help, especially Sophie Boutillier and Clotaire Moulougui who gave us advice on the structure of the book and Jean-Claude Raibaut, who read and made important corrections on the manuscript. And finally, we warmly thank John Kenneth Galbraith who, all along the preparation of this book, gave us his moral and intellectual support.

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List of Contributors Philip Arestis is University Director of Research, Centre of Economic and Public Policy, University of Cambridge, UK, and Professor of Economics, Levy Economics Institute, USA. Norman Birnbaum is University Professor Emeritus, Georgetown University Law Center, USA. John Cornwall is Emeritus Professor of Economics at Dalhousie University, Canada. Wendy Cornwall is Emeritus Professor of Economics at Mount Saint Vincent University, Canada. Fanny Coulomb is Assistant Professor (Maître de Conférences) of Economics, University Pierre Mendès France, Grenoble, France. Paul Davidson is Editor, Journal of Post Keynesian Economics, Bernard Schwartz Center for Economic Policy Analysis, New School University, New York. Jacques Fontanel is Professor of Economics, University Pierre Mendès France, Grenoble. Jean-Luc Gaffard is Professor of Economics, University of Nice Sophia Antipolis, IUF and OFCE, France. James K. Galbraith holds the Lloyd M. Bentsen Jr Chair in Government/ Business Relations at the Lyndon B. Johnson School of Public Affairs, the University of Texas at Austin, USA. Jeff Madrick is Editor, Challenge magazine and New York Times. Stanislav Menshikov is Professor at the Central Mathematical Economics Institute of the Russian Academy of Sciences. Richard Parker is Professor in Public Policy, J.F. Kennedy School of Government, Harvard University, USA. Kunibert Raffer is Associate Professor at the Department of Economics, University of Vienna, Austria. James E. Sawyer holds the Louis B. Gaffney Chair of Arts and Sciences, Seattle University, USA. Malcolm Sawyer is Professor of Economics, University of Leeds, UK. Dimitri Uzunidis is Director of the Research Group on Industry and Innovation (Lab.RII), University of Littoral Côte d’Opale, France. Robert Hunter Wade is Professor of Political Economy, Development Studies Institute London School of Economics, UK.

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Preface James K. Galbraith

These papers from the International Symposium honouring John Kenneth Galbraith held in Paris in September 2004 are individually a fine tribute to my father, suffused in many cases with reminiscence and personal affection. But taken together, they represent considerably more than that. One might say – indeed I declare – that they signal the re-emergence of a repressed current in modern economics, that of rigorous scholarship dealing with the large social questions from an engaged point of view. What are the largest social questions? Surely they include the use and abuse of power by leaders of large countries and the executives of large corporations. These issues especially feature on the pages that follow. Surely the greatest conceits of orthodox economics lie in the implicit treatment of the state as the dispassionate instrument for the pursuit of social welfare, and of the corporation as a price-taking profit-maximizer with control neither of its market nor of its technology, which is to say without distinctive identity in the mind of the consumer. Such a view, needless to say, renders many of the most important phenomena of modern life incomprehensible, and even invisible to the trained economist. For Galbraithians, on the other hand, the purposes of any organization are its own. They are to control resources, to stabilize present and future, to provide a comfortable style of life to members, to display and to exercise power. To a degree, these purposes and the organizational structures that pursue them are unavoidable, even necessary. Galbraith was never nostalgic for the never-never-land of ahistorical models. The point was not to obliterate large organizations and market power, still less the modern state, but to make their behaviour tolerable and consonant with the larger objectives of a good society. This goal, and the design of policies to achieve it, has become the province of the truly modern economist. These papers reach for modernity in that sense. Some deal with militarism, the disease of state power. Others deal with the failure of states to pursue the directed goals of full employment with reasonable price stability, and the subordination of these goals to others – privatization, deregulation, sound finance – advanced in some cases by economists in the subtle service of vested interest. Others deal with the emerging crisis of the corporate form, which flows from the decline of countervailing power, and that is the emergence of fraud and criminality among those who control the corporation itself. Still others address the wilful detachment of right-thinking economists in today’s academy – a salon society, as Jeff Madrick styles it – truly the microcosm of the culture of contentment. xi

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Preface

Galbraith’s economics centred on the American experience in the post-war world. But he long ago recognized that the future of economics lay in a global analysis, and he contributed to this in essays on development and poverty, inspired especially by his Indian engagement. These papers advance that recognition, with special emphasis on the failures of two decades of neo-liberalism and the imperative of a new direction in world financial structure and policy. The final papers here constitute – almost – a programme of action, if not a manifesto, in this direction. As Galbraith’s own ideas spring from multiple sources, his followers are institutionalists, Keynesians, socialists, environmentalists, feminists and free-thinkers of many other types. What unites us is a will to restore to economics the purpose that it had under Marshall and Keynes but has since largely lost among the puzzle-solvers, social apologists and forecasters of the academic and business realms. We seek to revive the profession of the social scientist as social critic; incorruptible, detached from power, and yet determined to point the way toward a better world. The test of our success cannot lie in applause or access to the corridors of power, still less in immediate or early accomplishment of policy objectives. Though John Kenneth Galbraith had his measure of these, conditions have changed, and they will not be forthcoming for us, at least not soon. What we can seek is to form and to sustain an intellectual community: active, critical, productive and self-improving. That is our goal. The international symposium in Paris and these papers represent a beginning. There will be more to follow. And sooner or later, something will come of it, we believe. Austin, Texas 12 March 2005

Introduction Blandine Laperche and Dimitri Uzunidis

J.K. Galbraith often refers in his writings to Alfred Marshall’s definition of economics: the study of man in the ordinary business of life. Such an approach to economics implies taking history into account to understand current economic facts. The analysed phenomena are placed in their historical and political perspectives, embracing political interests and class relations. Moreover, macro and microeconomic levels are used to obtain a richer analysis. And finally, economics tends to appear as a whole, including many fields which are considered as being the conventional divisions and subdivisions of the discipline. Galbraith’s open-minded approach cannot be confined in a narrow school of thought. Influences are of course important, and in the case of Galbraith, the influence of Keynesian theory is the first that comes to mind. However, many other influences must be emphasized, as stressed by the authors of this book which ensues from the Forum The Spirit of Innovation, John Kenneth Galbraith International Symposium (22–25 September 2004).1

Galbraith and the spirit of economics Coming back to Galbraith’s works is useful to modern economists because economic science and research are in the grip of contradictory forces. On the one hand, is a certain self-regulated economics, disconnected from reality and based on mathematical models and applications. On the other hand, the social requirements for economic expert evaluation (economic analysis and forecasting) in an uncertain context, every day invalidates the progress of pure mathematical research applied to economics. Coming back to Galbraith’s works enables us to consider more closely the economic realities that modern economists have to face. For example, the state plays a crucial role in all industrial societies, supporting the endogenous creation of resources and markets (notably through military and civilian research and innovation programmes) but it is also at the origin of 1

2


new forms of economic conflict between North and South (for example, international treaties based on ideological considerations of ‘free trade’). The first part of the book is devoted to Galbraith’s life and writings. The authors especially focus on Galbraith’s questioning of pure competition theory. They show the transition of Galbraith from a relatively mainstream to a heterodox position, influenced by Keynesian and institutionalist economists. In the second part of the book, the authors study Galbraith’s contribution to the development of strategies for overcoming the problems which characterize the evaluation of economic policies and the solutions proposed by conventional economists. The third part of the book expands this Galbraithian spirit to the wider world. The major issues faced by national economies in the developed and the developing world are intimately linked to the creation of a global capitalism in which international agreements often dominate autonomous national regulation. Conflicting relations within and between developed nations are propagated to the Third World in shock waves or in rebounds. What are the economic and political consequences for developing countries? This book proposes answers to such issues which could shape the future of economics as well as of economies.

Back to J.K. Galbraith In the first chapter, which transcribes the inaugural address of the conference, James K. Galbraith presents a personal review of the core propositions of J.K. Galbraith’s thought. The list he proposes is not exhaustive. However, drawing on J.K. Galbraith’s major books, it captures three essential themes. The first ensues from The Great Crash (1955), which demonstrates that financial panics affect the real economy and is, according to James K. Galbraith, one of the first great works on the subtle economics of insider operations and financial fraud. The second theme, found in The Affluent Society (1958), is the logical demolition of the orthodox theory of consumer choice. The third theme is the theory of economic organization in The New Industrial State (1967). This book, explains James K. Galbraith, challenges us rigorously to contemplate what happens when power passes irrevocably to the organization. Moreover, it helps us to understand the ‘Corporate Republic’ which characterizes contemporary America. From these starting points, James K. Galbraith develops elements of his own work that can apply the larger Galbraithian spirit to a research programme. What are the principles which could place Galbraith at the starting point of the future of economics? Ten of them are analysed here, including the abolition of the micro/macro distinction, the importance given to empirical work and to the teaching of the great thinkers and the good use of mathematics. According to James K. Galbraith, pluralism is a necessity, but it needs to be combined with discipline and

Introduction

3

rigour. The task, he says, is not only to understand economics and the world that economics attempts to describe, it is also to change it: a task which is discussed in this book in many different ways. For Richard Parker,2 J.K. Galbraith’s genius lies in his understanding of the interconnection between economics, politics (including statecraft, economics and political interests, class, corporation and so on) and society. In his speech, transcribed in Chapter 2, Richard Parker asks the question: where do Galbraith’s ideas come from? It is commonplace to assume that Galbraith’s embrace of Keynesianism in the 1930s is sufficient answer. But Parker brings to light the progressive political tradition of Galbraith’s family as a patrimonial legacy underlying his thought. Parker also shows the importance of the teaching of economics in the late 1920s and early 1930s. During these years, Galbraith’s teachers (notably Leo Rogin) introduced him to early Keynesian thought and to the progressive thinking of other non-Marshallians, especially the social-historical school, later known as the first institutionalists. From these influences and his encounter with towering figures in American agricultural academics and policy (such as Howard Tolley and John D. Black), Galbraith had already assembled, according to Parker, the mental architecture and the disposition to embrace Keynesianism when it arrived in the late 1930s. It is on elements of these pre-Keynesian influences that Galbraith drew in placing his own distinct stamp on post-war Keynesian thought. But how did the neoclassical Galbraith disappear and the Keynesian Galbraith emerge? How did the Post Keynesian movement emerge? Was it in reaction to Samuelson’s neoclassical synthesis of Keynesianism? How to explain the birth of the Journal of Post Keynesian Economics? Did Galbraith play a role in this birth? Would the world be different today if Galbraith had been secretary of state during the early days of the Kennedy administration? Why has Galbraith never been awarded the Nobel Prize in economics (although he clearly deserves it)? In Chapter 3, Paul Davidson gives answers to such questions. He recalls Galbraith’s life through professional, personal and familial anecdotes, showing the importance of Galbraith’s support for Post Keynesians in encouraging the development of a separate Post Keynesian School of economics. In Chapter 4 Jacques Fontanel and Fanny Coulomb raise the issue of the place of military power in Galbraith’s work. Galbraith, as economist of the peace, denounces excessive militarism. He sees the military sector as particularly illustrative of the power of ‘technostructures’ which are partially autonomous, evading democratic control. The authors explain that Galbraith was led to develop a heterodox theory on military issues, which is profoundly original even if its sources lie in Keynesian and Marxist theories. According to Galbraith, war, or its threat, makes it possible to control the conflicting tendencies of inegalitarian countries. Moreover, military power, in developing countries, but also in developed countries, is in opposition to democracy and economic development. Even though military expenditure may exercise

4


a short-term positive influence, in the long run, it represents an economic waste which limits economic development in the poorest zones, favours the emergence of bloody conflicts and only benefits a few. This is why Galbraith pleads for disarmament and for a decrease in military aid to developing countries in favour of humanitarian and educational aid. Galbraith has indefatigably exhorted economists to study the real problems of their time, including the questions of war and military expenditure. In our attempt to understand economics, the world that economics attempts to describe and also change, this message is of the highest importance. In his contribution, which is also the last chapter (Chapter 5) of the first part of the book, Norman Birnbaum examines J.K. Galbraith’s contribution to the discussion of industrial society (in its democratic variant) in the twentieth century and asks what lessons we can draw for the next one. He recalls that according to Galbraith, in order to contain the power of concentrated financial and productive capital held in the hands of a managerial class with administrative, scientific and technical knowledge, state intervention, the intervention of public interest groups and trade unions and the development of education have major roles to play. In other words – an idea which was in high degree of consonance with other thinkers all over the world – the goals of socialism could be attained only if the managerial and scientific elite were directly controlled by society. Democracy was necessary. However, what lessons can be learned from the lack of resistance of state socialism and from the failures of the European models of social democracy? For Birnbaum, they show that Galbraith’s view of the permanence of the social democratic transformation of the political economy in an industrial society requires rethinking.

The trouble with economists and policies The contributions in Part I illustrate J.K. Galbraith’s critical thinking, which still troubles the academy of economics. In Part II, the conventional – sometimes absurd – ideas of the dominating economic paradigm are dissected in minute detail through macroeconomic analysis and the study of problems of our times. In Chapter 6, Jeff Madrick considers tendencies in the practice of economics that are the consequence of bias rather than empirical findings or theoretical breakthrough. The author argues that the profession has become like the French Salon of the nineteenth century, whose rules and edicts were designed to maintain art standards but also served to restrict and control artists. Members of the economics profession are characterized by the fact that they do economics using statistics only and fail to see people behind their models. In this chapter Jeff Madrick studies several examples of this academic bias; from Friedman’s monetarism to free trade, the problem of inflation, the neglect of public investment and of the demand-side sources of growth, to the blind faith in markets and its real application to the case of shock

Introduction

5

therapy in Russia or in the theory of corporate management in the 1990s. This list of biases, which is a tour through some of the author’s own observations over time, has stifled debate in America and has led to damaging policies. According to Madrick, it suggests a lack of courage in the professional economic community, the sort of courage Professor Galbraith has always epitomized. In the same vein, in Chapter 7, James Sawyer relies upon a method drawn from Galbraith, Gramsci and urban planners Schöm and Rein to deconstruct conventional wisdom associated with neo-liberalism. The chapter explores assumptions of order underlying the neoclassical paradigm and probes discontinuities with the way in which the world actually works. According to the author, general equilibrium obscures hoarding behaviours by rentiers or ‘pseudo-capitalists’ (defined here as rentiers who hoard assets in uses that are non-productive of the common good) who commit what Galbraith calls ‘innocent fraud’.3 According to James Sawyer, correcting egregious behaviours requires re-conceptualization of the role of the government at the national and at the global level as well as rethinking the nature of capital. For the author, in the post-industrial world, capital must be seen as a means of moving from one set of outcomes to the future attainment of a more desirable one. In a postscript written in the context of the 2004 US presidential election, James Sawyer asks for more interdisciplinary and crossdisciplinary strategies which may prove the best means within and without the American academy for deconstructing the neoclassical conventional wisdom, thereby promoting a healthy iconoclasm in the tradition of J.K. Galbraith. John Kenneth Galbraith has argued that economists have needlessly reduced the depth and relevance of their theories by neglecting to include power and institutions in their analysis as major determinants of economic performance. One of the main tasks of John Cornwall and Wendy Cornwall in Chapter 8 is to support this charge, using developments in macroeconomic theory over the past half century. They found this neglect to be highly culpable in a decline in acceptance of the kind of macroeconomics associated with Keynes’s General Theory. The second task of the chapter is to outline an extension of the Keynesian model along Galbraithian lines. This requires a reformulation of Keynes’s theory of aggregate demand to include power and institutions as determinants of aggregate demand policies. This is performed by testing the model with standard econometric techniques. Their test results provide strong evidence that the distribution of political power and the degree of trust and cooperation in labour relations are important determinants of aggregate demand policies and therefore of unemployment rates. This holds true both across the OECD economies and over a period covering the ‘Golden Age’ and the ‘Age of Decline’. Recent developments in macroeconomic policy, both in terms of theory and practice, have elevated monetary policy while fiscal policy has been

6


downgraded. Monetary policy has focused on the setting of interest rates as the key policy instrument, along with the adoption of inflation targets and the use of monetary policy to target inflation. According to Philip Arestis and Malcolm Sawyer in Chapter 9 the effectiveness of monetary policy being questionable, fiscal policy should be reinstated. This is the main focus of the chapter. The authors consider at length fiscal policy within the current ‘new consensus’ theoretical framework. They find the proposition of this thinking – that fiscal policy provides at best a limited role – unconvincing. They examine the possibility of crowding-out and the Ricardian equivalence theorem (RET). A short review of quantitative estimates of fiscal policy multipliers gives credence to their theoretical conclusions. Philip Arestis and Malcolm Sawyer’s overall conclusion is that, under specified conditions, fiscal policy is a powerful tool for macroeconomic policy. The implementation of a policy of growth requires institutions suited to the choice of the main economic measures. The economic experience of the eurozone in the first five or more years of the existence of the euro has raised serious questions about the appropriateness of the institutional and policy arrangements governing the European single currency and their ability to deal with unemployment and recession (as well as inflation). This is the central issue addressed in Chapter 10 by Philip Arestis and Malcolm Sawyer, who argue that those arrangements must be changed. The institutional arrangements are embedded in the Stability and Growth Pact (SGP) and in the monetary policy operated by the European Central Bank (ECB). The authors begin by briefly locating the key theoretical features and policy implications of the system of European Monetary Union (EMU). Then they proceed with the discussion of the SGP and ECB arrangements and describe how they have been operated since their creation in January 1999. From a criticism of the present arrangements and the underlying theoretical perspective, they shift to suggestions for fundamental changes in the institutional and policy arrangements. Such suggestions are aimed at scrapping the Stability and Growth Pact and replacing it with modes of macroeconomic coordination which do not impose deflationary tendencies on the eurozone economies. Reform of the ECB with changes in its objectives and in its mode of operation is also suggested. What is the link between institutional change and economic growth? This is the issue dealt with by Jean-Luc Gaffard in Chapter 11. The problems that are common to all European countries are the maintenance of full employment, social achievement and levels of welfare. The common solution is growth and innovation, that is, access to the most advanced technologies as the way to revamp the growth process. In order to achieve this, the prevailing consensus, derived from unfavourable comparisons with the performance of the US economy, consists in promoting the emergence of a new institutional framework and enhancing potential growth rates. This consensus is built on a theoretical framework which focuses on structural properties of the economy. It considers macroeconomic intervention to assure stability and

Introduction

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balanced public budgets as a preliminary step – once the economy is stabilized – to structural reforms aimed at favouring innovation processes. This macroeconomic stability is regarded as a set of rules or behaviours to achieve monetary stability and fiscal discipline; given once and for all, they are supposed to be efficient whatever the moment at which they are applied. However, according to Jean-Luc Gaffard, most European countries were exhibiting wild and recurrent changes in growth regimes during the last two decades of the twentieth century. Such a degree of structural instability can largely be explained by coordination failures that concern both individual behaviours and economic policy. Some crucial episodes in the growth process of the different countries presented in this chapter lend support to such conjecture. In other words, the different productivity trends in Europe and the US in the 1990s and the apparent disappearance of the productivity paradox in those years in the US confirm the scenario that focuses on coordination failures. On the one hand, the poor performance of productivity in Western Europe is the result of a reduced process of accumulation, due to tight monetary policy and more generally to a wrong policy management. On the other hand a stable and substantial rate of investment is behind the positive productivity trend in the US. Ex post, this is an obvious explanation of the difference. But behind these various accumulation processes, different coordination mechanisms have been at work, the one actually sustaining this process, the other failing to do so. Different coordination mechanisms that cannot be reduced to the properties of technology and the character of the incentive systems but that involve the harmonization over time of all the elements involved in the adjustment process. According to Gaffard, institutions matter, but the real issue is the necessarily complex set of conditions that make the process of accumulation of capital regular. This set of conditions cannot be reduced to the choice of an institutional arrangement presumed optimal with respect to the need for catching up or forging ahead. Thus, contrary to the current consensus, macroeconomic stability, far from being regarded as a precondition of growth, will result from a process that requires discretionary interventions. The rationale of such interventions is, for Jean-Luc Gaffard, quite the opposite of that presiding over the measures making up the policy consensus previously expounded.

Economies in a global context: a programme of action Is it possible to correlate the entropy which exists in economics with the great change that faces national economies in a world becoming more and more interdependent? Economic activity cannot be dissociated from the global context. Commerce, finance, information and communication technology, the weight of international organizations and war – all of which have global repercussions even when local – shape the global context in which all economic activity takes place.

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In Part III, the authors show that the troubles of economists are not unrelated to the trouble which characterizes international economic relations. The authors emphasize and open up pertinent ways of thinking and acting for the future of economies. Despite the continuing support for the ‘Washington Consensus’ within the IMF, the World Bank and the US Treasury, most astute observers of the international financial system recognize that there is something seriously wrong with the existing system. According to Paul Davidson in Chapter 12, although many recognize the symptoms of a severe malady in the system, few realize what its fundamental flaws are. Accordingly, few can prescribe the correct medicine to cure the illness or vaccine to protect the international financial system from relapse. The global economy is at a crossroads. It can try to muddle through with the existing defective international financial system while hoping that some marginal actions can quarantine the devastating depressionary forces unleashed by financial crises to developing nations and avoid contagion spilling over to developed nations. Or we can produce a new financial architecture that not only protects all nations from the devastating effects of international financial crises similar to those the world has experienced since the 1970s, but also eliminates the global depressionary pressures of the current system and therefore makes possible the potential of global full employment. This chapter is devoted to suggesting how the latter can be achieved. Paul Davidson presents the foundational elements of his clearing system proposal. According to him, a global depression should not happen again if our policymakers have sufficient vision to develop this Post Keynesian approach. In other words, this is an example of the type of courage, in the sense developed by Madrick in Chapter 6, that thinkers, but also policymakers, should have. In their book Capitalism, Communism and Coexistence (1988), J.K. Galbraith and S. Menshikov assumed that the centrally-planned economy of Russia would slowly transform into a mixed system combining competitive market mechanisms, active state intervention and a well-developed social security infrastructure. In reality, explains Stanislav Menshikov in Chapter 13, the Russian economy today is a form of oligarchic capitalism with a high degree of concentration and monopoly in most basic industries, an underdeveloped banking system, weak government stimulation of the economy and a shrinking social security infrastructure. Such a system tends to rely on excessively high profit margins, hinders technological progress, promotes inflationary pressures, creates high income inequality and mass poverty, and prevents the rise of a numerous and stable middle class. The result is an extremely narrow domestic market, excessive dependence on high-priced exports of mineral resources, decay and stagnation in manufacturing and high technology, and lop-sided and unstable growth of the economy in general. A major reason for such developments is the neo-liberal model of market reforms and running the economy that turned out to be perfectly

Introduction

9

suited to the vested interests of an extremely narrow group of oligarchic capitalists focused on fast self-enrichment. Menshikov suggests a list of reforms needed to improve the situation. They are based on institutional and evolutionary economic theory. He presents a minimum programme of measures which propose the greater role of the state to support the capitaldeficient sectors of the economy as well as sectors with a high potential for competition in foreign markets. The government sector should also act as a pioneer in breaking up monopoly behaviour in the Russian economy. Another area of alternative economic policy is the consistent improvement of macroeconomic proportion in order to attain the normal expansion of the domestic market and adequate growth rates of the economy. And in the Galbraithian spirit, the author suggests that practical considerations, and not ideologically-motivated models, should be used as the basis for economic policy decisions and long-term strategies. Institutional problems also face countries which industrialized under strong state intervention. Traditional institutions disintegrate under pressure from the global context. Middle-income countries continue to be under pressure to further open their economies to free trade and investment, to privatize state-owned assets, deregulate entry and exit to sectors, and give no preference to domestic firms over foreign firms. The pressure comes from the global economic multilaterals (especially the WTO, the IMF and the World Bank) and from the US government and the EU. This consensus is justified by the claim that these policy shifts will lead to faster rates of investment and economic growth and thence to faster rises in average living standards above the national poverty line. This can be viewed, according to Robert Wade (Chapter 14), in terms of the ascendance of a rentier-oriented form of finance capitalism, which subordinates the needs of industrial capitalism to the extraction of financial returns to the holders of financial assets, seeking the highest returns on money capital worldwide. It opens industrial capitalism’s ownership to takeover by financial groups through mergers and acquisitions. Once they dominate industrial capitalism, mergers and acquisitions, often ‘hostile’, become the central process of capital restructuring. Wade’s premise in this chapter is that the governments of middle-income countries should be cautious about embracing anything close to this kind of policy. According to the author, policymakers and policy analysts in developing countries have to reconsider the thrust towards free markets as the route to catch-up development, and then engage in a more open-minded way with the East Asian experience of the development state. Some of the roles of the state in economic development in capitalist East Asia – first in the postSecond World War decades, then in the last decade of the twentieth century – are here presented. The author emphasizes that (a) a lot of the sectoral industrial policies and programmes set in East Asia were of a rather modest kind, yet in aggregate were probably very effective in accelerating the transformation of the economy into higher value-added activities; (b) they did not require

10 John Kenneth Galbraith and the Future of Economics

sophisticated calculations and a highly skilled bureaucracy; and (c) other developing countries can and should adopt the same norms of industrial policy, even if with still more modest, blunter instruments. Moreover, there is, according to the author, a body of theory, or theoretical insights, at hand to support a strategy of governing the market in a developing country context based on ideas of economies of scale, learning-by-doing, secondmover advantages, stickiness in location decisions of transnational corporations (TNCs) and the arbitrariness of much of ‘comparative advantage’. And there is also some relevant empirical evidence, even if its conclusions about effectiveness are open to dispute – though no more so than the evidence which purports to show the fallacies of governments’ efforts to change the composition of economic activity. John Kenneth Galbraith recognized the necessity of debt relief for the Third World. Later, he criticized the delay in finding a quick and fair solution, and the sacrifices imposed on people in the Third World that would be unacceptable in industrialized countries. In Chapter 15, Kunibert Raffer presents a solution to overindebtedness that would implement Galbraith’s views quickly and easily. After sketching the evolution of debts and showing why ‘debt management’ has not worked, this chapter contrasts the proposals presently on the table. It advocates adapting the basic elements of US municipal insolvency (Chapter 9, Title 11 USC) to sovereign states. Respecting the very foundation of the rule of law an independent panel of arbitrators, not creditors, would have the authority to take decisions on debt resolution. This fair and efficient procedure promotes human rights, decent living standards, a fresh start for debtors and democratic structures, and is also in the best interests of bona fide creditors. Extending basic legal protection mechanisms beyond OECD borders it would do away with debtor control by multilateral creditors and with the unjustified privileges presently enjoyed by them. Treating sovereign debtors economically like any other debtors would again allow market risk and market incentives to work in sovereign lending, improving the allocative efficiency of international capital markets. According to J.K. Galbraith’s hypothesis of the unequal power of players, the global legal framework of accumulation is drawn up by the most powerful states. The first consequence for developing countries is the questioning of their own market organization mechanisms and socio-economic relations in order to make them compatible with international rules. The national legislation increasingly being a framework for the implementation of supranational laws, a large part of the national economy is more and more beyond government control which, in normal conditions (which is less and less possible) is democratically established in order to provide solutions to specifically national issues. In Chapter 16, following a framework discerned in J.K. Galbraith’s thinking, Dimitri Uzunidis presents the evolution of the legal framework applied to global players in order to discuss the consequences of

Introduction

11

the introduction of supranational rules in developing economies. Then, the author imagines, with Galbraith, another global organization in which institutional revival and market control are replacing liberalism, globalization and development crises. He also explains that further to the setback suffered by neo-liberal economies in the 1990s, as well as financial crises, a measured return of regulation and institutionalism seems to be taking place internationally. Can this trend be a source of optimism? According to the author, such an analysis is limited, notably in the context of the return of bilateralism in the processing of economic issues and of the attitude of the governments of many developing or industrialized countries which accept the unilateral US position. This position, inscribed in the attitude of the great power is vital for the safeguard of US military and monetary power as well as of its big firms. At the same time, it diminishes the negotiating capacity of both developed and developing countries. Faced with such a huge economic power nations will be led into the same deadlock as the implementation of the measures of the Washington Consensus, revised by international institutions.

Notes 1. The Forum The Spirit of Innovation, John Kenneth Galbraith International Symposium, took place in Paris, 22–25, September 2004. The 68 participants, from five continents, contributed to the understanding of John Kenneth Galbraith’s writings on the themes of the large corporation, the role of states in economic dynamism, the origins of innovation and growth, the link between money, finance and the real economy, and the place of war in today’s capitalism. They also focused on the specificity of John Kenneth Galbraith’s approach to economics. 2. Richard Parker has recently published John Kenneth Galbraith: His Life, His Politics, His Economics (New York: Farrar, Straus and Giroux, 2005). 3. J.K. Galbraith, The Economics of Innocent Fraud (Boston and New York: Houghton Mifflin Company, 2004).

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Part I Back to John Kenneth Galbraith


1

Galbraith: a Partisan Appraisal James K. Galbraith

Let me first read a message from my father: To all attending: Age and medical restraint firmly prevent my attendance at this the greatest tribute to my writing and my political and economic history in all time. I am indeed sorry not to be with you on what I trust will be a glowing occasion, at least to the extent that Economics and its related subject matter permit. It is my pleasure that my son James K. Galbraith will be with you and will deliver his own comment. It is my further pleasure that he has emerged as one of the more influential economists of his time. The University of Texas has long been a center of the engaging, alert, and dissident economic view. In my early academic years economic visitors from Europe had at first on their schedule the diverse interests of New York, then Harvard, and on to Austin, Texas and its different and distinguished center of economic discussion. Now a part of this community, it is my particular pleasure that the second J.K. Galbraith will be with you. Also, I hasten to add, a full delegation of economic colleagues and one-time students. Few economists have been accorded the pleasure and, indeed, the esteem of a gathering such as this. I greet and thank you, one and all. John Kenneth Galbraith Paul M. Warburg Professor of Economics Emeritus, Harvard University It is obvious, after such a greeting, that I am not going to be able to restrict myself to comments on my father’s work; I will be obliged to say a little bit on my own. John Kenneth Galbraith always loved the many sessions of exegesis devoted to his work by the Association for Evolutionary Economics, the American Agricultural Economics Association, and even by the American Economics Association on occasional better days. I’ve attended a fair number of such convocations. I could never bring myself to get quite as much enjoyment out of them as he did. 15


For there is an element of the personal in such tributes that tends to be a little overwhelming. My father is often compared to so fundamental an intellect as Thorstein Veblen, as a brilliant mind, writer and social critic. At one level, who would not be content with that? But I always thought that he deserved more – that indeed Veblen also deserves more than he characteristically gets from such comparison to Galbraith. The deficiency lies in the way they tend to be treated as economists. There is something in the appreciation of the luminous individual that speaks, also, to the dark side, that evokes the loner, the evanescent flare, the cul de sac – the man whose message came and perhaps went, while the economists moved on. It never much bothered JKG but it bothers me. For, like Veblen, Galbraith in my view deserves to be recorded as a transforming figure. Like Veblen, he offers an approach, a manner of thought, a structure – to an economics that manifestly still waits, and greatly needs, to be transformed. Here I’ll sketch a case for that proposition – and then go on to suggest how we may achieve it. What are the core propositions of Galbraith’s thought? The following list is emblematic rather than exclusive. Among other things, I do not deal here with the topics of price control and the economics of strategic bombing on which Galbraith long ago built his technical reputation. But this list, drawn from his greatest books, captures three themes that are in my view essential. 1. From The Great Crash, we have of course the conviction that financial panics affect real activity. No one in the nineteenth century or with experience of agriculture ever seriously doubted that the economy runs on credit or that real activity depends on banks. Only in the higher reaches of academic life could such a thing be denied. The denial, nevertheless, took powerful hold. The Great Crash is a wonderful corrective. It has remained continuously in print for fifty years – outselling all of Galbraith’s other books, or so I believe. Still more important than the melody are the notes. Here we have not only mass psychology and vulnerable technology – the panic that outruns the ticker, as it did again in the market break of 1987. But The Great Crash also gives us the subtle interplay of players: how National City bribed the son of Peru’s president $450,000 for the privilege of marketing a $50 million dollar loan. As Galbraith notes, ‘Juan’s services were of a rather negative sort. He was paid for not blocking the deal.’ The debts so accrued forced Peru and other countries similarly traduced to attempt export-led growth. This was blocked by rising tariffs, which precipitated default and helped to set off the panic against the banks. The Great Crash is built on such stories. Taken together, they teach us that economics, like history, is made at least in part by particular persons. This is a message that the profession has stoutly resisted, preferring always the

Galbraith: a Partisan Appraisal 17

denatured maximizing abstraction homo economicus to the flesh-and-blood of Ivar Krueger, the Match King. Krueger deserves to be mentioned today because when he shot himself, on 12 March 1932, he did so in his apartment in Paris. JKG notes that ‘with the cooperation of the Paris police, the news was withheld until the [New York] market closed … [however] the security system of the Paris police was less than perfect. It is fairly certain that there was heavy selling that morning – including heavy short selling – of Krueger and Toll by continental interests.’ The Great Crash is one of the first great works on the subtle economics of insider operations and financial fraud. But it’s not just stories. I can’t resist giving you one example of the economic method it contains: To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s businesses and banks. This inventory – perhaps it should be called the bezzle … varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed … Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks. (pp. 132–3) Though the essential precedent for this approach – generalization from example – goes back to Adam Smith, there are not many passages in economics since Smith that illuminate a new subject with such penetration. Can anyone doubt that we could do with more? 2. The Affluent Society is best remembered for its endearing, enduring phrases, above all the ‘concept of the conventional wisdom’, and for its evocative passages on private opulence and public squalor, such as the one about the ‘family which takes its mauve and cerise, air-conditioned, powersteered and power-braked automobile out for a tour [and] passes through cities that are badly paved, made hideous by litter, blighted buildings, and posts for wires that should long since have been put underground’ before going on to ‘picnic on exquisitely packaged food from a portable icebox by a polluted stream [and spending] the night at a park which is a menace to public health and morals’ (p. 253).


But it is much more than that. In The Affluent Society, we find a logical demolition of the orthodox theory of consumer choice. It proceeds from the unassailable observation that stable preferences cannot exist for goods that do not exist. The process of innovation necessarily entails the creation of markets. Thus the dependence effect: the dependence of consumption on production and not the other way around. This is, in essence, a plain-English version of the point about instability of preference fields that Philip Mirowski drove home in More Heat than Light three decades later. Enormous trouble could have been saved if the profession had taken the hint the first time. 3. Then we have the theory of economic organization in The New Industrial State. Here Galbraith built on the foundation of Berle and Means, on Joseph Schumpeter and to some extent on Max Weber, on the behavioural formalisms of Herbert A. Simon, and on his own American Capitalism of 1952 and its concept of countervailing power. But the portrait in TNIS is altogether richer, conveying understanding not only of the separation of ownership from control but also the significance of the specific bureaucratic processes that generate corporate decision-making and the interplay of company and state. In The New Industrial State, Galbraith challenges us to contemplate rigorously what happens when power passes irrevocably into the organization. He forces us to recognize that the fundamental decisionmaking process of modern economics – maximization subject to constraint – is untenable in a world of asymmetric information (as Stiglitz has taught us to call it) and negotiated decisions representing the compromised interests of established players. The New Industrial State did not anticipate later developments in many respects. The incursion of the Japanese technostructure (especially in steel and autos) into the American scene in the 1970s, eventually stabilized by market sharing deals under President Reagan, wasn’t foreseen in the book. Nor was the return to power of high finance in the 1980s, as the demolition of Bretton Woods restored the role of the banks, and as high interest rates first permitted them to rake in their gains and then, in a repeat of the early 1930s, nearly ruined them all. Galbraith also did not anticipate that part of the technostructure would spin away from the large industrial corporations in the 1990s, becoming a distinct and independently financed economic force, susceptible (as we learned) to bubble and pop. Nevertheless, The New Industrial State gives us something that nothing else at that time did: a framework for analysing all of these phenomena in complex organizational terms. This is missing from the class analysis of the Marxists, different from the macro and sectoral analyses of the Keynesians, and alien to the denatured firms and representative households of neoclassical equilibrium. And it is much closer than any of these to the actual decision-making institutions of American capitalism.


One may argue that in the new millennium the large corporation has regained its central position on the American political scene – that we live in what I’ve called the ‘Corporate Republic’. Indeed one may argue for an understanding of the present American government – the George W. Bush administration – almost precisely in terms of corporate governance as The New Industrial State teaches it to be. ●

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We have the essentially clientelist character of decision-making, unable to deliberate in an extended, goal-seeking way, because of the overriding necessity of deference to players who happen to occupy particular roles. Thus we have the capture of strategic direction – in national security, finance, regulation and other areas – by cliques who (like the technostructure) can lay claim to expertise not available to outsiders, who can manufacture bogus expertise at will, claiming the privilege of dispensing it without fear of substantial contradiction. We have the public relations apparatus with the unique characteristic of a corporate propaganda machine, namely an inability to tell a truthful story that is consistent from one day to the next. Yet like the press releases of large corporations, this apparatus nevertheless expects and receives deferential treatment from the press. Meanwhile challengers and critics are treated as the financial papers handle unionists and tort lawyers. We have the rubber-stamping ‘board of directors’, which in the modern United States we refer to by the deferential title of ‘Congress’. We have the shareholders, nominal owners and participants in occasional elections, which the management is determined never under any circumstances to lose. Above all, we have the Chief Executive Officer as specialist in public relations – the man who spends his time on the golf course (or at the ranch) in order to show that he can, in order to advertise to the world that things are under control. Or more precisely to obscure the fact that they are not.

All of these characteristics have analogues in the corporation of The New Industrial State – or would have them, in any modest updating of that analysis. And that, my friends, brings me to my principal message for the morning. If we are weary, as Veblen (1972, p. 229) wrote, of a ‘monocotyledonous wage doctrine’, and a ‘cryptogamic theory of interest, with involute, loculicidal, tomentous and moniliform variants, what is the cytoplasm, centrosome, or karyokinetic process to which we may turn, and, in which we may find surcease from the metaphysics of normality and controlling principle?’ What are we doing? What are we doing here? Are we merely paying tribute to a great thinker, a brilliant man, a political inspiration? Or are we here for a more serious purpose? Are we part of the project – advanced with force and verve under French student leadership by the Post Autistic Economics


movement in recent years – of changing the way economics conducts its affairs? And if our purpose is, as I hope, the latter, then what must we do, together, to bring this about? The answer will not be found in wit, in literary genius or political celebrity. It can only be found in research. And one thing my father did not do – one thing that he never seriously attempted – was to build a research tradition that would carry on the spirit of his work. Nor, in the struggles of his day between Marxians, Keynesians and neoclassicals would economics have permitted any such thing. But if the ideas are to survive, that task is before us now. Needless to say this is a project I’ve had in view for many years. Let me say a few words about the elements in my work that, I believe, apply the larger Galbraithian spirit to a research programme. First, I and a growing group of students have shown that the study of inequality has operated greatly below potential. The reasons lie in the preference of economists for the analyses of individuals and their characteristics, for the sample survey and the sample statistic. But inequality is everywhere and always a social characteristic. By its nature the study of inequality relates individuals to each other. The essential task is therefore to discover the predominant patterns of change in the structure of relative pay and incomes. This can be done in fine detail, using data generated by social and political processes. We have done it for the global economy, for Europe, for Russia, China, India and the United States. The result is what Walt Rostow would call ‘meso-economics’ – an economics of regions, sectors and industries. With a rich portrait of the patterns of change, one can move far beyond the brilliant insight of Galbraith’s pen, toward numerical propositions that directly confront the conventional wisdom. I’ll offer just one example. Is it the case, as so incessantly argued, that European unemployment is due to the excessive equality, the socialist legacy, of European labour markets? The answer, we have shown, is that this is not the case.1 Higher pay inequality in Europe is systematically associated with higher, not lower, unemployment. The details of the finding are for another time and place. The simple message is that the quantitative arts are not the exclusive preserve of adherents to textbook theory. A second area to which I have been more midwife than parent concerns the problems of corporate governance and what my colleague Bill Black – an economist/lawyer/criminologist with a remarkable history as a whistleblower – calls ‘control fraud’. Control fraud is that type of fraud committed by those in control. It constitutes an especially interesting problem for the economics of crime and market failure, for it is a pattern of activity that directly challenges the rubrics of ‘law and economics’ – the concepts for instance of moral hazard and market discipline. The power of Black’s approach is that it calls attention to specific characteristics of control frauds that cannot be accounted for by these ideas. It opens the way to an understanding of


corporate behaviour which combines the institutional decision-analysis of The New Industrial State – focusing in this case on the interaction of control frauds and their lawyers and accountants – with the fine personal detail reminiscent of the narrative in The Great Crash. Third, let me mention the topic on which I cut my teeth as a practitioner: the conduct of monetary policy. I’ve been working on monetary policy for about thirty years now – my longest professional preoccupation. And it is here that my approach is perhaps most directly influenced by my father, even though he cares little for the topic. For while most economists treated monetary policy analysis as substantially a matter of numerical models, I pioneered the application of hermeneutics, of text-analysis, of explication de texte as I learned it in high school in Rennes, to the topic. And I believe that this approach – the deconstruction (if you like) of official statements – has perhaps the greatest promise of transforming the conduct of policy itself. For it turns out that to central bankers, numerical models are mainly matters of rhetoric. They are not serious affairs of scientific conviction. Central bankers care little for evidence, and are insensitive to test statistics however adverse. But they are rather vulnerable to ridicule in public, which can be effected by pointing to elementary illogic in their verbal expression. The spirit of this critical approach is obviously eminently Galbraithian. The shared characteristics in these three areas of my work are community and method. These are the ingredients that are, frankly, missing in John Kenneth Galbraith’s work. They are for lesser men and women to be concerned with, to be sure. But they are also the steps we must take if we wish – as I believe we should wish – to build an enduring intellectual tradition. Let me close, then, by suggesting ten broad principles for that tradition. First, the micro/macro distinction should be abolished. It exists in principle to separate irreconcilable doctrines. The new classicals have recognized this, and have abolished macro. (As Evelyn Waugh said of Randolph Churchill’s surgeons, it was a miracle, they found the only part that was not malignant, and removed it.) We should take the opposite tack: toward a theory of human behaviour based on principles of social interaction. Second, empirical work should be privileged. Real science does not protect bad theory by concentrating on unobservables. It is, rather, a process of interaction between conjecture and evidence. Believe it or not, this could happen in economics too. Third, our economics should teach the great thinkers, notably Smith, Marx, Keynes, Veblen and Schumpeter – and naturally Galbraith. We need not reinvent the field; nor should we abandon it. The Affluent Society could never have been written without Smith, Ricardo, Marx, Schumpeter, Veblen and Keynes. Fourth, pop constructs derived from neoclassical abstractions, such as social capital, natural capital and so forth, play a useful but at best a limited role.


They are noteworthy as efforts to reconcile neoclassical ideas and policy commitments to real social problems, and their exposition helps in the formation of tactical alliances. But these constructs also extend, rather than attempt to overcome, the logical flaws and empirical difficulties of the neoclassical system. As such, they lack the essential radicalism of our approach. Fifth, nor should we accept the reconstruction of economics as an amalgam of interest-group politics, however progressive the groups may themselves be. The fact that race, gender and the environment are important social issues does not mean that economics requires a separate branch for the economics of race, another for the economics of gender and another for ‘sustainable development’. It should mean, rather, that the core of our approach should handle these questions (which relate to power, discrimination, entropy and so forth) in a way that is central to the discipline we espouse. Sixth, an economics of modern capitalism should study the actual, existing features and behaviour of our system. Households, business enterprises of all types (including some characterized by diminishing and others by increasing returns, some with monopoly power and others without), money and credit systems, governments and their budgets, and the international system are all parts of a nested, hierarchical structure of rule- and conventionsetting institutions, of interacting and sometimes conflicting sources of power. That’s our subject matter; let’s pursue it with full attention to the complexities of its structure. Seventh, mathematics should clarify the complex implications of simple constructs, not obscure simple ideas behind complex formulae. Dynamical systems, fractal geometries, cellular automata can help us to understand the principles underlying evolutionary social dynamics. They are also fascinating. They help students learn to think. We do not spurn mathematics – we object only to its use as a bludgeon, to shut off debate. Eighth, measurement matters. We should embrace the full spectrum of information sources, not merely sample surveys (with their obsessive focus on personal characteristics) and the national accounts, but also credit, trade, industrial and financial data. And we should be both creative and aggressive in linking economic measurements to other information: political events, the environment, quality of life, demography, health. Ninth, a focus on social structures and the data that record them requires new empirical methods. The study of dispersions, of inequalities, is intrinsic to the study of power. The study of power is relational, and cannot be done properly with parametric techniques held hostage to the dogma of hypothesis and test. There is no single formula for empirical learning. Numerical taxonomy, discriminant analysis, multidimensional scaling, and many other techniques are available for studying economic relations. We should use them. There are large gains to be had here, for small investments of effort.


Tenth and finally, our economics is about problems that need to be solved. There remain before us the pursuit of full employment, balanced growth, price stability, development, a sustainable standard of life. That is why students once were attracted to our field. That is why they abandon it now. That is also why, if we develop a coherent research and teaching programme that broadly respects the principles outlined above, we will prevail in the long run. I have no desire to dictate a specific course of action. Pluralism can and indeed must be combined with discipline and rigour. Others these next few days will, I hope, speak to their own innovations. I’m anxious to listen, and to learn. But let’s be conscious of two fundamental tests. One of them is well captured by a remark of Paul Samuelson’s, quoted by Richard Parker in his stunning intellectual biography of John Kenneth Galbraith. Samuelson writes: ‘In the history of ideas, the thinker who creates a new synthesis and speaks in telling fashion to a new age is the one who plays the pivotal role in history.’ Galbraith met that test and so should we. And then there is a comment by Parker himself, capturing the essence of my father’s world view. ‘The “truth”, he writes, of an economic theory ultimately lay in its success or failure when applied to policy’ (p. 564). Let’s not forget our political obligations. As Galbraithians, our task is not only to understand economics and the world that economics attempts to describe. It is also to change it. And to do so in a spirit of abiding liberalism, generosity of spirit, openness and fair play, combined always with humour and a touch of detachment. Those are my father’s enduring traits and they should also be ours. Thank you very much indeed.

Note 1. J. Galbraith and E. Garcilazo, ‘Unemployment, Inequality and the Policy of Europe, 1984–2000’, Banca Nazionale del Lavoro Quarterly Review, LVII, 228 (2004), 3–28.

References John Kenneth Galbraith, American Capitalism: the Concept of Countervailing Power (Boston: Houghton Mifflin Company, 1952). John Kenneth Galbraith, The Affluent Society (Boston: Houghton Mifflin Company, 1958). John Kenneth Galbraith, The New Industrial State (Boston: Houghton Mifflin Company, 1967). John Kenneth Galbraith, The Great Crash 1929 (Boston: Houghton Mifflin Company, 1988).

24 John Kenneth Galbraith and the Future of Economics Philip Mirowski, More Heat than Light: Nature as Social Physics, Physics as Nature’s Economics (New York: Cambridge University Press, 1989). Richard Parker, John Kenneth Galbraith: His Life, His Politics, His Economics (New York: Farrar, Straus and Giroux, 2005). Thorstein Veblen, ‘Why is Economics Not an Evolutionary Science?’ in Max Lerner (ed.), The Portable Veblen (New York: Viking, 1972).

2

Where Do Galbraith’s Ideas Come From? Richard Parker

Let me say how pleased I am to see so many Galbraith scholars from around the world here today. If I may paraphrase John F. Kennedy’s famous remark to a White House dinner honouring Nobel Laureates, ‘This is the most extraordinary collection of talent, of human intelligence, gathered in one place, with the possible exception of when John Kenneth Galbraith dined alone.’ I am deeply indebted to many of you in my own work, and I look forward to continuing the conversations several of you have already begun with me here. Finally, let me say how appropriate it is that we gather in Paris for this meeting. I can imagine no place better than the City of Lights, with its ancient heritage of intellectual rigour and engagement, style and rebellious – indeed revolutionary – élan for us to celebrate the world’s most famous living economist. John Kenneth Galbraith is a towering figure in economics (perhaps the only giant of his generation who has not yet received the Nobel Prize) – and this conference, in taking his influence and legacy seriously, in seeking both to analyse and resurrect attention to his thought, will, I believe, itself be noted by future historians as a turning point in the West’s appreciation for Galbraithian economics. It moreover seems appropriate that we meet now at what is, of course, a critical moment in more than this man’s career. In barely six weeks American voters will choose a new President and Congress, a choice that will reverberate across the world as powerfully as the choice the United States made on 8 December 1941, when – a day after Pearl Harbor – it entered World War II. On that day 64 years ago, America chose not only to go to war, but to engage the world as it never had before. Following Pearl Harbor, the world’s largest economy transformed itself into the world’s greatest military power, and projected its power across the planet, from the plains of Germany to the deserts of North Africa and the jungles of Asia and the South Pacific. What Americans did not know then – but all of us know today – is that once that choice was made, America would never again turn back from its new role of global superpower, or from using its immense military, economic, 25


political and diplomatic power to constantly reshape, for better or worse, the lives of billions of human beings around the world. Today, America believes it is once again at war, as the consequence of the events of 11 September 2001, and is in many ways as full of righteous anger in its mission as it was after Pearl Harbor, convinced that it has again been attacked without cause by evil madmen bent on the destruction of its way of life; an innocent actor in the world who has been called once again from peaceful slumber to battle against darkness in the name of both good and God. But of course America is not so simply innocent, and the unwelcome role of America as superpower to many who see the United States as a hated world changer of the lives, values and cultures of others – without seeking their opinion, assent or cooperation – is at the heart of the anger which drives Washington’s ‘terrorist’ enemies today. But why is war and global power relevant to a discussion of economics and Galbraith the economist? Because, I believe, it is in his distinctive understanding of the deep interconnections between economics as a blackboard theory of production and distribution – and the far larger world of politics and nations, of statecraft, of economic and political interests, class, corporations, lobbyists, a concentrated media, and a global citizenry educated into thinking that the particular values of a hegemonically-organized world, driven by the latest evolutionary state of capitalism, are simply normal and inescapable – that his genius lies. But where do those ideas come from? The commonplace explanation to many is that Galbraith’s embrace of Keynesianism in the 1930s, along with many young economists of that generation, is sufficient. In the cauldron of the Depression, although he was an early supporter of the New Deal, it was his reading of The General Theory in 1936, and the 1937–38 academic year he spent at Cambridge, that ever after determined the broad outlines of his thought; even if from the 1950s onward, Galbraithian economics took on distinctive characteristics that often placed him at odds with his Keynesian colleagues in the neoclassical synthesis. Lest we forget, however, John Kenneth Galbraith in three weeks will celebrate his ninety-sixth birthday, meaning that far more than any of us here, he has lived the twentieth century first-hand – and that he didn’t read The General Theory until his late twenties, which leaves open the question of what influences shaped him before then. At his birth in 1908, kings, sultans and emperors ruled most of the nations of the earth, just as they had for thousands of years, and the number of authentically democratic states could be counted on two hands – or perhaps even one. Electricity was new, the automobile was new, motion pictures and the telephone and the airplane and modern medicine were all new. The majority of the world’s citizens were illiterate, and still lived by primitive farming in many ways just as their ancestors had, not by industry. And yet

Where Do Galbraith’s Ideas Come From? 27

the seeds of today’s world – our world – were already present then: industry, technology and science were creating a new mode of production; cities were exploding in number and size, with uneasy mixtures of extreme wealth and extreme poverty side by side; and migration, mass education and mass entertainment together were giving birth to unprecedented new forms and possibilities for individual identity and community. It was a world, in short, in the throes of change – in many ways far greater changes than those of the past twenty years, when talk of post-industrialism, the new economy, and the revolutionary impact of computers, the internet, and biotechnology have been all the rage. In Europe, socialists, communists, social democrats and others were challenging unstable monarchic and halfmonarchic, half-democratic governments on the continent, while in North America, populist and progressive forces were similarly challenging the entrenched power of a new capitalist plutocracy built on unprecedented concentration of wealth and its servile allies in politics. Yet the world also then stood poised to give birth to the bloodiest, most destructive century in human history, ten decades when more than 150 million would die in wars, millions more would die in revolutions and their aftermaths, and more than a billion would die of preventable disease or malnutrition generated in large measure by the dislocations all this modern change entailed. Galbraith has written sparingly of the influences those early years of his life had on him, and yet as we understand from psychology, they inevitably exercised a powerful effect on his later thinking. The start of World War I came when Galbraith was just six years old, but by the time it ended, not only the larger world, but the intimate world he knew in tiny Iona Station, Ontario had been changed forever. Canada in 1914 had loyally sent off hundreds of thousands of her sons to fight and die in Europe, and over the next four years had suffered horrendous casualties in the process. In Ontario alone, 70,000 men, nearly a third of those who served, were killed or wounded during those four years. The war’s political effects were no less gargantuan. The Liberal Party of Sir Wilfrid Laurier – to which Galbraith’s parents had long been loyal – had broken apart during the war over the issue of conscription, as more and more Canadians came to see the insanity of ‘the war to end all wars’. In 1917, the national election – ‘the bitterest campaign in Canadian history’, as historian John English (1993, p. 194) described it – ended with one wing of the Liberals narrowly winning power in an incongruous coalition with Conservatives. For those rebellious Liberals whose candidates were defeated – including Galbraith’s parents, Archie and Kate – it was a break point in their lives. Archie joined the local draft board, not to support the war but in order to exempt as many neighbouring farm boys as possible from the slaughter. When the war ended, he then joined the new United Farmers of Ontario, a remarkable (though today little remembered) insurgent party that won control of the Ontario legislature in 1919, during one of the most rebellious


years in Canadian history, when strikes swept the country and insurrection was in the air. Galbraith was eleven, and has often recalled going out with his father to campaign for party candidates, most famously the time his father spoke in a nearby farmer’s barnyard, and climbed atop a large pile of manure, where he then began his speech by apologizing for speaking from ‘the Tory platform’. Archie’s campaigning was, of course, a lesson in the power of wit – but also indelibly about the importance of choosing sides, and in fighting for what one believed. Over the next four years, the victorious United Farmers of Ontario, in concert with their Labour Party allies, acted on their beliefs, unleashing an extraordinary torrent of progressive legislation that, as historian E.C. Drury (1966, p. 108) wrote, ‘Canada and North America had never seen, or perhaps thought possible’. Minimum wage laws for women, expanded welfare for widows and orphans, civil service pensions, workers’ compensation reforms, an overhaul of education, new taxes on corporations and utilities, new public savings banks, new credits for farmers and cooperatives, rural road and rail construction, giant public hydroelectric projects, even critical funding for medical research that led to the discovery of insulin – all these now poured forth from the UFO/Labour government. When after four years, the government fell, in a rift between its ‘dry’ farmers and ‘wet’ urban workers over the issue of Prohibition, a pall settled over the Galbraith household, made far worse for the family because that same year Kate Galbraith suddenly died. Here again, Galbraith has told us little about the effects of events in 1923, when he was fifteen, but they are not hard to imagine. His sister has said that the gloom that settled over the house during the next several years was palpable, with their father so distraught there was no Christmas tree, no Christmas presents, no celebration of any kind for two years after. Galbraith soon found his grades plunging, and eventually took five years to complete high school. Whatever the pain a child feels losing his mother, it must have been equally terrible to experience the ongoing pain of his father, who never remarried, and who only gradually recovered over several years the warm and affectionate character he had shown his children for so many years prior. I am not a psychological historian, but the impact of those early years must have been extraordinarily powerful on young Ken Galbraith’s character and imagination. He had been born into a progressive, and in many ways modern, family. His father, both in his farming practices and community service, was considered what Galbraith later called, using the vernacular of the Canadian Scots, ‘a man of standing’, someone widely respected for his views and habits by the rest of the community, and sought out for his opinion. And indeed, when Archie Galbraith died in 1938, it is testimony to that community’s respect for Archie (and not just a son’s affectionate memory) that more than 600 people turned out in the midst of a raging Canadian snowstorm in the depths of winter for his funeral. One admirer of Archie’s


was so determined to pay his respects that when his car broke down, he hired a farmer to carry him and his car on a horse-drawn sled more than six miles to reach the funeral. If Archie Galbraith and the progressive political tradition he embodied are the patrimonial legacy present in Galbraith’s thought, the teaching of economics in the late 1920s and early 1930s is the academic pre-Keynesian element of no less importance. Galbraith was first exposed to this at Berkeley, where he was first trained in academic economics. Galbraith in his memoirs makes much of his introduction to Marshall and neoclassical thought, in which he was drilled by Ewald Grether. But, because most of us are not trained in the history of our profession, his classes with teachers such as Leo Rogin and Howard Tolley are of critical importance in terms of their impact. Leo Rogin was a fairly young figure when Galbraith encountered him, only a decade or so older than most of his students, and caught up in several challenges to conventional neoclassical thought. It was he who introduced Galbraith to Keynesian thought, albeit in its pre-General Theory outlines, as well as to the generally progressive thinking of other non-Marshallians. (Paul Sweezy (see Parker, 2005) later judged Rogin to have been a ‘Marxistinfluenced’ scholar, though from my own reading of Rogin’s few published works, I think that is incorrect.) Few today, however, fully understand the role of figures such as Rogin, or realize that the history of early modern academic economics in America up to the Great Depression and Keynes is not one continuous unbroken line that ran from Smith, Ricardo and Mill through Marshall, Walras, the Austrians and Pareto, but something quite different, akin to an ongoing academic war that spanned the decades from the American Civil War up to the Depression. In this war, there were two camps, one basically Marshallian and neoclassical, and one far more ‘Galbraithian’ if you will, in its earlier form known as the social-historical school, and later, as the first institutionalists (although neither of these terms is fully satisfactory). With the publication of Marshall’s great Principles in 1890, teaching of economics in the powerful private universities of the East – Harvard, Yale, Princeton and so on – quickly found its master text. But in the public universities of the Midwest and West, in states such as Wisconsin, Texas, Washington and California, it was Richard Ely’s text that was dominant. (Indeed, as Joseph Dorfman’s history of American economics reminds us, Ely’s Outline of Economics (1926) far outsold Marshall nationally, because of the greater size of the public universities, for more than forty years after the appearance of Marshall’s text.) Ely, like most of the social-historical economists, had received his graduate training in Wilhelmine Germany, in a moment when following unification the new German state soared as an economic and political power, and not only deeply involved the state in economic development, but pioneered


(under Bismarck, ironically) the creation of the first modern welfare state. To figures like Ely, the ‘German model’ exercised magnetic attraction in confronting the massive disruptions of America’s industrialization and the Social Darwinist justifications that accompanied it. To Ely, economics was foremost a moral science, and as a Christian Socialist, he founded the American Economic Association in 1885 in the belief that economists must direct state action ‘and say what will be the consequences of such action, and whether it will be for good or evil’ (Ross, 1991, p. 408). As Mary Furner, Dorothy Ross and other historians of American economics have underscored, the split between the more conservative Marshallians and the progressive Elyites defined the young profession for decades. There were repeated purges of the progressives by university presidents and trustees, who were alarmed at the supposedly ‘socialist’ direction of this sort of economics; purges that cost hundreds, including Ely himself, their jobs – and taught a lasting lesson about the values of caution to the profession that remained. After leaving Johns Hopkins, Ely eventually found work at the University of Wisconsin, where (after an attempted purge of him there) he went on to create the so-called ‘Wisconsin School’ of economics that served as a model for engaged progressive scholarship, using his research to draft a vast array of reform-minded legislation for the progressive state governor Robert Lafollette. As late as 1919, this rift in the profession was still so large that the profession’s first great mathematical economist, Irving Fisher of Yale, made it the subject of his AEA Presidential address. Fisher, in that address, frankly described the profession as deeply riven between ‘conservatives’ and ‘radicals’, and called for a truce based on simultaneous adoption of a Marshallian theoretical approach and a highly progressive legislative agenda that included a sharply progressive income tax, a nearly one hundred per cent inheritance tax to reduce wealth inequality, and transformation of large corporations into cooperatively-owned institutions. Through teachers in Berkeley’s Economics Department such as Leo Rogin, young instructors such as Paul Taylor, and through progressive fellow graduate students such as Gregory Silvermaster and Robert Merriman (who died in the Spanish Civil War fighting for the Republic), Galbraith learned as much about this second, competing, progressive ‘camp’ in American economics as he did about Marshall at the hands of Ewald Grether. No less important, in his agricultural training at Berkeley’s Giannini Foundation, he was also introduced to the latest thinking in agricultural policy by men such as Howard Tolley. Here again we, as modern city-dwellers, know little about this germane history or the attempts of economists such as Tolley to bring the power of the state to bear on the ongoing crisis of agriculture. Yet it is also crucial in tracing out the origins of Galbraithian ideas. The Department of Agriculture in those years was the most advanced and sophisticated cabinet department in Washington, with its own degree-granting graduate school, more PhD economists than any other department, and a


robust sense of the ways in which the federal government could reinvent its 150-year-long history of engagement in land and agricultural policy to remake the world in which half of all Americans still then lived. It was under Tolley that Galbraith was introduced to issues such as the hotly-contested McNary-Haugen bill, parity, domestic allotments, and the many other ways government was capable of structurally intervening on behalf of farmers, who – though the embodiment of Marshall’s ideal small producer in a competitive world of millions of small buyers and sellers – were being driven to ruin, not prosperity, by the unfettered ‘market’. Tolley had worked for many years at the Department of Agriculture before coming to Berkeley to teach, and would return there after Roosevelt became President, rising to become head of the legendary Agricultural Adjustment Administration. It was, in short, at the hands of men such as Rogin and Tolley that a young Ken Galbraith moved beyond the powerful emotional foundations of his father’s progressive world view, and the lessons of his father’s behaviour during World War I and under the United Farmer/Labour government of the early 1920s, to a disciplined and informed academic initiation into economics as far more than conventional Marshallian thought. (And it was of course Tolley who first introduced Galbraith to public service, hiring him to work for the ‘triple A’ the summer after he graduated from Berkeley.) John D. Black is the final figure I wish to mention as seminal in shaping Galbraith’s thought before he encountered the Keynes of The General Theory. It was Tolley who recommended that Black hire Galbraith for a lowly one-year instructor’s position at Harvard that began what became Galbraith’s forty-year-long career there. And it was Black who became Galbraith’s first real mentor, a man who not only used Galbraith as an assistant, but meticulously advanced his career at Harvard in the 1930s, helped advance his career thereafter, and willingly and persistently engineered his return to Harvard in 1948. Black, like Tolley, was a towering figure in American agricultural academics and policy, who singlehandedly made urbane Harvard for a time into the second largest producer of agricultural economics PhDs in the country. His unparalleled energies, his devotion to his students, his tireless service to advancing progressive farm policies both in the 1920s and then, with far greater success, during the New Deal, marks him as a giant, now all too sadly barely known. He encouraged Galbraith not only in his farm-related research, but in much broader concerns with structural questions about price behaviour, competition, and concentration in the non-farm economy that gave Galbraith the needed preparation for usefully ‘discovering’ Keynes. (Black, it should be noted, although he had no particular interest in Keynesianism, nonetheless was the hand behind the fellowship that allowed Galbraith to go to England to study with Keynes’s key disciples in 1937–38.) Black, it should be noted, in his own progressive attitudes was deeply influenced by the training he’d received while earning his PhD at the


University of Wisconsin, where he’d studied under Richard Ely’s great ally, John R. Commons. And it was to Alvin Hansen, Black’s Harvard colleague and America’s leading academic Keynesian (and a fellow Wisconsin graduate) that Black in many ways metaphorically ‘passed on’ Galbraith after his time in England and during the war years; a period that laid the grounds for Galbraith’s completion of his anointment as a full-fledged ‘Keynesian economist’. In working through the myriad of issues associated with the Galbraithian legacy, the influence of these early pre-Keynesian figures in the formation of Galbraith’s thought should be kept in mind. Despite the pretensions of some intellectual historians, influences on the imagination of a leading figure in any field are never a matter of simple causation, of one scholar or scholarly tradition ‘determining’ the thinking of a major new figure in that field. Oftentimes, there are deeply-rooted sources for that thinking, many of them non-academic or non-intellectual, and rooted in family, in youthful associations, in the very earliest academic training which may not easily offer lines of connection to better-known later influences. From all these early influences, I believe Galbraith had assembled the mental architecture as well as the disposition to embrace Keynesianism when it arrived in the late 1930s, and more importantly that it is from elements of these pre-Keynesian influences that Galbraith drew in placing his own distinct stamp on post-war Keynesian thought; the stamp that makes his work so singular. Galbraith in many ways was educated in the broadest sense to embrace ‘the Keynesian spirit’ of generosity, of humanity, and of the essentially instrumental role of economics in achieving a post-capitalist world; in some sense, a ‘Keynesian spirit’ that is inescapable when one reads Keynes in the original but which has been obliterated by an attempt to turn the master into a gigantic machine producing state-guided growth without end, and in some more profoundly moral sense, without purpose. We owe Ken Galbraith an enormous debt for keeping alive that ‘Keynesian spirit’ by bringing to bear the full weight of his own talent – his distinct intellectual adaptation of Keynes’s ideas, his humour and his determination – in his own work. In a profession that today shows little of the confident unity of purpose that the neoclassical synthesis had fifty years ago, convinced that government could, with the aid of economists, mathematical models and computers, swiftly guide the world to a prosperous material equivalent of Fukayama’s infamous ‘End of History’, the work of the Paris conference is of manifest importance. We would do well to remind ourselves that there are great economists today who understand afresh what Galbraith has given us. Amartya Sen, asked recently to appraise Galbraithian thought (Steele, 2002, p. 6), singled out The Affluent Society as an example of the greatness of Ken’s work. The book represents, he says Galbraith’s ‘great insight’ which ‘has become so


much a part of our understanding of contemporary capitalism that we forget where it began. It’s like reading Hamlet and deciding it’s full of quotations. You realize where they come from.’

Note Let me thank Blandine Laperche, James Galbraith and the other organizers of this conference for what has already been accomplished – and what still lies ahead in the next day or two. Second, let me note what a pleasure it is to have Catherine Galbraith here. Behind every great man there is a great woman, and for those who don’t know Kitty Galbraith, let me say that her diminutive stature is deceiving; this is a woman who in character and courage stands at least six feet, nine inches tall.

References John English, The Decline of Politics: the Conservatives and the Party System, 1901–20 (Toronto: University of Toronto Press, 1993). E.C. Drury, Farmer Premier (Toronto: McClelland & Stewart, 1996). Richard Parker, John Kenneth Galbraith: His Life, His Politics, His Economics (New York: Farrar, Straus and Giroux, 2005). Richard Ely, Outlines of Economics, 4th edn (New York: Macmillan, 1926). Dorothy Ross, The Origins of American Social Science (New York: Cambridge University Press, 1991). Jonathan Steele, ‘The Guardian Profile: John Kenneth Galbraith’, Guardian, 6 April 2002, 6.

3

Galbraith and the Post Keynesians Paul Davidson

Shortly after he published his wonderfully interesting memoir A Life in our Times, Ken Galbraith sent me a copy of this book. In this copy he wrote: ‘For the Davidsons from the pre Keynesian world (and after too).’ In this book, Galbraith discusses an interesting exchange of ideas on the cause of unemployment that took place between himself and Henry Dennison in 1936. According to Galbraith, Dennison was, at the time, ‘the most interesting businessman in the United States’ (Galbraith, 1981, p. 61). Dennison believed that income from production moved into two streams. One went to people of modest income (primarily wage earners) who were likely to spend all they earned. The other stream went to the affluent and to business enterprises (profit recipients) and was likely to be saved. This view was similar to that of Kalecki. According to Galbraith, Dennison believed that the cause of the depression ‘was the nonspending of the income in the savings stream … [Dennison’s] remedy or partial remedy was to shift taxation from income that was being spent … to income on its way to being saved – from a sales tax, as one example, to the corporate or personal income tax’ (Galbraith, 1981, p. 64). (This view is in direct opposition to economists in the current Bush administration who would favour eliminating the income tax in favour of a national sales tax.) Galbraith tried to convince Dennison that unemployment was the result not of oversaving but was rather due to the fact that ‘free competition had given way to oligopoly and monopolistic competition … The shortfall in production from these defects caused the depression … The remedy was more competition.’ Galbraith wrote a lengthy paper explaining all of this to Dennison. Obviously, at this early stage of his career, Galbraith was a good neoclassical economist trapped by the teaching of his professors at Berkeley. Galbraith writes, however, that ‘In the very same weeks that I was writing my brief for my views on competition and thus refuting the errors of Dennison, I was reading The General Theory. As I did I discovered that Keynes 34

Galbraith and the Post Keynesians 35

was with Dennison and not with me’ (Galbraith, 1981, p. 65). Galbraith recognized that ‘the explanation of oversaving was much more sophisticated than Dennison’s, but in practical consequences precisely the same’ (Galbraith, 1981, p. 65). Galbraith tells the reader ‘I was shaken’ by Keynes argument. Consequently, Galbraith told Dennison that Keynes was supportive of the Dennison position rather than Galbraith’s competition versus monopoly argument. Dennison’s response to this information was simply that he was not surprised since ‘Keynes has made more sense than most economists’ (Galbraith, 1981, p. 66). Yet, Galbraith’s talent as a wordsmith extraordinaire, had made such a persuasive argument in the paper that he had given Dennison that the latter thought there might be something in the Galbraith position. Consequently, Dennison forwarded the Galbraith paper to Felix Frankfurter (then still a law professor at Harvard). Frankfurter, believing that Dennison had given him the Galbraith paper as a proposal for a book, forwarded the paper to an Oxford University Press editor. The latter accepted this ‘proposal’ and offered Galbraith a book contract. Galbraith tells us that ‘Dennison was delighted and I did not resist’ the book contract. Dennison and Galbraith collaborated on a book entitled Modern Competition and Business Policy (1938). Only an honest author like Galbraith would later write about this book ‘It is a bad book that should never been printed … But being an expression in slightly novel form of a superbly orthodox position, it attracted favorable attention’ (Galbraith, 1938, p. 66). From this anecdote about his life, what can we conclude about Ken Galbraith? First and foremost, Ken Galbraith is one of those rare specimens – an honest economist rather than an ideologue. Only such an economist can have a mind that is receptive to new ideas, theories and policy prescription as economic events unfold and as the economic system evolves. Following his recognition of Keynes’s insightful analysis, Galbraith decided to go to Cambridge to get, so to speak, infused in Keynes’s General Theory at its well-spring origin rather than from the Harvard seminars on Keynes that ‘were frequent and intense’, with a difference of views on Keynes between the younger and elder faculty members. So in September 1937, Galbraith and his new wife, Kitty, departed for England to spend the year at Cambridge University. Unfortunately, Keynes was still recovering from his heart attack and so Galbraith’s exposure to Keynesianism was left to informal discussions with Richard Kahn, Joan Robinson, Piero Sraffa, and even Michael Kalecki. Galbraith notes that the formal Cambridge lectures on money and banking by D.H. Robertson ‘were not memorable although spiced on occasion with a certain innovative meanness. Robertson, a gentle man, was deeply pained by the errors of Keynes and also possibly by his notoriety’ (Galbraith, 1981, p. 76). From this background, Galbraith indicates he ‘penetrated the thicket


of technical controversy surrounding Keynes’s work and became one of the acknowledged oracles’ (Galbraith, 1981, p. 77). So we can date the academic year 1937–38 as the point in time when the neoclassical Galbraith disappeared and the Keynesian Galbraith emerged. Galbraith returned to Harvard in September 1938. From 1935–37, a young Canadian, Robert Bryce, who had attended Keynes’s lectures at Cambridge between 1933 and 1935 was believed to be the authority on what Keynes really meant. But as Colander and Landreth pointed out in their book The Coming of Keynesianism to America (1996), Bryce’s seminars on Keynes were developed in 1935 before he had read The General Theory – for Bryce had considered Keynes’s book very difficult to understand. When Galbraith returned in 1938, he inherited Bryce’s mantle. Galbraith had at least read The General Theory – something very few American economists have ever done. At the same time as Galbraith returned to Harvard, Alvin Hansen, a recent convert to Keynesianism after being a severe critic of Keynes, joined the faculty and began giving lectures on Keynesian economics. Attending these lectures was Paul Samuelson. Hansen’s version of Keynes filtered through the ‘simple mathematics of income determination’ of Samuelson’s 45-degree cross became, as Galbraith puts it, ‘the foundation of American economic thought, policy and instruction’ (Galbraith, 1981, p. 91). As early as the 1950s, my mentor and co-founder of the Journal of Post Keynesian Economics, Sidney Weintraub was arguing that the HansenSamuelson US version as well as the Hicksian ISLM (interest-savings, liquidity preference and money supply) version of Keynes was a perversion of Keynes’s analysis. It is in fact the reaction to Samuelson’s neoclassical synthesis Keynesianism, which attempted to stitch together classical microeconomics with Keynes’s macroeconomics, that gave birth to the Post Keynesian movement. Accordingly it is interesting to speculate whether if Galbraith had remained the most esteemed Keynesian at Harvard in the 1930s, there would have been any need for a separate Post Keynesian reaction to the old Keynesianism of Samuelson, Solow, Tobin and so on. I first saw Galbraith when I was a graduate student at the University of Pennsylvania and Ken came to give a seminar on The Affluent Society. I was thoroughly enthralled with the Galbraith thesis and therefore especially amazed and dismayed at some of the hostile reaction of the older faculty members. I did not meet Ken Galbraith again until I spent the academic year of 1970–71 at Cambridge University while working on my manuscript Money and the Real World (1972). It was my good luck to find that Ken Galbraith would be spending the first two terms of the same academic year at Cambridge giving lectures on what was to become Economics and the Public Purpose (1973). Louise and I diligently attended all his lectures. By early October, I was having ‘elevenses’ and ‘tea’ with Ken, Austin Robinson and Richard Kahn on almost a weekly basis.


One incident stands out in my mind. On 27 November 1970, Kitty Galbraith came up from London. Ken invited Louise and me to have lunch with Kitty and himself. We discussed many things, even Vietnam. I remember Ken saying he would have liked to be Secretary of State during the early days of the Kennedy administration. Galbraith’s opposition to military force in Vietnam is of course well known. But it was Dean Rusk, a strong hawk on Vietnam, who was Secretary of State. An interesting exercise is to try to think how the world would be different today if Galbraith rather than Rusk had been Secretary of State during these fateful days. One final anecdote from my Cambridge period with Ken Galbraith. One day, Ken informed Louise and myself that the American Economic Association nominating committee had proposed him for the next AEA president. Since the only alternative on the ballot was for a write-in candidate, nomination is equivalent to election. Nevertheless Ken had heard that Milton Friedman was so opposed to the Galbraith nomination that people at the University of Chicago were trying to organize a write-in campaign to defeat Galbraith. Of course, Galbraith won, but this tells how fearful conservative free-market economists were of having a liberal Keynesian like Galbraith in this office. No such campaign has ever been launched against the more traditional neoclassical synthesis Keynesians. Perhaps this fear of Galbraith and his economics might help explain why he has never been awarded the Nobel Prize in Economics, although he clearly deserves it. By the early 1970s, monetarism had begun to dominate the old neoclassical synthesis Keynesianism of Samuelson and the like in the economics profession; Keynes was becoming a dirty word. Sidney Weintraub argued that the effect would be that Keynesian theory would no longer be acceptable material for publication in professional economic journals – especially those published in the United States. Accordingly, Sidney approached me regarding the start of a journal that would be open to research and debate based on Keynes’s analytical framework. Since I was, at the time, the area-wide chairperson of the economics discipline at Rutgers University, Sidney felt that I could mobilize some of the secretarial and typing resources necessary to get such a journal off the ground. What would we name this journal? Sidney thought the obvious title would be the Journal of Keynesian Economics, but when I pointed out that the acronym for this title would be JOKE, the name was quickly discarded. Accordingly we chose the name Journal of Post Keynesian Economics – the JPKE. We quickly discovered however, that the resources that I could muster at Rutgers University would not be sufficient to produce a journal that had a high-quality publishing appearance. I suggested that perhaps we merely mimeograph each issue of the JPKE and mail it off to subscribers that way. But Sidney would have none of this. He decided that we should make a list of people who we would offer to make members of the Board of Editors of the JPKE. Then we would write to these people indicating why we thought


there was a professional need for this new journal. We would ask them not only to let us use their names as members of the Board of Editors but also for a donation of at least $50 as seed money to get the journal off the ground. Our original list of potential contributors consisted of some 75 names. We hoped to get positive answers (and money) from about 25 people on the list. To our amazement 67 of the 75 names accepted our invitation and sent us cheques. Ken Galbraith contacted us and indicated that he would match dollar for dollar whatever we received from the other contributors. He only asked that we had an editorial policy where we did not wait for manuscripts to, as he put it ‘come over the transit’. Instead we should also organize symposiums on important policy matters for publication in the JPKE. We immediately accepted this idea and have tried faithfully to follow it. With the Galbraith matching grant we were almost certain we could launch the JPKE. But Galbraith ended up making another generous contribution. One late autumn day, the president of the economics graduate student association came to me with a problem he was having. The association had received a grant of $2000 from Rutgers University to pay a big-name economist to come to the university to give a public lecture. He told me that they had originally invited Milton Friedman (who had been an undergraduate at Rutgers). After some time, Friedman declined the invitation. Then he had invited Arthur F. Burns (who had been Friedman’s professor at Rutgers in the 1930s). Burns also declined. If the students did not get a big-name economist to come within the next three weeks, they would have to return the $2000 grant. The students had heard that I knew Galbraith and so they asked me to invite him. I suggested that three weeks is not a big window of opportunity for someone as well known as Galbraith. Nevertheless I would try. I phoned Ken and invited him. He indicated that his calendar was very full and he did not think he could make it. I then said to him ‘Ken if you come, I will let you donate the $2000 honorarium in addition to the matching money you had promised to start up the JPKE.’ Without a moment’s hesitation, Ken replied ‘Great! Contact my secretary and if she can possibly work out a time period in my calendar within your time constraint, I will be there.’ Within a few hours, the details had been worked out and Galbraith came within the week. He even paid his own travel expenses so that the entire $2000 could go to help launch the JPKE. With these Galbraith-augmented resources, Sidney Weintraub and I no longer had to worry about financing the JPKE and could concentrate on providing the reader with the best possible manuscripts we could get. The first issue of the JPKE contained a symposium discussing what is Post Keynesian economics. In his contribution, Galbraith wrote: ‘Post Keynesian economics, like the great Keynesian revolution of forty years ago is amendatory and not revolutionary. It holds that industrial society is in a process of continuous and organic change, that public policy must accommodate to


such change, and that by such public action performance can, in fact, be improved. Its commitment is to reformist change, not revolution, but it does not consider this commitment a slight passive thing’ (Galbraith, 1978, p. 8). In this expression, Galbraith held the torch so that Post Keynesians the world over could see their way forward. We Post Keynesians owe a considerable debt to John Kenneth Galbraith. I am proud to say he is my friend and my hero.

Note This chapter also forthcoming as P. Davidson, ‘Galbraith and the Post Keynesians’, Journal of Post Keynesian Economics, Fall 2005, vol. 28.

References D.C. Colander and H. Landreth, The Coming of Keynesianism to America (Cheltenham: Edward Elgar, 1996). P. Davidson, Money and the Real World (London: Macmillan, 1972). J. Dennison and J.K. Galbraith, Modern Competition and Business Policy (Oxford: Oxford University Press, 1938). J.K. Galbraith, Economics and the Public Purpose (Boston: Houghton Mifflin, 1973). J.K. Galbraith, ‘On Post Keynesian Economics’, Journal of Post Keynesian Economics, 1 (1978). J.K. Galbraith, A Life in our Times (Boston: Houghton Mifflin, 1981).

4

J.K. Galbraith: Economist of the Peace Jacques Fontanel and Fanny Coulomb

John Kenneth Galbraith is among the most famous economists, not only known by specialists, but also by all those who wonder about the interactions between social evolution and economic factors. He has rejected the narrow hypotheses, axioms and postulates of the dominant economic science, criticizing the too-simplifying analyses based on a supposed ideal world generating economic development and peace. Robert Eisner, former President of the American Economic Association, asked why John Kenneth Galbraith had not obtained the Nobel prize yet, answered with a smile: ‘Because he is too intelligent’.1 He then added: ‘Maybe also because he is a free, really free spirit …’ Fukayama announced the end of history at the beginning of the 1990s, but today war remains a significant presence. It has taken the shape of colonialist/ civilizing operations in Iraq, civil and ethnic conflicts in former Yugoslavia, in Rwanda and in Sudan, and of terrorist wars in developed countries. During the last two decades, a number of economists have wondered about the narrow connections between war and economy. They have notably been influenced by the pioneer analyses of J.K. Galbraith, who is a founder member of the association ECAAR (Economists Allied for Arms Reduction), which is being further developed by his son, James K. Galbraith, with a new name, EPS (Economics, Peace and Security). The association promotes peace and the struggle against poverty. It has several Nobel Laureates among its members – such as Kenneth Arrow, Douglas North, Lawrence Klein and Franco Modigliani – and other famous members include economists such as Michael Intriligator and Jeffrey Sachs. The subject of military power has an important place in Galbraith’s work. The military sector is particularly illustrative of the power of technostructures, which are partially autonomous, evading democratic control. Showing the irrationality of the arms race (and after 1991 of the maintaining of high military expenditures in industrial nations), Galbraith (1993b) pleads for disarmament and for a reduction in military aid to developing countries in favour of other kinds of aid. His analysis remains nevertheless characterized 40

J.K. Galbraith: Economist of the Peace 41

by some pessimism as to the capacity of Western systems, and particularly of America, for reform.

The denunciation of an excessive militarism Galbraith’s analysis of the technostructure within the capitalist economic system, pursued over more than thirty years, has always integrated the question of the military sector. He has repeatedly denounced the autonomization of military power and has analysed the specific economic role of defence spending. In his analysis, the excesses of militarism notably ensue from a bureaucratic shift of the economic system. Militarism, technostructure and policy of contentment In The New Industrial State (Galbraith, 1967), Galbraith explains that the large corporation depends on state support to develop the research necessary for technological innovation. Its will to control the market favours the development of a ‘technostructure’, consisting of administrators and wageearning technicians, to the detriment of the entrepreneurs’ power. The technostructure seeks the continuation of economic growth as well as the satisfaction of shareholders, in order to ensure its perpetuity. Numerous problems follow from its increasing dominance, including the progressive autonomization of military power. Galbraith develops this idea in following works, in particular in Economics and the Public Purpose (Galbraith, 1974). He explains in this book that it is the power of the technostructure (more than that of the bourgeoisie) which is reflected in the structures of the modern state. He denounces the influence of the ‘military establishment’ – the armed forces, military bureaucracy and private suppliers, in particular arms firms – in the determination of the level of military expenditure and of foreign policy. Two types of bureaucracies are concerned: one private (the technostructures of arms industries) and the other public (in the US, the Pentagon). They pursue common objectives of growth and technical innovation in a ‘bureaucratic symbiosis’. Within the military sector, the citizen has no initiative, the power is in the hands of manufacturers and armed forces (Galbraith, 1974, p. 181). In The Culture of Contentment (Galbraith, 1993a), Galbraith devotes two chapters to the issue of the ‘collusion with the military power’ of the ‘content community’.2 He denounces the propensity of American capitalism to self-destruction because of the general commitment to laissez-faire and to market freedom. The privileged act to promote their comfort and immediate interests, and without long-term objectives. Consequently they consider state intervention to be a burden and they generally defend tax reduction; regardless of any potential negative impact on industrial productivity because of an increase in the budget deficit or of short-term interest rates. Moreover, within the large corporation, the power given to shareholders


leads to dogmatic emphasis on profit maximization and to the neglect of the production side. American society suffers from a ‘bureaucratic syndrome’, in particular within large organizations, which results from the search for contentment, with the will to fight against resistances, to avoid individual mental effort and to favour a harmonious social climate. Galbraith traces the origin of the ‘culture of contentment’ back to the American victory in World War II. The superpower status of the United States then required that the country undertook large military expenditures. The consequent excessive militarism, according to Galbraith, is the partial cause of the problems affecting contemporary American society. In contrast, Germany and Japan’s post-war development focused – with a typical ambition of the defeated, developing a culture of ‘economic war’ – on economic power rather than military power. The latter is not necessary to become an important country in the hierarchy of nations. It is, on the contrary, the countries which first pursued the ‘economic war’ issue that are now among the first in international competition. So at the beginning of the 1990s, Galbraith claimed the superiority of German and Japanese capitalism,3 which gave priority to production rather than consumption. Barring important domestic upheavals, the American economy risked slow decline into grave recession. This analysis can be placed in a broader stream of economics in the 1980s (see, among others Thuröw, 1992, or Väyrynen, 1992), which demonstrated the superiority of Rhenish capitalism over Anglo-Saxon capitalism. All these works built on ideas previously developed by Veblen, although he did not present militarism as an essential characteristic of Anglo-Saxon capitalism. In Imperial Germany and the Industrial Revolution (Veblen, 1964; first published in 1915), Veblen pointed out the tendency of ‘modern’ capitalist societies of the Anglo-Saxon type to become more and more peaceful, because ‘commercial interests’ overcome ‘dynastic interests’. On the other hand, dynastic societies (as in Japan and Germany) remain characterized by specific mental habits inherited from the feudal period, during which military conflicts and mercantilist policies were essential for these systems’ survival. In the long run, the dynastic model should normally disappear and be replaced by that of modern societies.4 Galbraith’s analysis is then inserted in the institutionalist current, where it distinguishes itself by its insistence on the importance of the military sector in capitalist economic development, especially in the United States. The use of the foreign threat by the military establishment According to Galbraith, the position of the military establishment in the culture of contentment was consolidated during the Cold War by its image as a bulwark against communism, which was presented as a direct threat to this culture (Galbraith, 1993a). Underlining the excessive and unfounded character (sometimes approaching ‘paranoia’, as in the time of McCarthyism) of the fear of the USSR in the United States and in other Western industrial nations, Galbraith explains that its manipulation by the members of the


military establishment allowed the maintenance of a high level of military expenditures. Such a situation served the interests of many members of the ‘content community’, such as directors and workers in the arms industry, defence lobbies, scholars and engineers (Galbraith, 1993a, p. 125). From 1973, in Economics and the Public Purpose (Galbraith, 1974, p. 192), Galbraith warned against the idea developed by the military and the Pentagon’s analysts of insufficient military preparation; an idea with the sole aim of serving their own interests to the detriment of national economic development, and one which Galbraith further developed elsewhere, notably in The Culture of Contentment (Galbraith, 1993a, p. 124). Here, he describes the impossibility of any American politician standing up for a position apparently ‘soft on communism’, considered at this time equivalent to being ‘soft on defence’, and how this has favoured the development of defence expenditures. The military establishment was therefore able to increase its power during the Cold War and it has become autonomous, escaping democratic control. During the Cold War, Galbraith also often denounced the role of ideology in American foreign policy. The numerous American military expeditions, whose declared objective was to contain Soviet expansionism, were mainly intended to increase the power of the military establishment. Thus, during the Vietnam war, Galbraith criticized the transformation of a civil war into a conflict with a strong ideological content, whose outcome was presented as decisive for the future social structure of all humanity (Reisman, 2001, p. 62). The many military operations outside the United States during the 1980s (Lebanon, Libya, Grenada, Afghanistan or Angola) were first and foremost used to justify the importance and the power of the military establishment. Also, the increase of military expenditure in the 1980s, during the Reagan administration, answered no rational motive, such as the emergence of new military threats, but rather responded to the fears of the ‘content electorate’ (Reisman, 2001, p. 125), which served the interests of the military establishment (Galbraith, 1993a, p. 137). This renewed arms race has led to the collapse of the Soviet Union, but its objective at that time was to satisfy the needs of the military sector rather than to achieve this unexpected victory. Thus, according to Galbraith, foreign policy is an instrument in the service of bureaucracy, in particular of careers within ministries. The abolition of obligatory military service in 1973 in the United States was a spectacular result of the increasing reluctance of the middle class, marked by the culture of contentment, to accept human losses in fighting, as had been the case during the Vietnam war (Galbraith, 1993a, p. 127). However, it has not hindered the interests of the military establishment, which now recruits from more underprivileged classes. The autonomy of military power and the lack of democratic control Galbraith has criticized the autonomous power of the arms industry lobby and the fact that military power is not subject to any democratic control.


While traditional economic theory teaches that firms serve the consumer (largely ignoring monopoly situations with huge profits or bureaucratic inefficiency within organizations), Galbraith considers that it is in fact the consumer who serves firms. Through marketing and advertising, consumer needs are shaped so as to serve the objectives and financial interests of the industrialists (Galbraith, 1993a, p. 132). The study of the firm has to take into account the fact that the organization’s members may privilege stability and bureaucratic comfort and not the objective of profit maximization. In the military sector, the internal power of the establishment is particularly important (Galbraith, 1993a, p. 133). Indeed, this sector avoids the constraint of multiple consumers’ choice and of effective demand, because it is the military establishment itself which decides on what to maintain and to produce in the field of military forces, installations and production. Military industries are both the decision-makers and the producers. This idea has notably been developed in Economics and the Public Purpose (Galbraith, 1974, p. 179)5 and in The Culture of Contentment (Galbraith, 1993a, p. 134). In the latter, Galbraith explains the close relations between the military sector and the political establishment, in particular between members of parliaments and the arms firms. These firms play an important role in the financing of election campaigns; in certain regions they also have a key role in employment. The constant search for technological innovation, justified during the Cold War by the claimed necessity to remain ahead in the arms race with the Soviet Union, has led to a culture of ceaseless renewal in the arms industries. According to Galbraith, innovation in military equipment is a stratagem by which the military-industrial technostructures create the demand which meets their production (Galbraith, 1974, p. 193). The fact that the end of the Cold War has not led to a significant disarmament is testimony to the autonomy of military power. Arms exports and the development of military technologies continue to be widely financed (Galbraith, 1993a, p. 139). The stabilizing effect of military expenditures in the capitalist system Galbraith’s theory on the role of military expenditures in the capitalist mode of production is profoundly original, even if it has its source in Keynesian and Marxist theories. Keynes himself had shown that military expenditure could serve as an instrument of economic reflation, like any public spending (Coulomb, 2004, p. 166); this idea was subsequently criticized by Robinson (1973) on the grounds that the relative utility of different public spending should be considered. Following Keynes, Galbraith recognized that the defence budget of the Reagan administration had been a factor in economic growth and had offset the recessive effects of tax reduction (Galbraith, 1995). His originality with regard to the Keynesian analysis is to show that defence expenditures are very specific,


exercising an inertia effect in capitalist economies: less flexible downwards than other public expenditures in times of budget cuts, they are also less flexible upwards in times of growth and of overheating, when they increase more slowly than other public or private spending. On the other hand, in a recession, because of the inertia effects inherent in the defence sector (programmes covering several years, inflexible and substantial personnel expenditures), military expenditures exercise a stabilizing effect. They are thus presented as an important element for the stability of capitalist economic systems, and particularly of the American economy. This analysis has been confirmed by the results of several econometric analyses (Fontanel, 1995, p. 58). Galbraith’s theory may also be compared to the Marxist theory of military expenditures, notably explored by Baran and Sweezy in the 1960s. According to these American economists, in a famous analysis of ‘monopoly capital’ (Baran and Sweezy, 1966), defence spending serves to absorb the economic surplus fostered by capitalism; the arms race is then consistent with the logic of capitalism which aims, through unproductive expenditures, at maintaining a constant ratio between production and solvent demand. The surplus can be absorbed through consumption or through civilian public expenditures, but military expenditures are more effective in this role. Indeed, they do not redistribute incomes to those whose productivity is weak, but they do stimulate collective values. Disarmament is not compatible with capitalism, which favours international tensions leading to armed conflicts or increased military expenditures. Galbraith offers an alternative to the Marxist theory of military expenditures, by emphasizing the role of institutions and the autonomy of the military bureaucracy (public and private), which answers its members’ own interests. The ‘superstructures’ are autonomous with regard to the class war.

The economic and political implications of disarmament A founder member of the ECAAR, Galbraith has warned in numerous works against the economic and political risks of excessive militarization at the world level. Judge of his time, he has underlined the central role of war and of its threat in the American system, but also the wastefulness of military expenditures, which limit economic development in the poorest zones, while favouring the emergence of bloody conflicts. The impossible peace? Galbraith (1989, p. 49) has traced the central place of the military sector in the United States back to the origins of the American state, founded by merchants who applied a mercantilist policy to foreign markets (according to rules defined by Hamilton), in spite of their support for Jefferson’s liberal philosophy. The military sector’s development has allowed them to


maintain their economic and political power at the domestic level. This system, based on war and on power, has proved its efficiency since then. This thought may be linked to a study (Anonymous, 1984; first published 1967) on the utility of wars and the possibility of a demilitarization of American society. It was a secret, anonymous report that was supposed to have been drafted by a special study group. J.K. Galbraith was for a time considered to be the director of the whole report. But it is now known that he had only written a review of the report under the pseudonym, ‘Herschel McLandress’, published in the Washington Post and the Chicago Tribune. In 1972 Leonard C. Lewin revealed in the New York Times that he had written the entire report. The ostensible project was to determine the implications of a lasting international peace for American society, which was organized around preparation for imminent war. The hypothesis is made that the world is not ready to face the economic, political, sociological, cultural or ecological consequences of large-scale disarmament. What then are the real functions of war (or of its preparation) in modern societies (Anonymous, 1984)? Is the end of war compatible with social stability? According to the report, the economic effects of disarmament are difficult to evaluate and there are no viable tests of such a scenario; they do not take into account the non-military functions of war in modern societies. The fundamental misunderstanding lies in the idea that war is the continuation of diplomacy, that it is subordinated to the social system which it is supposed to defend. However, the economy’s transition towards peace is not as simple as the establishment of new procedures and organizations. War has several nonmilitary functions (Anonymous, 1984, p. 104): economic (it slows down economic progress and stabilizes stocks in surplus), political (international relations serve to divert public attention from domestic social problems, so reducing the tendency to social disintegration), sociological (war and military institutions serve to channel antisocial elements, they prevent movements of social contestation), cultural and scientific (the military sector imposes ideals and gives science the power to solve all problems) and so on. What institutions (or types of expenditures) could be substituted for the military sector? According to the report, the present system cannot disappear without causing irreparable damage unless substitutes for war are found. These should meet four main criteria. They should: ● ●

● ●

Lead to resources waste Be exerted through the normal system of supply and demand (Anonymous, 1984, p. 151) Represent an instrument of regulation of cyclic recessions Convince citizens of their legitimacy, so that objections remain slight

Social programmes (health, education, housing or transport) are only imperfect substitutes for war, as is space research, as they do not propose substitute


enemies. The proposal of a conversion of war production to civilian public works demonstrates a misunderstanding of the current economic system. The report’s methodology and arguments are linked with both Keynesian and Marxist theories. Between economics, politics and sociology, it presents military expenditures as a pillar of the capitalist system. It also shares arguments with the ‘neo-mercantilist’ current. The thesis developed in this report may be applied, at least partially, to the current military overspending of the United States, at a time when foreign threats are not very evident. We can even consider that the American government creates the conditions of conflict by increasing military expenditures in an international climate more inclined to market economic development. The wastefulness of military expenditures During the Cold War, Galbraith repeatedly stressed the wastefulness which represented the arms race between the USSR and the United States. In a speech in The Hague in 1992,6 he underlined once again the exponential growth of military expenditures since the end of the Cold War, in particular the fact that between 1960 and 1990, military expenditures had quintupled in constant dollars, while the GNP had less than doubled. Galbraith often regretted that the question of resources’ allocation for military objectives remained too little studied by economists, particularly in the United States. The argument for the superior requirements of defence was used to justify a high level of military expenditures during the Cold War, to the detriment of the struggle against poverty.7 The allocation between military and civil needs shows a failure of the democratic process in the United States (Galbraith, 1995, p. 113). The collapse of the USSR in 1991 generated great hopes for world disarmament, while some foresaw a transition towards a multipolar interdependent world. The idea that security should from now on be ensured with a minimum of weapons, on the basis of the balance of threat, no longer seemed subversive. The complete elimination of nuclear forces appeared as an essential objective of humanity. In 1999, Galbraith asserted that the existence of nuclear weapons reduced the risk of open warfare, and that the United States was particularly vulnerable, because of the high concentration of economic and financial activities in certain zones, as in New York (Galbraith, 1999). The disarmament process initiated by the major powers partially met economic considerations, the American economy being weakened by competition from the European Economic Community and Southeast Asia – its strategic allies but also trade rivals – and the countries of the former USSR being confronted with an unprecedented political, economic and social crisis. From the start, Galbraith criticized the political orientation of the reforms in these countries, which according to him were not based on a serious reflection on the development of demand or on real


liberties (Galbraith, 1993, p. 28). And yet the risk is that democracy is identified with scarcity and economic difficulties; besides, it does not represent a solution by itself. Galbraith repeated this idea several years later (Galbraith, 1999). According to him, democracy is not the necessary and sufficient condition for economic development, which will occur only if the political teams are competent, honest and concerned about the general interest. In 1993, Galbraith remained sceptical about the possibility of rapid world disarmament (Galbraith, 1993a, p. 25). But six years later, he seemed more optimistic about the possibility of limiting war, thanks to economic globalization. The situation appeared very different from that prevailing in Europe on the eve of World War I, when heavy industries were the military allies of governments and favoured nationalism (Galbraith, 1999). This reflection was prior to the attacks of 11 September 2001 and to the conflicts in Afghanistan and Iraq. It developed the arguments of French physiocrats and of British classical economists for the pacification of international relations through the development of trade interdependences (Galbraith, 1995, p. 125). Thus, Galbraith has always defended the idea of worldwide disarmament. While he underlined in his writings of the 1960s and 1970s that the military sector had contradictory economic effects, by representing both a waste and stabilizing factor, he did not consider the possibility of the positive effects of military technologies on the civil sector. Today the United States is ahead of the rest of the world in research and development and in technological potential. It is the only superpower, combining military power without rival, very advanced technological development, diplomatic and cultural force, control of international organizations and a will to domination and proselytism. If the US still appears as defender of an impartial economic free trade, its economic policy is more than ever characterized by geo-economic considerations. The level of American military expenditures shows the importance given to support of the ‘society of contentment’ in a world still stricken by the ancestral plagues of misery, lack of freedom and violence. Military power against economic development J.K. Galbraith has consistently criticized the wastefulness represented by military expenditures in developing countries. The capitalist system facilitates the emergence of an independent military power in industrial nations, but its costs in human terms are only limited compared with that of the military power in poorest countries. According to Galbraith, this diverts the correct use of scarce resources and prevents the implementation of efficient government (Galbraith, 1993a, p. 27). It inevitably leads to deprivation and economic curbs. The resource requirements of the military sector represent ‘the greatest scandal and the greatest tragedy of our time’ (Galbraith, 1993a, p. 25). If some countries partially escape this fate, elsewhere in Asia, in Africa, in Latin America, the military power has excessive influence on the government, when it is not itself the government. Besides, the question of


the arms trade has remained widely ignored by economists, as if this issue, though essential, did not exist. Arms purchases by developing countries lead to a transfer of resources towards developed exporting countries and away from the satisfaction of essential needs and they favour murderous conflicts. Galbraith has also criticized the military aid to developing countries, which has always widely exceeded the civil aid in health or education (Galbraith, 1995, p. 269); the role of free education in the process of economic development has not been enough emphasized (Galbraith, 1993a, p. 27) although there is a direct link between the education level of a population and its welfare. Galbraith has moreover observed that the strategies of indirect conflicts embarked upon by industrial nations during the Cold War aimed to minimize human losses in these countries, while generating millions of civil and military victims in developing countries, as in Vietnam or in Afghanistan (Galbraith, 1993a, pp. 26–7). By destroying the potential for economic development, conflicts also generate humanitarian disasters that result in millions more deaths. Concerning contemporary conflicts, Galbraith declared himself in 1994 in favour of the duty to interfere in case of domestic massacres, as in Somalia or in the Balkans, under the auspices of the United Nations (Galbraith, 1995, p. 270). He has on the other hand called into question the efficiency of economic weapons, in particular the international economic sanctions, which only generate a transfer of resources within the target economy and a greater sacrifice by the civil population, without achieving their political or military objectives (Galbraith, 1995, p. 155).

Conclusion J.K. Galbraith has often regretted that economic analysis was limited to the study of production and demand in very rich economies, where fundamental needs were already satisfied, without considering the recurrent problems in less wealthy nations of misery, poverty and inequalities, resulting in violence. In 1953, Eisenhower underlined the wastefulness represented by military expenditure. From the same perspective, J.K. Galbraith has indefatigably exhorted economists to study the real problems of their time, and it has led him to develop a heterodox theory on military issues. To Galbraith, war or its threat allows control of the conflicting tendencies of inegalitarian societies. Moreover, military power, in developing countries but also in developed countries, is in opposition to democracy and economic development. Its autonomous character results from the increasing power of the technostructure within industrial nations, in particular in the United States. Finally, even though military expenditures may exercise a short-term positive influence on economic growth in developed countries, in the long run, they represent an economic waste, only benefiting a few. Galbraith’s analysis of peace has remained homogeneous in all its expressions. If he recognizes the interest of a dominant power in using military


force to deter enemies, to provide a social cement that the values of individualism do still not supply, and to maintain the ‘society of contentment’, he has also condemned the non-optimal character at the world level of military expenditures and the incapacity of modern societies to give up barbaric forms of conflict, wars or the domestic oppression of citizens by armies, which may be both instruments of power and the power itself.

Notes 1. Told by Jacques Fontanel. 2. The content community is the one which takes advantage of the system and defends it. 3. Which is based on a different economic organization, at the level of production and productive methods and management. 4. However, Galbraith’s analysis is not determinist. 5. Galbraith explains that arms production decisions are made by the producing firms and the armed services, and that the President, who ratifies the measures, is a prisoner of the military bureaucracy, which is represented in Congress by the Commissions of Armed Forces. 6. International Conference of the Dutch Flemisch Economists for Peace, The Hague, Holland, May 1992. Speech translated and published by Jacques Fontanel: Galbraith, J.K. (1993), ‘Le pouvoir économique autonome’, in J. Fontanel (ed.), Economistes de la paix (with J. Tinbergen, L. Klein, J.K. Galbraith, W. Isard, S. Menshikov, K. Hartley, R. Schwartz, M. Chatterji, R. Smith) (Grenoble: Presses Universitaires de Grenoble). 7. And notably during the Vietnam war (Galbraith, 1995, p. 212).

References Anonymous, La paix indésirable, rapport sur l’utilité des guerres, préface de J.K. Galbraith (Paris: Calmann Levy, 1984) (Original title: Report from the Iron Mountain on the Possibility and Desirability of Peace, 1967). P. Baran and P. Sweezy, Monopoly Capital (New York: Monthly Review Press, 1966). F. Coulomb, Economic Theories of Peace and War (London: Routledge, 2004). J. Fontanel, Les dépenses militaires et le désarmement (Paris: Publisud, 1995). J.K. Galbraith, The New Industrial State (Harmondsworth: Penguin Books, 1967). J.K. Galbraith, La science économique et l’intérêt général (Paris: Gallimard, 1974) (Original title: Economics and the Public Purpose, 1973). J.K. Galbraith, L’économie en perspective, une histoire critique (Paris: Seuil, 1989) (Original title: A History of Economics, 1987). J.K. Galbraith, La république des satisfaits (Paris: Seuil, 1993a) (Original title: The Culture of Contentment, 1992). J.K. Galbraith, ‘Le pouvoir économique autonome’, in J. Fontanel (ed.), Economistes de la paix (Grenoble: Presses Universitaires de Grenoble, 1993b), pp. 23–8. J.K. Galbraith, Voyage dans le temps économique (Paris: Seuil, 1995) (Original title: A Journey through Economic Time. A Firsthand View, 1994). J.K. Galbraith, Pour une société meilleure. Un programme pour l’humanité (Paris: Seuil, 1995) (Original title: The Good Society: the Humane Agenda, 1996).

J.K. Galbraith: Economist of the Peace 51 J.K. Galbraith, ‘Challenges of the new millenium. Talks with Asimina Caminis’, Finance and Development, WMF, December 1999. D.A. Reisman, ‘Social Capital and Political Economy: Galbraith on States and Groups’, in M. Keaney (ed.), Economist with a Public Purpose: Essays in Honour of J.K. Galbraith (London: Routledge, 2001), pp. 51–66. J. Robinson, An Introduction to Modern Economics (London: McGraw-Hill, 1973). L. Thuröw, Head to Head: the Coming Economic Battle between Japan, Europe and America (New York: Wm Morrow and Co, 1992). R. Väyrynen, Military Industrialization and Economic Development: Theory and Historical Case Studies (Geneva: UNIDIR; Aldershot: Dartmouth, 1992). T. Veblen, Imperial Germany and the Industrial Revolution (New York: Augustus M. Kelley, 1964) (First edition: 1915).

5

John Kenneth Galbraith and the Uncompleted Task of Progress Norman Birnbaum

Academic, ambassador, author, adviser to governments and presidents, an iconic figure of American ‘liberalism’ (our own and quite authentic version of social democracy), great witness to the century, and not least, a loyal counsellor and friend to so many – John Kenneth Galbraith can look back on a marvellous life. I propose to examine his contribution to the discussion of industrial society (in its democratic variant) in the twentieth century, and to ask what lessons we can draw for the next one – in which, not entirely to our delight, we now find ourselves. Of course, Galbraith’s view of industrial society, its culture and politics, is inseparable from his Keynesian view of economics, his youth in Ontario, his experience as deputy price administrator in the Roosevelt wartime government, and his subsequent role in the Democratic Party and as Kennedy’s Ambassador to India. He grew up on a farm, and began his academic work as an agricultural economist, so he knew at first hand of the great transformation by which industrial society has assumed its current state. He was a New Dealer, which no doubt accounts in part for the fact that Kennedy thought it wiser in the end to send him across the world to New Delhi rather than invite him to the White House: Kennedy valued his judgement greatly, but often managed not to follow it. He did have the idea, originally, of appointing Galbraith as Chair of the Council of Economic Advisers, but Galbraith himself considered that his public profile (the Republicans thought of him as an enemy of the existing order) would distract from his ability to advance through Washington’s political jungle. Moreover, the responsibility for executing economic policy fell largely to the Treasury. Kennedy’s Secretary of the Treasury was a Wall Street banker who had served in Eisenhower’s cabinet as Secretary of Commerce and who repeated every banal cliché of the business and financial elite with great conviction: nothing else occurred to him. It was, surely, Galbraith’s experience of government – as well as a superior intelligence – which never led him to confuse models of reality with reality itself. He knew that economic analysis was (and is) political economy in 52

J.K. Galbraith and the Uncompleted Task of Progress 53

every sense. Much has been written of Galbraith’s increasing estrangement from the discipline of economics. As economics became ever more a matter of refined quantitative analysis, it grew remote from the substance and texture of actual social life, in which the economy was embedded. In so far as the instruments over which the quantitative economists disposed were in fact capable of describing reality, most economists put them at the service of the institutions of power. The reality they described was not economic and social order in general, but a very specific one, with privileges for some, barriers confronting others. Ideas of objectivity were illusory – even or above all when drawn from the natural sciences, the methods of which were in any case often absurdly simplified or misconstrued by the economists loudest in their claims to be following these. Many economists of the present generation believe that social expenditure ought to be cut, adhere to vulgar notions of economic motivation (in which the prosperous can only be moved by the prospect of increasing, and the bulk of the working population by decreasing income), and believe despite ample evidence of its corruption, fraud and incompetence that the private sector is invariably more productive than the public one. Perhaps it was Galbraith’s early exposure to the Calvinism of his Scots ancestors, family and neighbours that made it possible for him to recognize unshakable religious convictions when he met them. Further, he was, with increasing outspokenness, an adversary of the catastrophic assumptions of American imperialism that led his Harvard colleagues and the Democratic Party’s leaders to urge Lyndon Johnson into the swamps of Vietnam – where they abandoned him. Galbraith had worked at the end of World War II on an inquiry into the efficacy of strategic bombing of German industrial targets and had concluded that it was not responsible for winning the war by inflicting catastrophic damage upon the German war effort. Scepticism about the foresight, knowledge and intelligence of the professional leadership of American diplomacy and our armed forces was another of his traits. He was for a brief unhappy period attached to the US State Department and assigned to work on the post-war reconstruction of Germany, Italy and Japan. He was appalled when notions of international politics utterly remote from the economic and social situations of the defeated nations counted for more than historical reasoning. The temporary mastery of the world occasioned by the end of the war, he observed, had gone to the heads of diplomats and politicians who could not think ahead. When foreign policy became the preserve of bankers and lawyers who alternated between government and service to capital, his scepticism increased. To their economic cupidity they added arrogant refusal to deal with the complexity and resistance of the rest of the world. That was a seemingly inexorable derivative of their position at the top of a society whose most ordinary citizens thought of themselves as privileged to belong to ‘the greatest nation on earth’. Galbraith grew up as a Canadian in the Great


Depression, and his father was a local leader of agrarian social protest. That, and his direct experience of capitalism’s catastrophic failures gave him critical perspectives he never abandoned. One of his many virtues is that before the absurdly over-used term, globalism, was in common use he understood that the world was round. That accounted for his interest in going to India as Ambassador. As a Canadian, a subject however distant of an empire that had exhausted itself by its conquests, he was immune to the familiar argument that the US was the natural heir of Britain’s (and Europe’s) imperial responsibilities. These were responsibilities the subjected populations had not entrusted us with, and our attempt to exercise them invariably brought conflicts which our elites were unprepared to meet with anything but force. Galbraith very early sensed a contradiction painfully evident in the policies of George W. Bush. The supposedly universal appeal of an American model of society legitimated the use of force to bring recalcitrant nations to reason. If the model was so compelling, however, why was so much force required? The pathetic refrain ‘Why do they hate us?’ (much repeated in the orgy of national self-pity that followed the attack on New York on 11 September of 2001) refracted a difficulty. Public opinion could not grasp the reality of our world since opinion is formed by imperial ideologues either unable or unwilling to acknowledge that the world refuses subjugation to American power. Galbraith was dismayed when Kennedy allowed his government to push him into the humiliation that was the Bay of Pigs – despite Senator Fulbright’s impassioned warning (he was Chair of the Senate Foreign Relations Committee) that the project was disproportionate to the threat entailed in the Cuban Revolution, contravened our national ideals and would be as devastating to our prestige if it succeeded as if it failed. Galbraith, throughout his career as political counsellor and publicist, declared that military expenditures took an undue share of the American budget. He thought the Soviet military threat, and the ideological danger of Soviet Communism, grossly exaggerated by an American party, bi-partisan, which lived not for service in the Cold War apparatus but from it. Urging Kennedy and then Johnson not to be pushed into the Vietnam debacle, he appealed to a sense of proportion: the manifold foreign policy disasters predicted by Bundy, MacNamara, Rusk and others should the Communists win did not in fact occur. Re-education camps in unified Vietnam, and the struggles of the boat people to escape, were indeed horrific. Another regime, in a nation unified by negotiation, might well have been more humane – but it was precisely negotiation between the Vietnamese parties that the US blocked. The Soviet triumph in launching the first satellite to circle the globe in outer space (the Sputnik) was a shock to American national consciousness. Galbraith used the event as a cautionary tale: national strength resided in matters like an educated labour force. His adversaries, however, used it to argue for still more military competition. Galbraith was enthusiastic, however,


when in his address at American University on 10 June 1963 Kennedy proposed a truce in which to negotiate an end to the Cold War. The speech was received by American opinion with some hostility and much indifference. Whether it was a factor in inciting a group or groups as yet unidentified to murder the President six months later remains an unanswered question. That speech, and with it the entire set of arguments for coexistence advanced by critics of national mobilization for confrontation with China and the USSR and ‘Communism’, are strikingly contemporary. The new Cold War is termed ‘the war on terror’ and frequently uses the imagery of the preceding campaign to instil anxiety and obedience in the American public. ‘Experts’ on the Soviet Union (mostly devoid of knowledge of the history of Russia or anything else) have been replaced by ‘experts’ on ‘rogue states’, ‘terror’ or ‘Islamic totalitarianism’, few of whom actually have read the Koran in Arabic. The career of our Secretary of State, Dr Rice, is in this respect exemplary: a scrutiny of her writings will show no cliché left unused – and no position ever taken uncongenial to those in power. About all of these matters, Galbraith was right. His persistent criticism of ‘military Keynesianism’ showed how aware he has been of the economic impact of the American imperial commitment. Could he have integrated his analysis of the political economy of the nation more closely with his relentless scepticism about the working of the imperial state? To a large extent, that scepticism suffuses much of his writing. The United States was not a society which, incidentally, conquered a continent and then found itself constrained to exercise world power. At the beginning of the twentieth century the historian Frederick Jackson Turner declared that the closing of the frontier would result in the end of the possibility of escape for surplus labour (to untilled lands). Now the US would be unable to escape the weight of its own inequalities and social conflicts. Those conflicts did increase, and some of Turner’s contemporaries and successors (the historians Charles Beard in the older generation and William Appleman Williams in a more recent one) argued that it was precisely to deal with class conflict that a new American empire was imagined – and then achieved. The recent shorthand for the relationship of empire to class society is the term, ‘the warfare-welfare state’. When we consider the large support for the most aggressive and unremitting of Cold War policies given by presidents of the central trade union organization, the American Federation of Labor–Congress of Industrial Organizations, the phrase is compelling. True, two of the recent presidents, George Meany and Lane Kirkland, were succeeded by the present incumbent, John Sweeney, who has more open doubts about the integration of the working class (and the trade unions, whose numerical and political decline continues) in the imperial system. The union movement, however, has not as such opposed the Bush foreign policy and as the 2004 election made clear, has been unable to convince those workers not in trade unions that it is in their interest to oppose that policy.


The American economy is part of an imperial polity and an imperial structure. The Bretton Woods agreements for the control of the international economy legitimated and provided mechanisms for the American economic predominance made possible by the nation’s huge accumulation of productive resources and wealth during the war. Predominance was reinforced by military power and by political power in the form of covert and overt interventions in the politics of other nations, including allied ones. Great Britain exhausted its holdings of overseas capital during the war and was reduced to debtor status vis-à-vis the United States. The American capitalist elite recognized the indispensability of Great Britain as a military ally in Europe and elsewhere, but was distinctly unforthcoming as regards support for two post-war governments (the Labour governments of 1945–50 and 1950–51) struggling with penury. In Germany, the US blocked the nationalization of parts of the economy in the western zones and had to tolerate the (slow) extension of the Bismarckian welfare state by the Christian parties to obtain German agreement to rearmament. In some sense, the American ‘warfarewelfare’ state was exported to its major European satellite state, the early Federal German Republic. Galbraith’s view of industrial society was presented in three books, American Capitalism: the Concept of Countervailing Power (1952), The Affluent Society (1958) and The New Industrial State (1967). There are differences of emphasis in the texts, but a coherent view unites the three. Galbraith argues that the power of concentrated financial and productive capital can be contained, because organized capital requires an indispensable set of state functions if it is to endure. These include regulatory intervention to organize markets, the centralization of ultimate decision-making in regard to interest rates and monetary aggregates and the provision of public goods (cultural, educational, and scientific facilities, infrastructure in housing and transport, and the protection of the biosphere through health care and environmental policy). Political democracy cannot function without the extension of citizenship to the economic sphere, the ideological precondition for the activity of political leaders and civil servants resistant to ever present opportunities to go on capital’s payroll. A complication is presented by the notion of technostructure introduced in The New Industrial State. Following a half century of familiar argument on the bureaucratization of control of the means of production, Galbraith sketched the consolidation of power in industrial societies by a managerial class equipped with administrative, scientific and technical knowledge. Rising levels of education, he declared, and the intervention of public interest groups and trade unions – borrowing from the first of the books – would enable democratic publics to avoid losing their sovereignty to the ostensible masters of the technostructure. The whole, then, presupposed a very high level, qualitatively and quantitatively, of participation in civic life. That is what Galbraith saw as the task of the Democratic Party, and he recognized


that its international allies were to be found in much of the social Christian spectrum, as well as in the parties of the Third International – and in the developmental projects of Congress in India and similar movements and parties elsewhere in the Third World. There was a high degree of consonance between Galbraith’s views and the depictions of industrial society by Raymond Aron, Georges Friedmann, and the younger thinkers like Jacques Delors and Alain Touraine (and Michel Rocard) in France. Similar views were expressed in the United Kingdom by Anthony Crosland, T.H. Marshall and (revising his earlier views) John Strachey. In Germany, Ralf Dahrendorf, Theodor Eschenburg and Helmut Schelsky (as well as lawyers in politics like Fritz Erler and Horst Ehmke) spoke in the same idiom. Alessandro Pizzorno and Paolo Silvos-Labini (and the political philosopher Norberto Bobbio) came to the same conclusions in Italy, as a Communist Party led by intellectuals secularized Marxism. Alva and Gunnar Myrdal presented the same general view in Sweden. Behind the Iron Curtain, the research group of the Czech Academy of Sciences which under Radovan Richta produced a report on science, technology and society, Julian Hochfeld, Jan Szecpanski and any number of Polish sociologists and Andrei Sakharov and a cautious but decidedly undogmatic group at the Soviet Academy of Sciences and in various Soviet institutes drew upon their anti-Stalinism to make a circuitous journey to the same conclusions. They argued that the technostructure inevitably transferred power from the ruling party, which could not control it, to the managerial and scientific elite: it followed that the goals of socialism could be attained only if that elite were directly controlled by the society – in other words, democracy was necessary. Galbraith was so convinced that an advanced moral and political equilibrium had been achieved in western societies, at least, that he did not object to the remarkable complacency of Kennedy’s declaration in his Yale speech of 1962 that our economic and social problems were now mainly technical. It followed that publics would be wise to listen to those who mastered technical argument, that is, to the sorts of persons who constituted the Kennedy government. I’m reminded of the remark by Christopher Lasch to the effect that the Kennedy White House was a fusion of café society and Route 128 (the highway around Boston favoured by technological entrpreneurs and their professorial partners from the Massachusetts Institute of Technology as a site for their firms). What has happened? Unregulated capitalism has for the time being returned, if anything in a more brutal form since the three twentiethcentury alternatives to it (state socialism, western social democracy, and Third World fusions of indigenous cultural ethos with Marxism) have been so unresistant. Let us begin with state socialism. The reformers in the Soviet bloc did think that their historical turn had arrived with Gorbachev. There was an appreciable amount of activity by civil society in the USSR in the years


following Stalin’s death, some of it repressed, some of it in the form of inner party debate around the work of the research institutes, some of it reaching the public. Whatever chance the enlightened Soviet technocrats had of initiating a democratic reform of their society, we can now say, was destroyed by the very pathology they sought to overcome: the absence of participatory institutions and an active public sphere. It was fear that these would develop that led the party conspirators and the military to attempt to overthrow Gorbachev. Into the vacuum not filled by Yeltsin’s ambiguous attempt to construct a new legitimacy, two forces rushed. One was nationalism, not only the nationalism of the separate republics but Great Russian nationalism in a virulent form. The other was the unrestrained acquisitiveness of a segment of the Soviet managerial elite, joined to the piratical talents of homines novi collaborating with international capitalism. The thousands of Gorbachev supporters in the old Soviet technostructure had very little political capacity of their own and in the end their resistance was feeble or null. The US in particular is now loud in its injunctions to the Russian government to limit its obvious authoritarianism – but that authoritarianism is a political response to the limitless rapacity encouraged by the American official sponsors of the new Russian capitalism. The society in the Soviet bloc in which the transition to a post-Communist order has been accompanied by the retention of a considerable amount of social decency is Poland. It, however, since 1956 was ruled by a CatholicCommunist alliance. In Solidarnosc, the working class was allied to the creative and technical intelligentsia. Poland in terms of cultural and economic exchange, opportunities to travel, and a semi-independent foreign policy was in any case far more open to the rest of the world than was the USSR before Gorbachev. The contrast between Poland and Russia suggests that not only the general political culture of a society but the specific social alliances of the managers and workers of the technostructure are important determinants of their political choices. The case of China confirms our sense of the limits and specificity of the autonomy of the technostructure. The creative and technical intelligentsia in China were traditionally champions of the rights of peasants and workers. That is why so many of them considered the Communist state the legitimate successor to Sun Yat-Sen’s republic. The leadership of the Chinese Communist Party can claim to have made an original contribution to social history, by encouraging (and indeed participating in) an unprecedented extraction of surplus value from the population while using Communist rhetoric. The rhetoric has appreciably diminished in recent decades, and the Communist state justifies its existence, its powers, its repressiveness, by describing itself as the guardian of the national interest as against the conflict and fragmentation intrinsic to capitalist development. The millions working in the technostructure have been corrupted or cowed. It is not much consolation for those who expected


better of the Chinese Revolution to say that contemporary China is a conspicuous refutation of the absurd assertion of a necessary connection between capitalism and democracy. What of the resistance to a renewed unleashing of capital in the western social democracies? Unless and until the United States abandons universal health insurance for those over sixty-five years of age (Medicare) and universal old-age pensions, disability payments to those unable to work and support for the survivors of those who die during employment (Social Security) it can claim to be residually social democratic. That is what troubles the present President, but his offensive against Social Security (in the guise of a project to privatize it in part) has incurred a good deal of resistance. That much of the rest of the New Deal legacy, and that of the New Dealer Lyndon Johnson’s great successor project, the Great Society, has been either destroyed or is marked for liquidation by the party of the market, to which the Democrats seem incapable of consistent and vigorous resistance, is hardly a recent phenomenon. The critical American phenomenon (and seen as such by Galbraith in his subsequent works, Economics and the Public Purpose, 1973, and The Culture of Contentment, 1992) is the systematic decomposition of the idea and practice of solidarity. The development of this amoral sentiment has been accompanied by the increasing inability of American citizens to imagine that the world being the way it is, it could be otherwise. To evoke that possibility, for millions of Americans, is to remind them that they count for very little in the eyes of the elite – a perception usually strenuously denied. During the Great Depression, those in the not inconsiderable technostructure of the time were either themselves economically exploited or threatened or moved to participate on moral grounds in the adventures of social reform. If, however, the very existence of alternatives is denied, the morality of solidarity appears frivolous and in any case politically irrelevant. That the counter-offensive of capital has altered the doctrines and practical engagements of a majority of economists is for Galbraith an obvious source of regret – no, sorrow. Here, what we can say is that the availability of the economists for service to American capital suggests that whatever the technostructure may generate, it does not by itself produce disinterested citizens and professionals committed to the public good. It is not only in the old Soviet Union or in the US that these negative developments have disappointed the hopes expressed by Galbraith. That the US has a political culture consisting primarily of individualism is an untruth, compounding historical error and market ideology. Ever since the American Revolution, the nation has been marked by eruptions of large and powerful social movements. The Revolution itself entailed several – and a civil war fought against the third of the population of the thirteen original colonies loyal to the Crown. That much said, the Europeans are the heirs of 1641, 1789 and 1917. The European welfare states are results of the struggles of liberals, social Christians and socialists (of all kinds) to extend the scope of


citizenship and limit the sovereignty of the market. Moreover (even in the United Kingdom with its Civil Service tradition) the European intelligentsia has a tradition of state service, of commitment to the public realm, far older than the twentieth-century approximation of it achieved in the US. In the circumstances, present developments in Western Europe, especially, are striking. A considerable segment of the intelligentsia, working in the technostructure of their societies, has resigned itself to a substantial reduction in the European welfare state. This is not taking place without argument, and indeed severe resistance, as the conflict over the structure and substance of the European Union and its proposed Constitution shows. The struggle is joined, in pervasive if complex ways, to the European effort to resist the claims of the US to global leadership. Those who think like Galbraith in the US, advocates of an American version of social democracy, can no longer be sure that whatever happens to us, the European social model will persist in its distinctive form. There are in Europe much higher rates of political participation than in the US, and immense amounts of unease in many sectors of European society over the consequences of the re-institutionalization of the market, the renewed commodification of entire areas of culture. Still, the party of global capitalism has cause to congratulate itself, not least on an achievement Orwell might well have recognized: measures reducing or terminating social protection and the regulation of the economy are termed ‘reform’. Galbraith’s instinct, in 1961, to go to India as Ambassador may have been prophetic. Many of the nations once thought of as underdeveloped (especially in Asia) have experienced large increments in national wealth – distributed, usually, in ways which resemble the savage inequalities of the beginnings of industrial capitalism in Europe and the US in the nineteenth century. Meanwhile, economies then held to be irremediably stagnant in Latin America have had similar transformations. A major source of irregularity in growth and domestic social crisis in these nations has been the ebb and flow of capital from Europe and the US, and the interventions of the IMF. No general characterization of what was once the capitalist periphery is possible: cultures and histories are too diverse. It remains to be seen if, for instance, the bloc being formed by Brazil, Chile, Argentinia, Uruguay and Venezuela will constitute a different version of social democracy. For the moment, as alternative sites of production with cheap labour – and not, as previously, only suppliers of cheap commodities and purchasers of manufactured goods – the nations once on the periphery are now central to the fate of capitalism and democracy. It may be possible that critical contemporaries of Galbraith (Paul Baran and Paul Sweezy, C. Wright Mills and Herbert Marcuse) were right on two counts. (1) The institutions constructed by the Atlantic social democrats and social Christians to control and domesticate class conflict had insufficient powers of resistance when capital launched an offensive to destroy them.


(2) The control by capital of culture (the media in its assiduous and more or less successful attempts to cretinize large segments of the western publics, and the academic systems in their production of a generation or two of dutiful conformists) has attenuated and deformed the consolidation of democracy. A public sovereign and able to think for itself is wanting. Galbraith, like Adam Smith and Keynes before him, had philosophical presuppositions – an idea of progress, incarnated in an educated citizenry capable of assuming command, by instructing politicians and public servants of their duty to the larger public good, of the destiny of their nations. The new internationalization of capital, its capacity to escape the restraints once imposed by the social consensus in the advanced industrial democracies, has ended that consensus. Galbraith’s view of the permanence of the social democratic transformation of political economy in industrial society requires rethinking. That Galbraith is still doing a considerable amount of that is what we should expect. The earlier achievement, meanwhile, set for us all standards of intellectual probity and political independence we would do well to emulate.

Bibliography Ad Hoc Committee on the Triple Revolution, The Triple Revolution (Washington: The Committee, 1964). R. Aron, Eighteen Lectures on Industrial Society (London: Weidenfeld and Nicolson, 1967). P. Baran and P. Sweezy, Monopoly Capital (New York: Monthly Review Press, 1966). D. Bell, The Coming of Post-Industrial Society (New York: Basic Books, 1973). N. Birnbaum, After Progress (New York: Oxford University Press, 2001). W. Brandt and the Independent Commission on International Development Issues, North-South, a Program for Survival (Cambridge, Massachusetts: MIT Press, 1980). A. Crosland, The Future of Socialism (London: Jonathan Cape, 1956). A. Gorz, Strategy for Labor (Boston: Beacon Press, 1968). M. Lewin, The Gorbachev Phenomenon (Berkeley: University of California Press, 1988). S. Mallet, The New Working Class (Nottingham: Bertrand Russell Peace Foundation for Spokesman Books, 1975). H. Marcuse, One Dimensional Man (Boston: Beacon Press, 1964). C.W. Mills, White Collar (New York: Oxford University Press, 1951). G. Myrdal, Beyond the Welfare State (New Haven: Yale University Press, 1960). R. Richta, La Civilisation au Carrefour (Paris: Editions Anthropos, 1969). A. Sakharov, Progress, Coexistence, and Intellectual Freedom (New York: Norton, 1968). Alain Touraine, Post-Industrial Society (New York: Random House, 1971). I. Wallerstein, The End of the World as we Know it (Minneapolis: University of Minnesota Press, 1999).


Part II The Trouble with Economists and Policies


6

The Bias in Academic Economics: the Economics Salon Jeff Madrick

What has always impressed me most about John Kenneth Galbraith has been his intellectual courage. Even when government was more or less in fashion in the 1960s, Professor Galbraith stood apart. His iconoclastic advice to John Kennedy on Vietnam is well known. His refusal to endorse the famed Kennedy/Johnson tax cut was probably shared by some of his colleagues, but few on the inside, as he was, said it out loud. Galbraith correctly wanted more spending on public goods. The nation chose to reorient the debate towards something abstract, technical, and more palatable. Economic growth through fiscal stimulus would solve the nation’s problems. Galbraith knew that growth was imperative, but it was not enough. When government became unfashionable, Professor Galbraith did not change. The profession bent with the times; Galbraith did not. He has been fearless in standing apart from his colleagues, as well as against wealthy financial and powerful political interests, in the pursuit and propagation of his economic views. The history of Galbraith’s iconoclasm should be a lesson in the sociology of knowledge for all of us. As Americans have turned more conservative politically in recent decades, Galbraith has remained a stalwart believer in the importance of public goods, the undue influence of Wall Street interests, the limits of markets, and the peculiar and growing insularity of much of the economics profession. In this spirit, I wanted to present briefly from an American economic writer’s point of view tendencies in the practice of economics that I believe are largely the consequence of bias rather than empirical findings or theoretical breakthroughs. I think the profession has become all too comfortable with powerful interests. Money is more important even at the university these days. This may be the principal explanation for what I perceive as blatant bias in the profession. Business supplies grants and research monies; they supply consultancies and outright jobs. Or maybe, and more kindly, economists are going with the fashion of the moment. But the sociology of economics goes beyond this, and I have a hard time understanding this fully. For me the profession has become, to choose a Parisian analogy, something 65


like the artist’s Salon of the nineteenth century. Rules were established allegedly to maintain art standards, but arguably and perhaps more importantly also to keep this fraternity of chosen French artists restricted and controlled. You had to be talented to get into the Salon, yes, but you also had to paint by the rules – and that often precluded the best and over-represented those who either were comfortable with rules or were so ambitious they did not care. To some critics, the art produced, with exceptions, eventually became something like painting by numbers. Those who could see anew – Manet, Monet, Cezanne and so on – refused to paint by these rules. Critics eventually realized these revolutionaries and iconoclasts saw far more clearly and painted more beautifully than most of their Salon brethren. Too much of the most prestigious of economics academia today is like the French Salon of the nineteenth century. They paint by numbers and no longer can see. That is, they do economics by statistics only and fail to see the people behind their models. But this is not universally true and the barriers have been falling for a while. Many economists participate in breaking down the economics Salon; but the issue will be considered later. First, I will trace a few areas briefly and impressionistically in which I think bias has been palpable, and an alleged scientific method, rather than exalted, has been bent to a less than worthy purpose. 1. For me, the most important of the turning points in public policy economics were the debates between advocates of American Keynesianism and those of Friedmanite monetarism during the 1970s. The story of Milton Friedman’s ascent is fascinating. It began more or less in 1953, when he published his first essays on positive economics. The most important of them held that an economic model’s assumptions need not be realistic. No matter that consumers in interviews, for example, might suggest a certain amount of irrationality in their purchasing decisions. What matters is that the outcomes of the economic model conform to what actually happened in the real world. Ultimately, we may not know exactly how changes in the supply of money affect nominal GDP, for example, but empirical evidence, Friedman argued, shows that they do. Friedman’s best work is probably not his monetarism, which argued that the Federal Reserve should only maintain a stable rate of growth of money. Rather, many agree, it was his work on the long-term nature of the consumption function, which had a strong and fairly objective empirical underpinning. But his greater fame depended on his 1968 talk to the American Economic Association about what became known as the natural rate of unemployment. He summarizes his views articulately, as usual, in his Nobel lecture. What I am concerned with here is why the views that had less empirical substantiation – the monetary rules and the natural rate – nevertheless caught on.

The Bias in Academic Economics: the Economics Salon 67

Let us return first to his monetarism by rule. The great irony is that Friedman’s version of monetarism caught on as a policy tool in the 1970s. At that very point, the empirical relationship with money and GDP, as dubious as I think it always was, broke down. A piece by Goldfield et al. in the Brookings Papers as early as 1976 clearly showed that money failed to predict nominal GDP as Friedman and Schwartz (1963) suggested it would – and failed by a wide margin. Later in the 1970s, Alan Blinder showed convincingly in the book called Economic Policy and the Great Stagflation that measures of money supply growth missed the forecasting mark time and again. There were many possible reasons for this. Not least was that the regularity of the relationship was never all that stable. Money can be endogenously created; velocity is not stable. All the while, innovations in the 1970s in commercial banking made money measures still harder to decipher. Demand deposits and savings deposits were now increasingly mixed together, money market funds exploded; Regulation Q was gradually being whittled away. The money definition had to change, new measures were created. Due to such institutional changes, and the strong economy (endogeneity), the monetary aggregates kept rising even when interest rates were raised significantly. Velocity based on M1 (cash and demand deposits) also rose sharply in 1976 and then bounced all over the place. Again, a strong economy and high inflation probably affected velocity. Yet strict monetarists like Alan Meltzer and Michael Mussa would write later how delinquent Arthur Burns and William Miller were in holding the monetary aggregates in check. They and others scoffed at loose money in 1977 under Burns and in 1978 under Miller, as if these were simple matters. In fact, interest rates were raised significantly in those years, and for some of the reasons cited above, it was very difficult to get a true sense of where the nation’s money supply stood, or even what it was. Charles Schultze, Carter’s CEA chairman, for example, was concerned early in 1978 that money velocity would suddenly slow and that monetary policy was therefore too tight. Still more financial innovations in 1978, such as money market certificates, confounded the authorities further. High mortgage rates, for example, failed to stifle housing demand as they had in the past because institutions could still raise new funds from depositors even as rates soared. In the past, because they could not raise interest rates to market levels, depositors withdrew funds rapidly, which was known then as disintermediation. By late 1978, Schultze and Treasury Secretary Blumenthal thought money was too loose. But that was an easy call, if you were so disposed. OPEC doubled oil prices again in late 1978 and early 1979, after having quadrupled them in 1973 and 1974, and inflation was inevitably soaring as a result. The CPI reached 9 per cent in 1973 and 12 per cent in 1974. But a loose money policy could not account for that, according to any of the predictive models. Loose money could not account for inflation of 12 and then 13 per cent in 1979 and 1980, either. Money growth might have been able to


explain 6 per cent inflation in the mid-1970s and 7 or 8 per cent or so in the early 1980s. Yet at that point, and especially later, mainstream economists were determined to treat the money supply aggregates as the determinative factor of inflation. In fact, only the food shocks and the two OPEC oil crises, along with a mistaken consumer price methodology that included mortgage rates, could cause the CPI to reach double digits. Without these, inflation would have been far lower, and perhaps even manageable. I do not mean to trivialize the effects or even the tenacity of inflation. Even temporary shocks could find their way into inflation for a longer period of time by raising expectations. And I believe the inflation had to be subdued. But what panicked the nation were the double digit rates, not rates of 7 or 8 per cent that rapid money growth may arguably have induced. It seems clear that many economists were simply determined to claim that the 1970s’ inflation was a monetary phenomenon, and therefore they had to minimize the impact of the price shocks. But loose money policies were the subsidiary causes of the double digit inflation, the price shocks the main ones. Blinder’s evidence is pretty telling. The loosening regulations, which once rationed credit and now no longer did, may also have had a serious causal affect. I don’t know of any studies that tried to measure this, although notable Wall Street economist Albert Wojnilower did treat it to some degree in a Brookings paper. So we are left with this question. The empirical justification of public policy monetarism – that is, all one must do is hold the growth of the money supply stable – was falling apart in the 1970s. The relationship between nominal GDP and money growth was far from stable. But monetarism was widely adopted, especially among Wall Street economists and forecasters. Why? Because monetarism could serve as a theoretical and therefore scientific (and intellectually neutral?) justification of a new recession. And recession was the old-fashioned way to fight inflation. You didn’t need a new theory for that. Paul Volcker, claiming for a few years he was a monetarist, was the man to implement such a strategy. Few believed that Volcker had full faith in the monetary rules, though he still says he did to some extent. Rather, many argue that he used it for the cover story that it turned out to be. Volcker could more or less tell Congress it was not he who was raising interest rates; rather, they were going up on their own because all he was trying to do was stabilize the money supply. So, we needed monetarism, not because it was empirically justified or theoretically sound, but because it provided good cover for a harsh economic remedy. Even Wall Street wanted a deep recession to stop inflation once and for all. Under inflation, stock prices had stagnated for a decade, and bondholders saw their wealth rapidly depleted. The American people, standing in line for gas and seeing food prices soar, also now believed inflation was their principal worry, according to surveys. Inflation did indeed


harm them, but would temporary inflation harm them as much as long-term employment weakness? In particular, they blamed government deficits for their ills. Keynesian spending became an easy mark. This is not to say the economists did not urge too much stimulus in this period. It is to say that they over-reacted to inflationary fears in the opposite direction based on a theory that was losing any empirical credibility. The natural rate theory stood on firmer ground at that time. Friedman’s monetarist rules were undermined by empirical facts, but Friedman’s natural rate theory was seemingly confirmed in those years. The Phillips curve did indeed seem to be vertical, and it was soon widely held that Friedman had explained stagflation. You could have high unemployment and high inflation simultaneously, and it could indeed get worse. I do not mean to belittle the idea of a non-accelerating inflation rate of unemployment (NAIRU), perhaps at high rates of inflation it has validity. What I doubt is whether there is any permanent NAIRU, or that it is necessarily high. But unlike basic Friedmanite monetarism, empirical observation did support the NAIRU in the 1970s. Therefore, it was arguable that expansive monetary policies, including low interest rates, would not stimulate the real economy, only stoke the fires of inflation. But at the same time, you didn’t need a rather implausible theory (which assumed that wages adjusted rapidly) of the natural rate to explain stagflation. The price shocks offered a much simpler explanation. The sudden spurt in prices acted simultaneously as a tax that dampened consumption and investment and as a cost that pushed up inflation. Isn’t there some scientific principle that one always abides by the simpler theory if it is equally valid empirically? Add to this the mysterious slowdown in the growth of productivity in the 1970s and one has a compelling, simple and traditional explanation for stagflation. Economists, even at old Keynesian institutions, climbed aboard the NAIRU consensus. Only a few years ago, Brad DeLong wrote that you cannot explain the inflation of the 1970s by way of the price shocks. Due to monetary expansion based on the assumption that NAIRU was lower than it really was, he estimates that the underlying inflation rate rose to 7 per cent. If annual inflation only reached 7 per cent in the 1970s, American history would be remarkably different. The people would not have been nearly this upset. Arguably, inflation would not have gotten as high as the price shocks pushed them without a higher underlying rate. But they got to 12 per cent in 1974 with a lower underlying rate than in 1978. It turned out that the empirical evidence did not continue to support Friedman’s claims about a NAIRU in the 1980s and 1990s. This did not stop the mainstream profession from adopting a simplistic version of it, however. A paper by William Brainard and George Perry, called ‘Making Policy in a Changing World’, in a book of 2000 called Economic Events, Ideas and Policies, edited by Perry and the late James Tobin and published by Brookings makes


a persuasive empirical case that the Friedman assertion held empirically only in the 1970s. Why did the high and unchanging NAIRU attract so many followers? Was it the power of the theory? Was it the strong empirical support? It is hard to escape the conclusion that it fit the politics of the time. It was a fine theoretical way to justify tight money and slow growth over this period. Professor Galbraith once said the NAIRU was apparently the unemployment rate at any given time. He put his finger on it again. Just a few final words about this period. Friedman’s view of the natural rate was soon supplanted by the rational expectationists. Friedman at least said it took a while for workers to figure out that their real wages weren’t rising. The rational expectationists felt the workers could figure it out as fast or faster than anyone else. Hence, no policy but stable money could possibly have any effect on real outcomes in the economy. In other words, you could not truly improve the condition of the economy except to avoid instability. Moreover, the response to the high interest rates of Volcker’s Fed would be so swift and so rational that their dampening effects on the economy would not be all that bad. Sargent in particular proposed historical examples to demonstrate this. The 1982 recession was not in the sights of this Chicagoled school. The severity of that recession almost immediately cast strong doubt on the theory. But without serious empirics, why did rational expectations catch on? And it has been widely influentional on most macroeconomic theory, even if it has now largely been discarded. But remember what was going on at the end of the 1970s. Herbert Stein said there was no widely accepted consensus about fiscal and monetary policies as early as the mid-1970s. Charles Schultze has told me in conversation only God could have created policies for the late 1970s. It was a time of confusion and a deepening sense of futility. And the nation was readily willing to accept a theory that said policy was always and everywhere ineffective. Lucas and Sargent offered up their policy ineffective proposition. We should turn our attention on ourselves, of course. Some intelligent reader might say that Keynesianism was just an excuse for government spending. Well, Keynesianism has made something of a theoretical comeback. People are not only talking about liquidity traps again but even sticky wages. It could well be, contrary to Friedman, that the quality of assumptions matter. At the least, I think of Keynesianism as appropriate in some if not all circumstances. But there remains a strong argument for investing public goods as well, with or without Keynes. Here, Professor Galbraith will always be the leading light. 2. Let me turn briefly to other areas of palpable bias. Few areas of economics attract as much academic support as does free trade. I lean towards being a free trader myself. But it is pretty remarkable to me how rarely it is pointed


out that the standard theory depends on a key assumption being fulfilled. The economy must be operating at full employment. We rarely hear about such a constraint. In studying free trade, I always believed that what gave it its grit was its empirical justification. Is the gain in consumer and business surplus so much greater than losses due to unemployment and bankruptcy? I looked again at some of the historical studies. In retrospect, they are models of ineptitude. A fine little book published by the Upjohn Institute helped me with this enormously. It is called Job Creation, Job Destruction and International Competition by Michael W. Klein, Scott Schuh and Robert K. Triest. The earlier work of the 1970s and 1980s was based on net flows of jobs and work. A net change in the unemployment rate of 2 per cent in manufacturing masks a gross job creation of 10 per cent and a gross job loss of similar magnitude. The dislocation effects are much larger than any computation based on net changes could arrive at. Many of those who find jobs take them at lower wages. There are other costs for job-seekers as well as for companies to find and train new workers. One of the more influential early studies was undertaken by Stephen Magee and published in 1972, and it was based on net changes in industries, not gross changes. It is not surprising that he found overwhelmingly in favour of free trade. He estimated that eliminating all trade restrictions in the US would add 1 per cent to GDP. But the costs of dislocation, measured on that net basis, were only 0.01 per cent of GDP. The gains from trade exceeded the costs by 100 to one. Who could argue with this? But, it should be asked, who could imagine doing a study based on net changes in employment unless one were determined to minimize the costs of job dislocations? Gradually, the studies became more realistic. By making necessary and obvious adjustments, Baldwin and others in 1980 found only a 20 to one advantage to free trade. Still pretty overwhelming but far less than Magee’s findings. Further appropriate adjustments of these studies, Klein, Schuh and Triest argue, could reduce the multiple of gains from trade to costs to a mere two to one. Well, two to one is still pretty solid empirical evidence for free trade. But it is no longer overwhelming. At the least, it should make policymakers think twice before reflexively choosing free trade without supplementing it with other policies. In America, the safety net must be improved to support a free trade policy, in my view. But the nature of professional bias concerning free trade is strongly suggested by the evolution of these studies. 3. Let me take another area that is especially close to my heart. In the US there is a very strong consensus among academic economists that inflation is habitually overstated. Some mathematical issues, involving using geometric means, have been clarified, though even here there is controversy. I am not fluent enough in them at this time to discuss them. But the main area of


contention is that improved quality of products is not satisfactorily accounted for in the data. Much of this has changed at America’s Bureau of Labor Statistics in recent years, largely due to the work of the so-called Boskin Commission. The commission of distinguished economists, headed by the first Bush’s former CEA chairman, Michael Boskin, was appointed by the Senate Finance Committee. The committee made few bones about it. It believed inflation was too high, and if this blue-ribbon panel could show the BLS was wrong, the committee could reduce the annual increases to Social Security recipients that were indexed to the consumer price index. What a fine upstanding way to circumvent the legislative process. The Boskin Commissioners set about doing their more or less pre-ordained work, and what sloppy work it was. The commission noted that the great variety of fruit increased quality and reduced inflation. It noted that VCRs made it far cheaper to go to the movies, assuming poor people who now could at last see movies used to take their three kids in the car on weekends, buy four-dollar popcorn, and blow fifty bucks. Now they need only spend three dollars. Thus, given such quality increases, inflation was lower than reported. What was most telling about the quality of the Boskin Commission report was that the economists uncovered no instances of reduced quality that might suggest some inflationary input was too high. And they eliminated the discussion of public goods altogether. An automatic key lock for a car made cars more valuable, and therefore reduced inflation. But increasing traffic, according to the illustrious commission, had no bearing on the value of cars, and should not affect inflation. Many criticized the superficiality of the report including myself in the NY Review of Books. But what stunned me, at least in my own anecdotal experience, was how the academic community readily accepted it. Since then, a commission headed by Charles Schultze has cast needed doubt on many of its findings. But the economics profession was terribly willing to please. The new findings also made it appear that real GDP and productivity growth were also higher than reported. This must have been heartening to economists who believed America was following the right policies in this period. 4. I would like to say one thing more about public investment. The evidence is strong that public investment has had a substantial pay-off in America. Why is there no strong united front among most economists on the benefits of public investment? I understand the Chicago School’s claims about the inherent inefficiencies of government. But there is so much strong empirical work in its favour. And fundamental theory suggests that the case for public goods is strong. One NBER economist, Ishaq Nadiri of NYU, for example, has done especially intriguing work with sophisticated production functions measuring the consequences of transportation investment. It shows that


public and private investment returns are about equal on average, and may at times favour public goods. Robert Eisner has long discussed such issues. William Nordhaus has taken up the quest for the grail. Professor Galbraith is now the godfather of this vein of work. But in my informal observation of academic economics, little attention is devoted to it. Is this simply a bias stimulated by the wealthy private donor to universities? Despite the attempts by Feldstein, Barro and their disciples to show the inefficiencies of high taxes and government spending, Joel Slemrod has done exemplary work demonstrating that neither high taxes nor high levels of government spending have any correlation to economic growth. William Easterly has climbed aboard, showing clearly how empirical studies that claim otherwise have been untenable and unstable. Peter Lindert has a strong new book on why government spending does not on balance detract from growth. Yet I don’t find these catching fire. To the contrary, here in Europe, the economics establishment almost only talks about reducing labour costs and payroll taxes. There may be room for restructuring, of course. But economists do not understand that America has been running on a tank of public goods it has not refilled in years. It will not be running on empty soon, but the cost of replenishing that tank is not fully accounted for. 5. I also have another pet gripe. Growth theory as practised by mainstream economists has been, I think, especially frustrating. The adoption of Solow model type thinking has focused mainstream theory about the sources of growth almost entirely on supply-side variables. New growth theory, which makes some allowance for rising economies of scale and endogenous growth, does not seriously alter this point of view. Thus, to support growth, we must save more, invest more, educate more. But what about stronger domestic markets as a source of growth? What can historical analysis add to the theory? Surely, one of America’s major advantages is the size and efficiency of its market. Wal-Mart exists because of that market. I think the size of the American market created the fertile ground that gave rise to the scale economies of the internet. Surely, as historians like Gavin Wright, Richard Nelson and Alfred Chandler have shown, market size and efficiency, including a single language and a single currency, were key advantages – perhaps the key advantage – for America. For that reason, I believe in the value of the EU and think that China and India will become enormously powerful. If demand-side sources of growth were fully acknowledged among mainstream economists, there would be more concern about stagnating wages, income inequality and lost incomes due to trade. The result is that growth theory in the US has a bias in favour of policies that support savings and capital over labour. And perhaps the popularity of such policies in the current environment creates an incentive to keep growth theory as narrowly focused as it is. 6. A quick point about shock therapy in Russia. Ironically, some of the empirical justification for shock therapy was just the argument I make


above. A large market will promote economies of scale. But empirics said nothing about the overnight creation of a market. What truly drove some mainstream economists, notably from Harvard, towards shock therapy was blind faith in markets. Milton Friedman lingered lovingly in their minds. Capitalism assured liberty. The simplistic idea was carried forward ideologically. Neither theory nor practice, as far as I can tell, justified it. Only high fashion. 7. Finally, consider the theoretical work involving the management of the firm that turned out to be the foundation of some of the excesses on Wall Street in the late 1990s. The new theory of the management of the firm was derived from efficient markets theory (as was rational expectations), introduced in the early 1960s by John Muth of Carnegie Mellon and carried forward by estimable economists such as Eugene Fama, Franco Modigliani and William Sharpe. The theory argued that financial markets so efficiently incorporated new information that it was difficult for any individual to outperform the market as a whole. The empirical evidence was basically that, adjusted for risk, you couldn’t find anyone who beat the market. The adjustment for risk may have involved some tautological assumptions, and eventually it became clear that some investors did indeed beat the market over time. Such performance was sometimes attributed to other factors, such as inside information. At best, the weak case for efficient markets holds. But the strong case for efficient markets is that, not only does the market rapidly incorporate new information into stock prices, it is usually ‘right’ about the future earnings of corporations. It is a small jump from assuming that the stock price is a correct estimate of future earnings to making it the arbiter of managerial performance. If the stock price goes up, managers must be doing something right. So reward them with stock options and they will serve shareholders best. The issuance of stock options distorted corporate behaviour in the 1990s, and was a major source of scandal. The higher your reported earnings, the better your stock did; the better your stock did, the wealthier your managers were. The principal advocate of this view, Michael Jensen of Harvard Business School (formerly Rochester), has since backed off the strong form of efficient markets theory. In fact, he has claimed he never held it. But such market faith had damaging effects and was simply not supported by empirical work. Stocks went up with the fashions and excesses of the time, not with the quality of management. Stock prices could be efficient without being rational in the everyday sense of the word. Economics adopted a bias, I believe, that was rarely defied among academics until the crash and the scandals made it untenable. Why? Again, there is the Salon effect. But it was also awfully nice to be on the side of the bull market and huge consulting fees. This is fairly random list of examples of bias that I believe can be substantiated. It is partly a tour through some of my own observations over time.


Such bias has stifled debate in America and has led to damaging policy. It suggests a lack of intellectual courage in the professional economics community and our best universities, the sort of courage Professor Galbraith always epitomized. But I should note that I think there is a healthy resurgence of good sense among economists. Akerlof, Dickens and Perry intelligently took on the natural rate hypothesis in 1996. Stiglitz has been tireless in showing where imbalances in information can distort markets. There is a growing body of criticism of efficient markets theory, epitomized by Shiller’s book, Irrational Exuberance. The large body of work in behavioural economics and finance is encouraging, and to some degree is headquartered, ironically enough, at Chicago. I think the work of the new structuralists such as Lance Taylor may be catching on again. Some of the trade work of Dani Rodrik and others has been impressive. Amartya Sen remains an institution unto himself. And on. I am sure I leave many out. Many of these people I mention disagree with some of John Kenneth Galbraith’s work. But few do not admire his iconoclasm, courage, wit and contributions. A half century ago, Milton Friedman found a home for his iconoclastic views at the prestigious University of Chicago, where the spirit of laissez-faire economics was already alive and well. There is no similarly prestigious home in the US for alternatives to simple laissez-faire economics today. But perhaps that is changing. Harvard was once Professor Galbraith’s house. It is no longer. But maybe even it will make a comeback.

Partial bibliography G.A. Akerlof, W.T. Dickens and G.L. Perry, ‘Near-Rational Wage and Price Setting and the Long Run Phillips Curve’, Brookings Papers on Economic Activity, 1 (2000), 1–60. A. Blinder, Economic Policy and the Great Stagflation (New York: Academic Press, 1979). Boskin Commission Report, ‘Toward a More Accurate Measure of the Cost of Living’, US Senate Finance Committee, 1996. W. Brainard and G.L. Perry, ‘Making Policy in a Changing World’, in Economic Events, Ideas and Policies: the 1960s and After (Washington DC: Brookings Institution, 2000), pp. 43–82. A.D. Chandler, Scale and Scope (New York: Belknap, 1990). DeLong, J. Bradford, The Inflation of the 1970s, www.j-bradford-delong.net. M. Friedman, Essays in Positive Economics (Chicago: University of Chicago Press, 1953). M. Friedman, A Theory of the Consumption Function (Princeton: Princeton University Press, 1957). M. Friedman, ‘The 1977 Nobel Lecture’, The Nobel Foundation. M. Friedman and A. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963). S. Goldfield, D.I. Fand and W.C. Brainard, ‘The Case of Missing Money’, Brookings Paper on Economic Activity, 3 (1976), 683–730. M.C. Jensen and W.H. Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, Journal of Financial Economics, 3 (1976), 305–60.

76 John Kenneth Galbraith and the Future of Economics M. Klein, S. Schuh and R.K. Triest, Job Creation, Job Destruction and International Competition (Kalamazoo: Upjohn Institute, 2003). P. Lindert, Growing Public (Cambridge: Cambridge University Press, 2004). K. Murphy, A. Schleiffer and R. Vishny, ‘Industrialization and the Big Push’, Journal of Political Economy, 97(5) (1989), 1003–26. M. Mussa, ‘Monetary Policy’, in M. Feldstein (ed.), American Economic Policy in the 1980s (Chicago: University of Chicago Press, 1994), pp. 81–145. I.J. Nadiri and T. Manunueas, Contributions of Highway Capital to Industry and National Productivity Growth, Department of Transportation, 1996. R.R. Nelson and G. Wright, ‘The Rise and Fall of American Technological Leadership: the Postwar Era in Historical Perspective’, Journal of Economic Literature, 30 (4) (1992), 1931–64. T.J. Sargent, ‘The Ends of Four Big Inflations’, in R.E. Hall (ed.), Inflation: Causes and Effects (Chicago: University of Chicago Press, 1982), pp. 41–97. Reprinted in T.J. Sargent (ed.), Rational Expectations and Inflation (New York: Harper and Row, 1986), pp. 40–109. R.J. Shiller, Irrational Exuberance (Princeton: Princeton University Press, 2000). J.B. Slemrod, ‘What do Cross-Country Studies Teach about Government Involvement, Prosperity, and Economic Growth?’, Brookings Papers on Economic Activity, 2 (1995), 373–431. H. Stein, Presidential Economics, American Enterprise Institute, 1994. L. Taylor, Reconstructing Macroeconomics (New York: Harvard University Press, 2004). A.M. Wojnilower, ‘The Central Role of Credit Crunches in Recent Financial History’, Brookings Papers on Economic Activity, 2 (1980), 277–339.

7

Reframing Capitalism James E. Sawyer

Over the past quarter century advocates of the conventional capitalist paradigm have engineered a resurgence of laissez-faire style public policies, particularly in the United States. Challengers to this ‘religion’ have been beaten back or otherwise marginalized by advocates of so-called free-market economic policies as they clamour for a form of societal auto-regulation through market-based institutions. Eventually, if challengers are to prevail against this laissez-faire resurgence, popularly described as neo-liberalism – according to the perspective of Antonio Gramsci1 – either they must demonstrate the prevailing paradigm is without foundation, or alternatively, they must pose philosophical syntheses of greater importance and significance. Many of neo-liberalism’s challengers become exhausted in pursuit of the former, when the paradigm’s primary vulnerability is with the latter. The method here derives from Gramsci’s perspective about posing competing philosophical syntheses. MIT urban planners Donald Schön and Martin Rein2 offer a perspective that articulates with Gramsci’s. Their work addresses policy-related conflicts in which the parties observe the same facts but attach different interpretations, meanings and emphases in order to dismiss antagonists. They define a metacultural frame as pertaining to the broadly shared beliefs, values and perspectives through which a particular culture gives meaning to its thought and action. Informed by Karl Popper3 on the nature of scientific propositions, and by Thomas Kuhn4 on the nature of scientific revolutions, through the lens provided by Schön and Rein it may be impossible empirically to falsify the metacultural frame of an opponent. This may be particularly true in what Harvard’s Michael Porter5 calls wealth-driven societies characterized more by wealth preservation than wealth creation. Arguably the United States is becoming such a society. In the sense of Gramsci, then, the particular opportunity for challenging neo-liberalism is to demonstrate that its metacultural frame is inconsistent with the resolution of the most intractable contemporary problems. 77


Of course, a popularly held metacultural frame is none other than what John Kenneth Galbraith calls the conventional wisdom. Indeed, the challenge of deconstructing the conventional neo-liberal wisdom begins with sorting out the difference between how the world is perceived to work by neo-liberals, from the way in which the world actually works. One thinks of the Galbraithian dictum that ideology should never trump reality. The way in which the world works changes – sometimes gradually, sometimes precipitously – while too often the way in which the world is perceived to work does not keep pace. As Keynes reminds us, all too often dysfunctional economic outcomes have their genesis with some defunct economist. Indeed, so it is with the contemporary neo-liberal conventional wisdom. It is a lens into how the world was perceived to work in the bygone neoclassical age of industrial capitalism. In many ways this lens is becoming decreasingly relevant to contemporary wealthy societies because it can be oblivious to many negative externalities including environmental degradation, intransigent poverty stubbornly coexisting alongside material plenty, and egregious market-based behaviours – particularly in the United States – of the ilk of Enron, WorldCom, ad nauseam.6 Keynes called for the euthanasia of rentiers, and his dictum would certainly extend to what Galbraith calls ‘innocent fraud’ perpetrated at Enron and a host of other US corporations by pseudo-capitalists. A pseudo-capitalist is defined here as a rentier who hoards assets in uses that are non-productive of the common good. These are people or institutions who consciously manipulate or ‘game’ the system for their own self-serving ends. Many pseudo-capitalists have been able to stay below the radar of the neo-liberal paradigm because its ideological adherents are predisposed to excuse or minimize the significance of their behaviours. Why is this so? Across two centuries, the conventional wisdom of doctrinal capitalism has asserted that the pursuit of self-interested action articulates universally with the attainment of the common good when executed through the institutions of private property and minimally regulated markets. For pre-industrial or classical societies, the central problem within this frame pertained (and continues to pertain) to wealth creation, and for industrial or neoclassical societies, the central problem pertained (and continues to pertain) to the explanation of cost or value. However wealth or cost-driven perspectives neither describe nor adequately address the pre-eminent problem of postindustrial societies, which is how to publicly choose among alternative futures; that is, how to determine what the future shall be, how access to future outcomes shall be distributed, and the rewards that will flow to entrepreneurs who facilitate such outcomes. A crucial related problem is how to police non-productive behaviours in which self-interested action does not articulate with the attainment of the common good. Such action can occur when pseudo-capitalists and other rentiers enable themselves to be compensated as capitalists, but without

Reframing Capitalism 79

proffering the requisite industry, skill and risk-taking anticipated by society in exchange for the preferred treatment it confers upon entrepreneurs. Of course, the prevailing paradigm is silent – in any practical way – about what the rate of profit on capital should be. Capital is about the cultivation of future capability. For classical economist David Ricardo, the central problem was wealth creation and the nature of capital was agricultural, or seed corn. For neoclassical economist Alfred Marshall, the central problem was the determination of value and the nature of capital was industrial; it was an aggregate, denominated in a monetary unit. Even now one may argue that the nature of capital is in transition. Industrial outcomes are segueing into emerging post-industrial society. These are characterized by satiation of basic goods and services accompanied by technological acceleration, a widening dispersion between the ‘haves’ and the ‘have nots’, a deteriorating environment, and the qualitative pursuit of lifestyle, among others. Fierce competition exists for scarce ‘lifestyle goods’ such as strategically located real estate, fashionable cars and clothes, exotic vacations, entertainment and sporting events. In a qualitative sense capital in the post-industrial world becomes whatever is necessary to move from one set of outcomes or potentialities to the future attainment of some other set. Indeed, it exists relative to the outcome that the electorate chooses to create. Since capital investment is about the cultivation of capability, it is rooted in some vision or scenario of the future. Rather than speaking of laissez-faire capitalism or mixed capitalism, then, the contemporary milieu might better be characterized as relative capitalism. That is, capital requires definition relative to some vision it is engaged in creating. Otherwise, it is argued, it becomes merely a rentier asset engaged in extending the status quo. For the hypothesis of relative capital to be sustained, Say’s tautology must be rejected anew, and with it the presumption that Newtonian order prevails in real economies modelled upon the received doctrine. With the admission of disequilibrium in which planned saving may diverge from planned investment,7 hoarding8 behaviours become admissible theoretically as well as practically as pseudo-capitalists may seek equivalent rewards with capitalists, while withholding the full menu of entrepreneurial services expected by society. Pseudo-capitalists, then, may save or control the saving of others, but fail to expand social output to potential because they restrain the attainment of equilibrium-level investment and may actually contribute to disinvestment. The roots of pseudo-capitalism are innocent enough; indeed, they are staples of conventional instruction in management education and applied policy analysis. Consider the so-called least cost rule of the marginal productivity theory of resource demand. ‘A firm is producing a specific output with the least-cost combination of resources when the last dollar spent on


each resource yields the same marginal product.’9 A corollary is that one dollar’s worth of any asset should receive the same high rate of return as one dollar’s worth of any other asset. Otherwise, the financial asset holder may reduce opportunity cost and therefore increase portfolio yield by replacing lower yielding assets with higher ones. But this ostensibly rational dictum at the level of the individual or organization too often becomes reified and dogmatized, and prescribed as a path of rational action for entire societies. For instance, consider how pseudo-capitalist behaviours may emerge within a contemporary economic environment in which trillions of dollars are traded electronically each day in global financial markets and few factories are more than a day’s plane journey away from the global markets they serve. In this environment a product may be designed, financed, produced and marketed in entirely different countries. Here, industrial capitalists who choose to do so may morph conveniently into post-industrial pseudo-capitalists. This transformation is described by beginning with the dictum that one dollar’s worth of any asset P should receive the same rate of return as one dollar’s worth of any other asset C, where P and C denote pseudo-capitalist and capitalist assets, respectively. For instance, we begin with the capitalist holding C and the pseudo-capitalist holding P. Soon the capitalist may be motivated to morph into a pseudo-capitalist because he recognizes the opportunity cost of holding C is the extra skill, industry and risk-taking that s/he perceives to go uncompensated. The unmitigated pursuit of self-interest may ultimately lead all capitalists to act as pseudo-capitalists. To the extent this occurs, then societal outcomes are reduced by the value of the extra contributions indicative of the difference in social product between the capitalist class and the rentier class. Pseudo-capitalist behaviours are not likely to raise opposition from the ranks of either conventionally trained policymakers or the academic keepers of the sacred paradigmatic flame who sustain them. Buried beneath the surface of the prevailing paradigm, however, are embedded assumptions that may have appeared benign in the industrial age but have profound ethical implications in the post-industrial age. Among these is the assertion that the pursuit of self-interested action universally articulates with the attainment of the common good. While this may have been a reasonable generalization of authors including P.H. Wicksteed10 and John Bates Clark,11 writing a century ago about the Industrial Revolution, now, too often it describes merely an ideological position rather than extant reality. In part this has transpired because the way in which the world works has changed, while the way in which we think about how the world works has remained remarkably static in the face of a global revolution in the way business is conducted. In this transformed environment, relative capitalism advocates that wealthy societies act publicly to create social welfare functions through the polity rather than solely privately, through the market, in the designation of


what constitutes capital. Since capital in post-industrial society becomes the qualitative asset base necessary to move from the status quo toward some other preferred scenario, it requires voters, today, to select among alternative scenarios, in order for the one that is chosen to come to fruition some number of years hence. Consequently, entrepreneurial acts that do not conform to the democratically prevailing social welfare function12 become non-productive or even counterproductive. The prevailing neo-liberal paradigm that camouflages pseudo-capitalist behaviours is rooted in a Newtonian methodological view in which time and friction are banished, and in which equilibrium is assumed to prevail continuously. In the simple model, Say’s tautology mandates that all planned household saving shall be identical to all planned business investment. No leakages are allowed in the model that would otherwise be manifested as unemployment or unsold inventories, for instance, within the standard Keynesian system. One serious problem is that the conventional method takes ‘snapshots’ of an actual economy when equilibrium is presumed to prevail, rather than continuous sampling in anticipation that extant disequilibrium may be more the norm. This latter perspective, of course, led to Keynes’s rejection of Say’s tautology. This allowed government policies based upon Keynesian method to focus on, analyse, and correct for unemployment and unsold inventories within an industrial framework. Seven decades following the Great Depression, however, it is asserted that Say’s tautology has become reimposed subtly as a consequence of the laissez-faire resurgence. Because it denies disequilibrium, the methodological invocation of Say’s tautology is also blind to hoarding13 behaviours in which capitalists invest less than is transmitted to them in household saving in the simple two sector formulation. This occurs because entrepreneurs may be motivated to hoard or otherwise act as pseudo-capitalists, but the political–economic system is blind to their manipulations and continues to reward them as legitimate capitalists.14 Contemporary hoarding takes many non-productive forms including accounting frauds and other egregious behaviours by some US corporations. John Kenneth Galbraith reminds us that the corporation is an essential feature of modern economic life. However, he also reminds us that without public oversight the corporation can become a cover for devious actions that extend to outright theft on a massive scale. ‘Innocent Fraud’15 may occur within or without the boundaries of law, precipitated with no sense of guilt or responsibility, and may derive from conventional economic teachings in business schools and elsewhere. A new perspective is required that realigns conventional economic thinking about the way in which the world works, including a dramatically revised role for government to oversee the designation of capital, even as the Keynesian paradigm asserted a new role for government – almost 70 years ago – of provisioning economic security. Government’s pre-eminent new


role within contemporary relative capitalism becomes the coalescence of a vision of the future with the attendant capital assets necessary to attain it, then the creation of an incentive structure to bring that vision into being.16 It must set the rate of profit on capital in order to curb hoarding behaviours. An example of a negative incentive directed at hoarding behaviours or pseudo-capitalist behaviours, for instance, would be the Tobin tax, an excise tax on cross-border currency transactions, one outcome of which would be to reduce so-called financial churning by speculators. Enormous challenges accompany government’s emerging role. Indeed, the emerging commons of contemporary corporate capitalism is global and is less amenable to control by nationalistic economic policies. However, where are the global institutions to determine the character of capital, to set the rate of profit, and to impose sanctions upon pseudo-capitalists across the global marketplace? A coordinated, multilateral oversight of global corporate capitalism is required, even at a time when the United States in particular is becoming dangerously unilateral.17 Within the conventional neo-liberal wisdom of the United States, the paradigm of self-interest has been virtually reified, thus rendering the coalescence of a widely shared public vision of the future enormously challenging at best, and at worst, untenable.18 Also, because capital relativity places great emphasis on vision, it leaves post-industrial societies increasingly vulnerable to ideologically motivated manipulations by charismatic and media-smart politicians who too often may attract popular support without credible plans for shared sacrifice to implement the common good.

A postscript on the US presidential election Democrats flagellate themselves even as they direct anger at one another following the November 2004 election victory of George W. Bush. The challenger lost by over three million votes in an election portrayed by The Economist19 as a contest between the incompetent Bush and the incoherent John F. Kerry. Editors of the pre-election edition preferred incoherence as the lesser of two evils but, to the contrary, Republicans hung on handily to retain the presidency and to extend their majorities by four each in the House of Representatives and the Senate. Multiple conservative appointments of seats on the nine-member Supreme Court are sure to follow in Bush’s second term. The reality is that the United States has become a centre-right global superpower. Indeed, the neo-liberal sweep may well usher in the greatest structural re-engineering of the American institutional landscape since the Great Depression, including delegalization of abortion and sweeping social security and tax code overhauls. Certainly the election was about the way in which the world is perceived to work and the rules by which the game is perceived to be played.


Conservative columnist David Brooks20 of the New York Times describes the campaign as having been a war of ideology, and surely it is a war in which American liberals are losing. They remain unsuccessful at recasting themselves as a distinctive, coherent and credible political alternative to the monolith of neo-liberalism. Their opponents have persevered shrewdly. Beginning after right-leaning Barry Goldwater’s failed presidential bid in 1964, a veritable industry of think tanks and policy institutes has formed to shape, refine and dispense the Republican conventional wisdom. This transformation has been abetted indirectly by neoclassical scholars, although some may be reluctant to acknowledge the direct links to their ideas. Arguably, many economists function in dual roles as de facto social philosophers, successfully camouflaged within a profession notorious for hiding its value judgements behind a smokescreen of professed value neutrality. Galbraith Symposium presenter and New York Times correspondent Jeff Madrick21 argues that convergence of the profession around an accepted set of views – characterized by insularity and comfort with powerful interests – represents the very problem J.K. Galbraith has always fought against. Madrick’s point is that a healthy iconoclasm – lacking in the American academies – is essential to thorough debate of economic issues in the media. Certainly the US media debate is becoming ever less robust. It is argued here that the failure Madrick identifies – in the sense of Antonio Gramsci – should be extended to encompass the American academy’s failure to challenge the very metacultural frame undergirding the neo-liberal conventional wisdom. In short, US liberals need to go on the offensive with a more credible story that also deconstructs the story of their opponents. The neo-liberal story, based in a Newtonian world view of order, presumes that market-based institutions essentially auto-regulate societies crafted upon laissez-faire principles. Social welfare functions created outside of the market are eschewed and government-led planning is dismissed as congenitally inefficient at satisfying citizens’ consumer preferences. Of course, disequilibrium hoarding behaviours by pseudo-capitalists are of little interest to neoclassicals who undergird the neo-liberal story line with a portrayal of general equilibrium as the norm rather than the exception. Arguably, American liberals should break through iconoclasm to make a new beginning, even as neo-liberals did four decades ago. In doing so they must better explicate their own intellectual system from theoretical top to applied political bottom, thereby dismissing antagonists, as Schön and Rein describe, by using their analyses to cast doubt upon the competing metacultural frame. To this end, esoteric research must be translated into practical applications. An example is behavioural economics. Recently (2000), Princeton psychologist Daniel Kahneman won the Nobel Prize for pioneering research in this emergent subfield. Behaviourists describe how individuals often act irrationally, thereby supporting the case that government may need to play a role in guiding markets and individuals in areas where failure


is likely. Such findings constitute a promising new line of refutation of efficient market theory, used by neo-liberals to sustain their case for a world view of order in which government intervention in the market is denigrated.22 American economists may also do well to consider other promising possibilities for interdisciplinary and cross-disciplinary scholarship. Among these are motivated social cognition from the field of psychology, and the application of cognitive science to politics from the field of socio-linguistics. Briefly regarding the former, Stanford’s John T. Jost23 and colleagues have integrated several decades of research dealing with the psychological bases of political conservatism into a seminal article integrating theories of personality, epistemic and existential needs, and ideological rationalization. They regard political conservatism as an ideological belief system that is significantly related to motivational concerns having to do with the psychological management of uncertainty and fear. Regarding the latter, Berkeley socio-linguist George Lakoff24 has pioneered the cognitive study of how liberals and conservatives think. In his work on so-called moral politics, Lakoff analyses the unconscious world views of liberals and conservatives to explain why they are at odds over so many seemingly unrelated issues, including taxes, regulation and social programmes. The differences, according to Lakoff, arise from radically different conceptions of morality and ideal family life, meaning that family and morality are at the core of American politics. In turn, these variables may be highly correlated with the conservative penchant for certitude and order, with enormous attendant implications for the role of equilibrium in economic thought. In sum, interdisciplinary and cross-disciplinary strategies may be among the most hopeful within and without the American academy, for deconstructing the neo-liberal conventional wisdom, thereby promoting a healthy iconoclasm in the tradition of John Kenneth Galbraith.

Notes 1. A. Gramsci, Quaderni del carcere. Cited in G.C. Harcourt, Controversies in Political Economy (New York: NYU Press, 1986), p. 106. Passage on ‘The Intellectuals’ read at the memorial service for Piero Sraffa, November 1983. 2. D.A. Schön and M. Rein, Frame Reflection: Toward the Resolution of Intractable Policy Controversies (New York: Basic, 1994). 3. K.R. Popper, Logic of Scientific Discovery (New York: Basic Books, 1962). 4. T.S. Kuhn, The Structure of Scientific Revolutions (Chicago: University of Chicago Press, 1970). 5. M.E. Porter, The Competitive Advantage of Nations (New York: Free Press, 1990). 6. Enron’s plan for manipulating wholesale electricity prices in the Californian market during the winter power crisis of 2000–01 is described graphically in internal memos handed over by company attorneys to the Federal Energy Regulatory Commission (FERC). The Commission released the documents with an accompanying observation that Enron traders were ‘creating and then relieving phantom


7.

8.

9. 10.

11.

12. 13.

congestion’ on California’s electricity grid (www.nytimes.com/2002/05/07/ business/07ENRO.html). In one strategy called ‘megawatt laundering’, Enron bought power in California, resold it out of the state, then bought it back and resold it again into California – allowing the company to circumvent price caps. This is a specific instance of gaming the regulatory functions of government. Other pseudo-capitalist revelations abound. For instance, the CMS energy corporation acknowledged that $4.4 billion worth of its volume for 2000 and 2001 resulted from ‘round trips’ with no economic value. Round trips are ‘wash sales’ or ‘mirror-image’ swaps in which the same amount of power is exchanged at the same price between two players. Revenue is booked on each of the operating statements, even though there is no revenue. The Securities and Exchange Commission is boosting its investigation into an array of such schemes. Swaps of fibre-optic capacity have occurred in the telecom industry, for instance, apparently for similar reasons. A lawyer familiar with these transactions claims that at least in some cases no service has been provided (Wall Street Journal, 16 May 2002). See literature on ex ante versus ex post equilibrium, for instance in: R. Clower, ‘Reflections on Science … and Economics’, Intermountain Economic Review, 5 (1974), 1–12; and A. Leijonhufvud, On Keynesian Economics and the Economics of Keynes (New York: Oxford University Press, 1968). An agricultural example of hoarding is illustrative within a classical system. A farmer holds capital including in the form of a plough horse; the horse may be ‘enumerated’ or counted according to its use to verify that it is making a productive contribution to economic output. However, consider that after the farmer uses the horse in his field to pull a plough, he tethers it permanently by the door of his house for the pleasure of his children. Now, the horse no longer would be enumerated as a capital asset because it has been removed from the stock of capital assets and hoarded by a ‘rentier’ into the stock of consumption producing assets. It is no longer an instrument of growth because it has slipped from productive to non-productive use. In the logic of the classical system it now contributes only to private good rather than the common good. (We are reminded again that Say’s tautology asserts this will not happen in a real economy.) C.R. McConnell and S.R. Brue, Economics 16e (New York: McGraw-Hill Irwin, 2005), pp. 504–17. P.H. Wicksteed, An Essay on the Coordination of the Laws of Distribution (London: Macmillan, 1894), and The Common Sense of Political Economy (edited with an Introduction by Lionel Robbins) (London: Lowe and Brydone, 1933). J.B. Clark, The Distribution of Wealth (London: Macmillan, 1899). Clark declares in the preface (p. v): ‘It is the purpose of this work to show that the distribution of the income of society is controlled by a natural law, and that this law, if it worked without friction, would give every agent of production the amount of wealth which that agent creates.’ See, for instance, Bator’s seminal article. F. Bator, ‘The Simple Analytics of Welfare Maximization’, American Economic Review (1957), 22–59. Hoarding became a significant topic of the post-General Theory exchange between Jacob Viner (J. Viner, ‘Mr. Keynes on the Causes of Unemployment’, Quarterly Journal of Economics, 51:1 (1936), 27–33) and Keynes (J.M. Keynes, ‘The General Theory of Employment’, Quarterly Journal of Economics, 51:2 (1937), 209–23). Keynes clarified that in disequilibrium, with household saving exceeding business investment, production also exceeds consumption and hoarding is the outcome, in the form of cash balances, otherwise known as the liquidity trap.


14. 15. 16.

17.

18.

19. 20. 21. 22. 23. 24.

Risk-averse households demand greater money stocks, descending interest rates notwithstanding. A substantial professional literature has developed in the ensuing years regarding the role of the liquidity trap with various policy disputations or solutions under highly specialized circumstances (see, for instance: D. Patinkin, Money, Interest and Prices: an Integration of Monetary and Value Theory (Cambridge: MIT Press, 1965, 1989).) However, unfortunately, except for the specialized liquidity trap application, the concept of hoarding has largely disappeared from the economic lexicon. J.E. Sawyer, Why Reaganomics and Keynesian Economics Failed (London: Macmillan and New York: St Martin’s Press, 1987). J.K. Galbraith, The Economics of Innocent Fraud (Boston and New York: Houghton Mifflin, 2004). Indicative economic planning, as the term is used for instance in the economies of Austria and Japan, is roughly proximate to the concept of a social welfare function that includes setting the rate of profit on capital. Global partnerships require a measure of shared sacrifice rather than the unmitigated pursuit of unilateral self-interest. Whereas international cooperation on issues such as SARS may be possible because failure to do so immediately invokes a ‘common bad’ on all nations, atmospheric carbon reduction is more illusive. On many such global issues the Bush administration has pursued a role equivalent to neo-liberal ideological bully. This is possible, in part, because most outcomes, such as environmental degradation, occur over the longer term, beyond the immediate accountability of a single presidential term in which domestic voters are likely to hold an administration responsible for negative outcomes. Also, a large percentage of American voters appear uninterested in world opinion outside of the United States. Also required are public initiatives to curtail self-interested acts by individuals, with large negative external effects. For instance, economist Michelle J. White contends that drivers have been running an ‘arms race’ on American roads by buying increasingly large vehicles, particularly sport utility vehicles (SUVs) and light trucks. An important reason for driving them is that they provide their families extra protection in the event of a crash. But these vehicles pose an increased danger to occupants of smaller vehicles as well as to pedestrians, cyclists and motorcyclists. ‘For each one million drivers that shift from driving cars to driving light trucks (SUVs included), between 34 and 93 additional car occupants, pedestrians, bicyclists or motorcyclists are killed per year and the value of the lives lost is between $234 and $624 million per year.’ See M.J. White, ‘The “Arms Race” on American Roads: the Effect of SUVs and Pickup Trucks on Traffic Safety’, Working Paper 9302 (San Diego: Department of Economics, University of California at San Diego and Cambridge, MA: National Bureau of Economic Research, 2003). The Economist, 30 October 2004. nytimes.com/2004/07/24/opinion/24brooks.html. See Chapter 6. Wall Street Journal, 18 October 2004. J.T. Jost, J. Glaser, A.W. Kruglanski and F.J. Sulloway, ‘Political Conservatism as Motivated Social Cognition’, Psychological Bulletin, 129(3), 339–75. G. Lakoff, Moral Politics: What Conservatives Know That Liberals Don’t, 2nd edn (Chicago: University of Chicago Press, 2002).

8

Power and Institutions in Macroeconomic Theory John Cornwall and Wendy Cornwall1

Introduction While increasingly large segments of the economics profession cast themselves adrift in a sea of representative agents governed by the invisible hand, John Kenneth Galbraith has spent a lifetime studying and explaining the realities of the advanced industrial state. These realities are dominated by problems that stem from the accumulation and exercise of power by large corporations, and the obligation of government to counter this power in the public interest. This focus has made Galbraith a persistent critic of economic theories that give power and institutions at best a very minor role, and more usually none at all, in influencing economic performance. He finds this neglect of power and institutions, typical of mainstream economic theories, seriously diminishes their capacity to improve our understanding of the real world and its problems. In this chapter we find that recent radical changes in economic theory, initiated and propagated primarily by American economists, reaffirm Galbraith’s assessment. This shift has resulted in an entirely new formulation of macro theory, profoundly different from that associated with Keynes’s General Theory. We focus on how macroeconomic theories explain unemployment, because the treatment of unemployment is at the centre of this revolution in macroeconomic analysis and policy. By contrasting the core features of the original Keynesian macroeconomics with the new mainstream macroeconomics (hereafter referred to as Keynesian and New Keynesian macroeconomics respectively), we can more easily identify the shortcomings and misrepresentations that result when power and institutions are omitted from theory. These are essential determinants of macroeconomic outcomes, needed in order to understand why performance differs over time and among countries, and to design effective policies to remedy malfunction. The second section contrasts macroeconomic developments in the two episodes comprising the period since World War II, the ‘Golden Age’ and what we designate the ‘Age of Decline’. The third section reviews the 87


changing mainstream schools of macroeconomics that prevailed over the same historical period. The fourth section summarizes in non-technical terms our extension of traditional Keynesian theory, in which power and institutions are integral elements determining macroeconomic function. In the fifth section these ideas are organized formally as a constrained optimization problem. This model is tested in the sixth section, which reports the results of an econometric model that includes measures of power and institutional characteristics as possible influences on unemployment performance in the OECD economies. The conclusions are contained in the final section.

The stylized facts Table 8.1 records unemployment and inflation data for 18 developed capitalist economies from 1960 until the end of the century, the 1990s being the last short-run period for which comparable data are available. The countries fall into three groups: those with low rates of unemployment through the entire period (the low unemployment countries); those with relatively high rates of unemployment throughout the period (the high unemployment countries) and a third group in which low unemployment until the mid-1970s was followed by high unemployment thereafter (the low-high unemployment countries). The data show there were two lengthy episodes distinguished by their differing performance, the Golden Age of low unemployment, moderate inflation and rapid growth (not shown), followed by what we designate the Age of Decline, an episode of high unemployment, high rates of inflation and slow growth. Each episode covers a series of shortrun business cycles, with turning points in GDP determined by the OECD and cited at the top of the columns. The customary definition of full employment emphasizes the absence of involuntary unemployment after an adjustment for frictional or ‘job-search’ unemployment. Inspection of Table 8.1 shows an overall average unemployment rate of 2.3 per cent for the 18 developed capitalist economies during the Golden Age. During this episode 3 per cent was commonly accepted as the full employment rate of unemployment in the United States. We follow this custom, although choosing an overall average rate as high as 4.5 per cent would not alter the nature of our conclusions. Table 8.1 brings out clearly the exceptional unemployment and inflation records of all but four of the economies in the first episode; these form the high unemployment group. This was a period of expansion of the welfare state, especially outside of the United States, resulting in noticeable reductions in poverty rates and in the inequality of income distribution. It was clearly a Golden Age for most. The period from the mid-1970s to the closing years of the century was one of economic decline. Accelerating inflation rates in the late 1960s and early

Power and Institutions in Macroeconomic Theory 89 Table 8.1: Annual average standardized unemployment rates (U) and rates of consumer . price inflation (p) for 18 OECD countries (%) 1960–67

1974–79

1980–89

U

. p

U

. p

U

. p

5.2 7.1 6.9 6.0 5.6 6.2

1.8 1.9 1.8 1.9 0.4 1.6

6.2 9.9 8.7 9.8 4.0 7.7

3.3 2.5 2.8 2.6 0.6 2.4

3.8 2.5 8.3 7.9 3.3 5.2

3.9 3.2 4.8 7.1 3.1 4.4

2.4 1.0 2.5 3.3 2.3 2.3

5.4 5.6 5.7 4.6 5.3

4.6 8.9 5.8 5.0 6.1

7.2 9.2 7.9 14.9 6.6 16.1 6.8 8.5 7.1 12.2

9.4 6.5 14.3 9.2 8.0 11.1 7.3 5.5 9.8 8.1

9.3 11.3 10.6 5.6 9.2

2.2 2.6 4.0 3.0 3.0

2.2 2.8 6.2 5.6 3.6 2.7 3.6 3.3 3.6 3.7

2.0 2.5 1.0 2.6 2.6 1.0 1.5 0.3 3.3 1.9

5.6 4.9 6.3 5.8 6.1 4.6 6.9 7.4 7.5 6.1

5.1 7.1 6.1 5.1 4.5 3.2 5.4 0.8 4.7 4.7

7.5 8.4 9.8 4.9 8.1 6.9 5.4 7.1 8.8 7.3 5.8 2.9 7.9 2.8 4.6 11.8 9.8 7.4 7.5 6.6

8.4 8.5 7.1 11.7 11.1 7.7 5.4 7.8 8.0 8.4

2.7 2.2 2.2 2.3 1.9 2.5 2.5 2.1 3.6 2.4

3.7

2.5 6.1

7.5

2.5

U

. p

Low unemployment Austria Japan Norway Sweden Switzerland Unweighted average

2.0 1.4 2.0 1.6 0.0 1.4

High unemployment Canada Ireland Italy United States Unweighted average

1968–73 U

. p

3.6 5.7 3.9 3.8 3.4 4.1

1.8 1.2 1.7 2.2 0.0 1.4

4.8 4.9 4.8 4.9 4.9

2.4 4.0 4.0 2.0 3.1

Low-high unemployment Australia Belgium Denmark Finland France Germany Netherlands New Zealand United Kingdom Unweighted average

2.2 2.0 1.6 1.6 1.6 0.6 1.0 0.1 2.7 1.5

Overall average

2.2

12.2 8.4 10.8 12.6 10.7 4.6 7.2 13.8 15.6 10.7

4.4 10.2

6.6

6.5

1990–2000

Sources U: OECD Historical Statistics 1970–2000 and earlier issues, Table 2.19, Standardized Unemployment Rates. For 1960–64, unemployment rates were obtained from the LSE data set. For Austria, Denmark and Switzerland, and for New Zealand prior to 1974, standardized rates are not available; unemployment as a percentage of the total labour force is used instead. . p: OECD Historical Statistics 1970–2000 and earlier issues, Table 7.10.

1970s were followed by persistent inflation problems in spite of restrictive aggregate demand policies and rising unemployment rates. Episodes of high unemployment for most economies began in the mid-1970s and extended over a period approximately twice the length of the Golden Age.2 The unweighted average unemployment rate rose from approximately one and a half times its Golden Age average rate to triple this rate by the 1990s short-run cycle. Within these average figures there were also exceptions, as the five low unemployment countries continued to experience low unemployment rates, except for Sweden in the 1990s.


The continued failure to achieve full employment raises a serious challenge to the belief that capitalism is self-regulating. Although mild fluctuations in output and unemployment within this episode might be attributed to shocks, they cannot explain the persistence of the high and rising unemployment that began in the mid-1970s; it has gone on too long and has been experienced by too many economies. Instead, this episode draws attention to a long and widely shared period of inadequate aggregate demand. This requires explanation, as does capitalism’s success in the previous period. We return to the analysis of this deterioration in performance following a discussion of the radical shift in mainstream macroeconomic theory that accompanied the decline.

Paradigm shift The Golden Age of capitalist development was also the golden age of Keynesian macroeconomics. Mainstream macroeconomic models gave a central role to aggregate demand in determining the equilibrium of the system. Any failure of the private sector to achieve full employment levels of aggregate demand would be short-lived, corrected when necessary by stimulative fiscal policies. It was the high growth rates of aggregate demand experienced during this episode that led to the economies’ achievement of full employment levels of output and employment. With few exceptions, inflation was at acceptable rates throughout the Golden Age. It was modelled by an assumed stable, downward-sloping Phillips curve with a politically acceptable menu of inflation/unemployment choices. Given the commendable macroeconomic performance of the episode and economists’ wide acceptance of a Keynesian explanation of the stylized facts (‘we were all Keynesians’), little effort was made by macro-economists to push the chain of causation deeper to consider whether there were specific historical factors underlying performance and delivering a Golden Age. Bouts of rather severe inflation in the late 1960s and early 1970s marked the beginning of the end of the Golden Age. Central bankers, business and political leaders believed the underlying force generating unacceptable inflationary pressures to be the growing exercise of labour power, to a large extent caused by the rising affluence and sustained high employment of the Golden Age. This led to an ‘overload’ of demands on the economy, especially demands on governments made by labour, that could not all be satisfied. The economy had become inflation-prone and needed a drastic antiinflationary response from government. Based on this appraisal, the recovery programmes advocated by business and political leaders, especially in the United States, Canada and the UK, increasingly involved reduction of the welfare state and deregulation, to yield greater ‘flexibility’ in capital and labour markets. Their adherence to this explanation of decline and its remedy can be considered to large extent political, a resurrection of a latent

Power and Institutions in Macroeconomic Theory 91

ideology of long-standing importance in these countries. According to this world view, these kinds of market interventions are symptoms of undesirable power shifts. Abolishing them redistributes power and restores the efficiency of a private enterprise market economy. The stagflation of the 1970s and 1980s was accompanied by the emergence of New Keynesian macroeconomics, which was to replace Keynesian theory as mainstream macroeconomics. This is a theoretical framework with a causal structure and policy implications fundamentally different from Keynesian macroeconomics. In New Keynesian macroeconomics the equilibrium rate of unemployment, a non-observable entity, is uniquely determined by exogenous supply-side factors. Aggregate demand plays only a passive role. Given some initial level or growth of aggregate demand, built-in adjustment mechanisms bring aggregate demand into line with the supply-determined equilibrium, that is the natural rate of unemployment or NAIRU. Inflationary problems are then explained as the consequence of the authorities’ efforts to reduce unemployment below its equilibrium rate through overly stimulative aggregate demand policies. The long-run Phillips curve was claimed to be vertical at the equilibrium rate of unemployment, a ‘fact’ ignored by Keynesian policymakers at their peril. Although actual unemployment was high and there was substantial evidence that much of it was involuntary, this was nonetheless claimed to be an equilibrium according to New Keynesian macroeconomics. The apparent difficulty was resolved by alleging that the real wage was too high to employ all workers willing to work; moreover, the wage was rigid downward, because of excessive labour power, so that unemployment could not be decreased by stimulative aggregate demand policies. The failure of restrictive aggregate demand policies to quickly reduce inflation to Golden Age rates, in spite of substantial and prolonged high unemployment, reaffirmed the beliefs of economists who already subscribed to a laissez-faire vision. The growing acceptance of vertical Phillips curve analysis and its unique unemployment equilibrium reinforced this vision. It can be said that a serious omission was a prime cause of the decline in support for Keynesian theory, and that it contributed to an even wider acceptance of New Keynesian principles. Keynesian theory provided the policy solutions to economic problems, but could not explain why these policies were not routinely used by all countries, or applied uniformly over time by an individual country. Once economic theory enters the real world via a prescription for interventionism, as Keynesian theory does, it must consider the institutions and the distribution of power that might constrain policy options. By including institutions and power and changes in their structures, the analysis can identify the constraints at work and the appropriate policy responses. More exactly, beginning with the decline in macroeconomic performance in the mid-1970s and continuing to the present, Keynesian economists had


failed to develop a general explanation of governments’ unwillingness to supply the aggregate demand policies required to achieve full employment. Without such a theory the best available explanation of stagflation, especially among the younger macro-economists, was seen to be the rising political and economic demands upon the system by labour. The appropriate ‘remedial’ measures included reductions in labour power. Effectively, this New Keynesian explanation of the difficulties and programme for recovery coincided with the views of business and political leaders. With the notable exception of work by the Post Keynesians, the macroeconomics that emerged was embedded in the supply determined equilibrium framework, a framework that denies the need for any theory of aggregate demand other than its automatic adjustment to aggregate supply. Arguments for rejecting New Keynesian macroeconomics as a method of analysis are a subject for another paper. We will offer a critique of their policies below.

A political economy theory of aggregate demand Extending the Keynesian model The remainder of this chapter focuses on formulating a theory of aggregate demand that can explain differences in unemployment rates both between economies and through time. It builds upon a traditional Keynesian base, and is intended to correct the omission in Keynesian macroeconomics referred to in the previous section. While this chapter deals with differences in aggregate demand and unemployment across countries, the model can also be used to analyse the changes in aggregate demand and unemployment from the Golden Age to the Age of Decline. In the extended model, aggregate demand policy is endogenously determined. Its starting point is a central insight of the General Theory – high unemployment rates and low levels of output are caused by deficient aggregate demand and can be remedied by fiscal policy. Persistently high unemployment can therefore be attributed to the authorities’ failure to supply the needed expansionary policies. We then push the analysis deeper by asking why they might fail to provide this level of aggregate demand (or why they have been willing to do so in the past). The answer lies in the underlying power and institutional structures. Although these change relatively slowly compared to movements of the usual economic variables, they are nevertheless ‘historically specific’ having varied significantly from one historic episode to the next.3 The demand for and supply of aggregate demand Thus, we model the dominant macroeconomic policy response of the authorities in any historical episode as the outcome of an interaction between the supply of and demand for full employment policies. In this framework, the strength of demand for full employment policies is determined


by the distribution of political and economic power among organized interest groups. The policies supplied by the fiscal authorities depend upon whether there are constraints limiting their policy options.4 For example, they may be unwilling to supply full employment levels of aggregate demand because to do so would generate unacceptable inflation or external imbalance, or because there are laws that limit budget deficits. To focus on essentials, in this section we assume that the only constraint limiting the authorities’ policy options is an unacceptably high inflation rate at full employment. In the fifth section the central issues are analysed in a more formal manner, allowing for the treatment of additional constraints on policy options, followed in the sixth section by an econometric test of our political economy theory of aggregate demand. The party control theory of economic policy is the most prominent of the models focusing on the demand side and is a useful point of reference. It offers a political explanation of policy choice, explaining differences in unemployment rates across countries in terms of the relative strength of right-wing and left-wing political parties (for example, Kalecki, 1971; Hibbs, 1987; Alesina et al., 1997). It assumes that political parties represent the society’s socio-economic divisions, and that labour is more willing than capital to trade price stability for lower unemployment, a preference registered at the ballot box in its choice of political parties. However, this analysis is incomplete. The distribution of political power accounts only for the strength of demand for expansionary policies. Even the most ardently prolabour government must consider the costs of supplying a full employment policy, the most obvious being the inflation cost. In this case, the key factor underlying the costs and willingness to supply stimulative policies is the position of the Phillips curve, with a poorly placed Phillips curve acting as a constraint. For example, if the maximum politically acceptable rate of price inflation intersects the Phillips curve to the right of the full employment rate of unemployment, policy will target an unemployment rate greater than the full employment rate. In such an economy, inflation costs constrain expansionary policies. The position of the Phillips curve is determined by particular labour market institutions. In the period since World War II, the most important of these has been the strategy adopted by labour, business and government to institutionalize ‘fairness’ in labour markets. With some variations, there were two types of strategy. One permitted full employment with politically acceptable rates of inflation; the other failed to do so.5 The latter results from using a ‘market power’ strategy in which wage settlements were reached through unrestricted collective bargaining between labour and management. There were no institutions that would routinely coordinate wage settlements with national goals; governments had failed to exercise leadership in establishing such institutions. The lack of coordinating institutions resulted in a strong emphasis on the money wage as the target of bargaining.


Maximizing the money wage, with the cost of living and wage settlements in other sectors as guides, was the means chosen to secure real wage gains. The adoption of this labour market strategy reflected, and helped to perpetuate, the conflict endemic to an adversarial industrial relations system, often manifested as a high strike volume. Since labour’s market power rose when unemployment rates fell, this strategy generated a negatively sloped longrun Phillips curve. Further, this strategy produces a high strike volume, which pushed the Phillips curve to the right, creating a menu of inflation– unemployment choices that excluded simultaneous full employment and acceptable inflation. In other economies a ‘social bargain’ strategy was adopted by labour in cooperation with capital and overseen by government. In this case labour accepted the need for money wage restraint in order to achieve national goals such as wage and price stability and international competitiveness. In exchange, labour was promised full employment, the rising real wages that full employment generated through higher productivity growth, and welfare programmes as a safety net. Variations in the institutional forms of the social bargain, including the generosity of welfare programmes and employment protection measures were largely the result of differences in the power of labour. In the late 1960s, the breakdown of social bargains in many economies and their replacement by a market power strategy was a contributing cause to the end of the Golden Age. According to our analysis, increased strike activity would be expected as a result of this institutional change, a consequence of the industrial unrest inherent in an adversarial bargaining strategy. Table 8.2 records the average days lost per thousand workers as a consequence of strikes for each of the three country groups of Table 8.1. For the groups with consistently low or consistently high unemployment, we can see that strike activity is also consistently low or high. But in the group of countries whose social bargains collapsed in the late 1960s, strike activity increases to well over twice its earlier level. This institutional change, from harmonious to adversarial industrial relations, caused their Phillips curves to shift rightward, with the earliest impact felt on wage inflation; the effect on unemployment was delayed until the mid-1970s, as governments countered rising inflation with restrictive policies, according to the New Keynesian prescription. Table 8.2: Average days lost to strikes, per thousand workers, 1960–89 Country group Low unemployment High unemployment Low-high unemployment

1960–67

1968–73

1974–79

1980–89

43 370 97

32 676 257

32 706 248

57* 333 207**

Notes * This falls to 36 if Sweden is excluded. ** Excludes Belgium, because of missing data.


A formal model Our contention is that power and institutions act together to determine economic outcomes, unemployment in our example. Our example has so far considered the chosen labour market strategy as a determinant of the position of the Phillips curve, because this indicates the degree of trust and harmony in industrial relations. While the level of industrial harmony is crucial, here we allow for the existence of additional institutional constraints that determine economic outcomes. The distribution of power decides the political party whose preferences will be furthered, but the pursuit of these preferences is limited by what is possible.6 The model consists of a political preference function which is to be optimized subject to the existing Phillips curve.7 The Phillips curve is assumed to be downward sloping, so that there are trade-offs between unemployment and inflation that governments can exploit. The formal model clearly overstates the precision with which governments act; multiple policy goals, lack of information, and policy mistakes make such precision highly unlikely. Fortunately, all that is needed in practice is the assumption that political preferences differ enough to produce consistent differences in unemployment outcomes as governments attempt to optimize.8 The Phillips curve The price inflation Phillips curve can be written as . p f (U; V1)

(8.1)

. where p and U represent the inflation and unemployment rates, and V1 is a vector of variables that influence its slope and position. These include economic variables such as productivity growth, an import price index, and as a measure of external demand conditions, unemployment in the trading partner countries. There are also institutional variables, included to capture the effects of different and changing industrial relations systems. Other explanations of differences in the position of Phillips curves among countries have included such regulatory measures as payroll taxes and various dimensions of the welfare state, particularly the ratio of unemployment benefits to wages, with mixed results.9 Rather than isolating individual regulations, which are relatively easily changed, we emphasize institutions that have a broader and more persistent influence on labour market behaviour. The political preference function The political preference function measures the disutility (M) of pairs of unemployment and inflation rates. It is assumed to be strictly convex, ensuring that it yields strictly concave indifference curves. It can be written as . M M( p, U; V2)

Mp, Mu 0

(8.2)


where V2 is a vector of political and institutional variables influencing its slope and position. The parameters of the preference function vary with the political party in power, and it is expected that left-leaning governments will attach a relatively greater weight to unemployment than will right-of-centre governments, yielding steeper indifference curves. Put simply, the left-leaning government will accept a greater rise in inflation to achieve a given reduction in unemployment than will the right-wing government. Custom and tradition also influence preferences, causing different weights, and so different slopes, even among countries with similarly left- or right-wing governments. For example, compared to others, a country with a strong aversion to inflation, such as Germany, will attach a greater weight to inflation whatever government it elects. Optimization Each unemployment outcome is interpreted as the result of the government acting to optimize its preference function subject to the existing Phillips curve. The preference function measures disutility, so that the indifference curve closest to the origin is preferred. In Figure 8.1 this is shown at point A, the point of tangency between the Phillips curve (PC1) and the indifference curve (IC1). Should the Phillips curve shift to PC2, there is greater disutility at the optimum point B. The effect of alternative preference functions is shown in Figure 8.2, where the steeper indifference curve (ICL) depicts the effect of a more left-wing government than curve ICR. Given the prevailing Phillips curve, optimization occurs at point A, with lower unemployment and higher inflation than at point B, which would be the choice of a right-wing government.

p

B A

PC2 PC1 IC1

IC2 U

Figure 8.1

Optimizing political preferences


p

A

B PC ICL

ICR U

Figure 8.2 Alternative political preferences

The reduced form Our interest lies in the extent to which actual unemployment outcomes are determined by an economy’s institutional characteristics and distribution of power. Each observed (optimal) unemployment rate can be represented by a reduced form equation U U (V1 ,V2)

(8.3)

where the vectors V1 and V2 contain the institutional and other exogenous or predetermined variables.10 Estimation of this reduced form will provide information about the importance of power and institutional variables in explaining the differences in unemployment rates both between countries and over time for a group of OECD economies. Problems associated with business cycle fluctuations are avoided by using data averaged over the cycle. The first step is to specify the variables to be used and relate them to our theoretical model. The vector V2 is from the political preference function, and includes variables that determine the slope of the indifference curves. The idea that left or right political leanings will affect the slope is tested by using the proportion of left of centre votes cast in the period as a measure of effective political preferences. Others (for example, Hibbs, 1987; Alesina et al., 1997) have distinguished left-wing from right-wing governments by using dummy variables that simply assume values of plus or minus one. Using left of centre votes allows a finer distinction, providing a measure of the extent to which any government hoping for re-election must moderate its ideological


preferences. A strong left vote will move the policies of a right-wing government toward the centre, or strengthen a left-wing administration’s ability to resist the claims of powerful business and financial interests. Neither can the simple left–right classification distinguish between high unemployment countries like the United States and Canada, and Japan and Switzerland which have low unemployment, since they all consistently elect right-wing governments. But they have very distinct voting patterns; the average percentage of left votes is 38 per cent for Japan and 26 per cent for Switzerland, compared to zero for the United States and about 15 per cent for Canada. The use of left votes also avoids some of the measurement problems for multi-party states that often have coalition governments. In general, the higher the proportion of left votes, the greater the tolerance for inflation and the stronger the preference for low unemployment. Identical voting patterns do not imply identical indifference curves, since political preferences also depend on a country’s history and institutions. One source of variability is the level of aversion to inflation, proxied here by an index of central bank independence.11 Lastly, because it was voluntary, membership in the European Monetary System also represents political preferences; a dummy variable is used to capture its effects. The monetary policy of EMS members was affected by exchange rate coordination, lowering inflation rates (Jenkins, 1996). EMS membership is therefore an additional measure of a preference for lower inflation. The Phillips curve defines the set of possible outcomes; its parameters are defined by the variables in vector V1. The degree of industrial conflict is expected to have a strong influence on the position of the Phillips curve. It is measured here by the volume of strikes, which is lagged to allow time for changes in industrial relations to exert their influence. Harmony in industrial relations depends upon trust, particularly in wage bargaining. When management’s assessments of costs and productivity are believed, wage claims will take them into account, reducing conflict and the likelihood of strikes, and improving the inflation–unemployment trade-off.12 The volume of strikes is a more direct and more sensitive measure of the wage bargaining environment than the structure of collective bargaining used by others (for example, Calmfors and Driffill, 1988). The position of the Phillips curve also responds to changes in economic conditions, for example, the international economic environment. We account for external demand conditions by using unemployment in each country’s trading partners’ economies, weighted by its exports to GDP ratio. This weight allows for differences in openness that determine the degree of exposure to external demand. Finally, lagged inflation is included as a determinant of the position of the Phillips curve, but we use the average inflation rate in the previous business cycle. Therefore it is not a simple inflationary expectations variable; instead, it measures the cumulative effects of past inflation on the position of the Phillips curve. These effects can be traced to institutional changes in the post-war era, especially the increasing power of labour. Backed by this power,


labour’s claim to ‘fairness’ in wage settlements induced employers to accept the protection of real wages as a legitimate objective (Hicks, 1974; Perry, 1975). Past inflation can also affect the Phillips curve via the restrictive policies it induces, in a hysteretic process. In addition, more familiar economic variables such as productivity growth and import price inflation are potential determinants of the position of the Phillips curve.13

The test results and some implications We tested the model using a sample of 18 OECD countries, with four observations for each, for the years 1960–67, 1968–73, 1974–79 and 1980–89, which approximate the business cycles of the period.14 These observations were pooled, and estimated using OLS.15 The variables are defined in Table 8.3. Table 8.4 lists the countries in the sample, and reports regression results for the reduced form unemployment equation (8.3).16 Tests for changes in the coefficients after 1973 showed the estimates to be very stable, with one possible exception. The Hocking specification test points to a break in the lagged inflation variable. Its coefficient was not significantly different from zero prior to 1974, but afterwards took a positive value, implying that lagged inflation came to play a part in determining unemployment only after the end of the Golden Age. This result is consistent with the greater intolerance of inflation, and acceptance of higher unemployment rates to combat it, which occurred in many countries at that time, and also with the widespread use of restrictive policies since the mid-1970s. The coefficient of the external demand variable (WU) is significant, with a value a little less than one. This is expected, given the extent of trade among these countries, and sufficient time in each period to allow the transmission of changes to take place. This coefficient suggests that if a country exports 50 per cent of its GDP, and the unemployment of its trading partners rises by 1 percentage point, it can expect its own unemployment rate to rise by about 0.5 percentage points.17 Table 8.3: Definitions of the variables used in the unemployment equation U LV CBI EMS STR WU LINF

Average unemployment rate over the period Left of centre votes as a proportion of total votes cast in elections during the period Index of central bank independence Dummy variable for membership in the European Monetary System Logarithm of man-days lost to strikes per thousand workers, lagged one period Weighted average unemployment rate of the other 17 countries in the sample, scaled by the country’s own exports to GDP ratio Average inflation rate, lagged one period

Sources: Voting data, Mackie and Rose (1991); central bank independence index, Cukierman et al. (1992); strike data, ILO Yearbook of Labour Statistics, various issues; OECD data are used for the remaining variables.

100 John Kenneth Galbraith and the Future of Economics Table 8.4: Regression results for the reduced form unemployment equation Equation (8.1) Left of centre votes Central bank independence Membership in the EMS Strikes ‘World’ unemployment (WU) Lagged inflation 1974–89 dummy lagged inflation Constant Adjusted R2 Hocking test critical value Hocking sp

4.877 (4.02) 3.046 (2.64) 3.016 (4.60) 1.005 (8.05) 0.944 (4.04) 0.195 (3.43)

2.7337 (2.27) 0.8222 2.0317 3.5445

Equation (8.2) 4.535 (3.77) 2.810 (2.47) 3.149 (4.87) 1.001 (8.17) 0.794 (3.27) 0.037 (0.28) 0.198 (1.88) 2.0652 (1.68) 0.8289

Notes: The figures in parenthesis are the absolute values of the t-statistics. The 18 countries included are: United States, Japan, Germany, France, Italy, United Kingdom, Canada, Australia, Austria, Belgium, Denmark, Finland, Ireland, The Netherlands, New Zealand, Norway, Sweden and Switzerland. There were four observations for each, for the years 1960–67, 1968–73, 1974–79, 1980–89.

Of greater interest to our analysis are the coefficients of the institutional and power variables, which are all of the expected sign, and significantly different from zero at the 5 per cent level. The ‘left votes’ variable used to capture the distribution of power, suggests that a 10 percentage point increase in left votes would result in a drop of approximately 0.5 percentage points in unemployment. The institutional variables have similarly strong implied effects. Membership in the EMS increases unemployment by about 3 per cent, ceteris paribus. Increased central bank independence also increases unemployment rates. For example, the difference in the index between the USA and Japan is 0.30, and accounts for almost 1 percentage point of the difference in the unemployment rates of these countries. For the period 1973–89, the annual average days lost to strikes per thousand workers for the ‘high unemployment’ economies of Table 8.1 was 692, and it was 32 for the ‘low unemployment’ group, accounting for a 3 percentage point difference in their unemployment rates. The strong partial correlations of these variables with unemployment, and the high overall explanatory power of


the estimates support the view that power and institutions play a significant part in determining unemployment rates. In the third section we noted that New Keynesian economists blame the effect of labour-friendly institutions accumulated during the Golden Age for the increased unemployment that followed. The cure was deregulation, to create a more competitive, flexible labour market. Another influential view is that institutions aid performance the closer they are to some competitive norm. Both views are contrary to the historical record. Among the best performers during this episode were Austria, Germany and the Scandinavian economies, all characterized by extended welfare states, high taxes, high union densities and highly regulated labour markets. In contrast economies with institutions closer to a competitive norm, for example, Canada and the United States, were among the worst performers. Using our estimates to account for the change from the Golden Age to the Age of Decline provides some numbers that support this. While EMS membership and international demand conditions account for a large share of the increase in unemployment between these two episodes, labour market institutions were important. In Canada, Ireland, Italy, Australia and the United Kingdom, increased strike activity accounts for about a 1 percentage point increase in their unemployment rates. In four of the five countries that kept their social bargains, strikes fell, reducing their unemployment rates by an average 1 percentage point, while in Sweden a small increase in strikes had a minimal effect. These estimates suggest that far from hindering performance, social bargains can assist it.

Conclusions Galbraith has argued that by failing to take into account historical context, economists have produced theories that lack depth and relevance. The power structures and institutions of a country are important determinants of economic performance. These change over time, influenced by and influencing economic development. Analysis that ignores them provides at best only a superficial interpretation of events, and at worst misinterprets them. Our chapter supports this charge, citing developments in macroeconomic theory over the past half century. We conclude that the currently dominant New Keynesian macroeconomics has advocated policies to reduce unemployment that are based on assumptions inconsistent with the historical data of Table 8.1. The historical record does not support the position that macroeconomic performance improves the closer institutions conform to the competitive model. In fact those economies whose structure most clearly resembles the competitive model were consistently among the high unemployment performers, for example, Canada and the United States. On the other hand, the economies with the best unemployment records, in the Golden Age and beyond, were those in which the authorities engaged


in market interventions, establishing and maintaining labour-friendly institutions. We also contend that underlying the decreasing acceptance of the kind of Keynesian macroeconomics associated with the General Theory has been its failure to include power and institutions as part of its theoretical framework. Perhaps most damaging in this context has been its inability to provide a general explanation of stagflation. The remainder of the chapter presents a model that extends Keynesian macroeconomic principles. This reformulation of Keynesian theory includes power and institutions as determinants of aggregate demand; it is offered here as a remedy to some of Galbraith’s criticisms. The importance of power and institutions is supported by our econometric tests. But Galbraith’s critique of current theory goes further, and concerns the manipulation of public preferences and the consequent induced impact on institutions. The concentration of power in the modern economy, and its use to further consolidate its already formidable strength has been at the root of Galbraith’s writings. This is the overriding characteristic that he insists we recognize. Once we have done so, any vestiges of self-regulating markets evaporate, and then we can begin to understand how real economies work. Although we have not ventured into analysing the use of power to form or manipulate preferences, we have taken the first steps to investigate how power promotes the preferences of particular groups via the policy choices that are made. This has increased the power of our analysis by showing how power and institutions are linked to economic policies and performance. For the future, we believe a research programme that emphasizes case studies and historical analysis will provide the detail that will allow us to refine and expand our results.

Notes 1. We are indebted to the Academic Vice-President’s Office, the Faculty of Science, and the Department of Economics, all of Dalhousie University, for providing financial support for this research. 2. This understates the length of the Golden Age episode because of an absence of comparable data in the period before 1960. 3. Institutions can be defined as the beliefs, customs, laws, rules and norms that guide the behaviour of individuals and groups within society. One of their functions is to legitimize power; another is to provide the mechanisms for conflict mediation. For this study, power is usefully defined as the ability of dominant individuals or groups in economic relationships to make subordinate individuals or groups act in the former’s interest. Economic and political power are distinguished by the means used to exercise them, that is via the market or via political channels. When institutions legitimize a power relationship, they simultaneously legitimize the economic outcomes that flow from it. These economic outcomes are often, although not exclusively, concerned with income distribution, as are many of the conflicts that arise. 4. In this analysis monetary policy is treated as a separate institution, with the degree of independence of the central bank varying among countries. For an earlier study employing a similar framework see Gordon (1975).

Power and Institutions in Macroeconomic Theory 103 5. For greater detail see Cornwall (1994), chapters 5–7. 6. The resulting model develops earlier ideas that have emphasized the political economy aspects of the unemployment–inflation issue (for example, Cornwall, 1994; Hibbs, 1987). 7. This model was originally used by Lipsey (1965) and later by Trevithick (1976) to provide a definition of full employment that is consistent with other objectives of economic policy. It is implicit in partisan control theory (for example, Hibbs, 1987). 8. There are several arguments for rejecting the use of vertical Phillips curve analysis (for example, Cornwall and Cornwall, 2001). 9. The variables are used to measure real wage rigidities, which are then used to explain unemployment (for example, Layard et al., 1991). Others claim that labour market rigidities fail to explain differences in unemployment (McCallum, 1986; Freeman, 1995). . 10. Similarly, there is a reduced form equation for inflation, p P( V1, V2 ). It should also be noted that the vectors V1 and V2 may have some elements in common. 11. We support the proposition that central bank independence is caused by aversion to inflation, whether this is ‘grass roots’ aversion (Debelle and Fischer, 1994) or the view of powerful financial interest groups (Posen, 1995). 12. McCallum (1983) and Paldam (1980) provide further discussion of these points. 13. Our tests showed these to have coefficients that are not significantly different from zero, probably the result of using data averaged over the business cycle. 14. More recent data are not included, partly because there is not a complete business cycle, and partly because of the inconsistencies created by the unification of Germany. 15. Using Monte Carlo simulations, Hauk and Wacziarg (2004) show that OLS applied to averaged country data provides estimates with reduced overall bias compared to other commonly used estimation methods. 16. For a full treatment of the model, the variables used for estimation, and additional estimation results, see W. Cornwall (1999). 17. These numerical illustrations use the coefficients of equation (8.1) in Table 8.4.

References A. Alesina and N. Roubini, with G. Cohen (1997), Political Cycles and the Macroeconomy (Cambridge: MIT Press, 1996). L. Calmfors and J. Drifill, ‘Bargaining Structure, Corporatism and Macroeconomic Performance’, Economic Policy, 3 (1988), 13–22. J. Cornwall, Economic Breakdown & Recovery: Theory and Policy (Armonk, NY: M.E. Sharpe, 1994). J. Cornwall and W. Cornwall, Capitalist Development in the Twentieth Century: an Evolutionary-Keynesian Approach (Cambridge: Cambridge University Press, 2001). W. Cornwall, ‘The Institutional Determinants of Unemployment’, in Mark Setterfield (ed.), The Political Economy of Growth, Employment and Inflation (London: Macmillan, 1999). A. Cukierman, S.B. Webb and B. Neyapti, ‘Measuring the Independence of Central Banks and its Effect on Policy Outcomes’, World Bank Economic Review, 6 (1992), 353–98. G. Debelle and S. Fischer, ‘How Independent Should a Central Bank be?’, Goals, Guidelines, and Constraints Facing Monetary Policymakers, Federal Reserve Bank of Boston Conference Series, 38 (1994).

104 John Kenneth Galbraith and the Future of Economics R. Freeman, ‘The Limits of Wage Flexibility to Curing Unemployment’, Oxford Review of Economic Policy, 11(1) (1995), 63–72. R. Gordon, ‘The Demand for and Supply of Inflation’, Journal of Law and Economics, December (1975), 807–36. W.R. Hauk. and R. Wacziarg, ‘A Monte Carlo Study of Growth Regressions’, NBER Technical Working Paper Series, T0296 (2004). D. Hibbs, ‘Political Parties and Macroeconomic Policy’, in The Political Economy of Industrial Democracies (Cambridge, MA: Harvard University Press, 1987). J. Hicks, The Crisis in Keynesian Economics (New York: Basic Books, 1974). M. Jenkins, ‘Central Bank Independence and Inflation Performance: Panacea or Placebo?’, Banca Nazionale del Lavoro Quarterly Review, 49 (1996), 241–70. M. Kalecki, ‘Political Aspects of Full Employment’, in Selected Essays on the Dynamics of the Capitalist Economy (Cambridge: Cambridge University Press, 1971), Chapter 12. R. Layard, S. Nickell and R. Jackman, Unemployment: Macroeconomic Performance and the Labour Market (Oxford: Oxford University Press, 1991). R. Lipsey, ‘Structural and Demand Deficient Unemployment Reconsidered’, in A.M. Ross (ed.), Employment Policy and the Labor Market (Los Angeles, CA: University of California Press, 1965). T. Mackie and R. Rose, The International Almanac of Electoral History (London: Macmillan, 1991). J. McCallum, ‘Inflation and Social Consensus in the Seventies’, Economic Journal, 93 (1983), 784–805. J. McCallum, ‘Unemployment in the OECD Countries in the 1980s’, Economic Journal, 96 (1986), 942–60. OECD, Historical Statistics 1970–2000 (Paris: OECD, 2001). M. Paldam, ‘Industrial Conflict and the Phillips Curve: an International Perspective’, memo 80–4/5, Institute of Economics, Aarhus University (1980). G. Perry, ‘Determinants of Wage Inflation around the World’, Brookings Papers on Economic Activity, 2 (1975), 403–47. A. Posen, ‘Declarations are not Enough: Financial Sector Sources of Central Bank Independence’, in B. Bernanke and J. Rotemberg (eds), NBER Macroeconomics Annual 1995 (Cambridge, MA: MIT Press, 1995). J. Trevithick, ‘Inflation, the Natural Unemployment Rate and the Theory of Economic Policy’, Scottish Journal of Political Economy, 23 (1976), 37–53.

9

Reinventing Fiscal Policy Philip Arestis and Malcolm Sawyer

Introduction1 There has been a major shift within macroeconomic policy over the past two decades or so in terms of the relative importance given to monetary policy and to fiscal policy, with the former gaining considerably in importance, and the latter being so much downgraded that it is rarely mentioned. Monetary policy has focused on the setting of interest rates as the key policy instrument, along with the adoption of inflation targets and the use of monetary policy to target inflation. The Central Bank sets its discount rate2 with a view to achieving the set inflation target, but the discount rate can be considered as set relative to an ‘equilibrium rate’ so that the problem of aggregate demand deficiency appears to be effectively dispensed with.3 This can be seen in the operation of Taylor’s rule for the setting of the discount rate (Taylor, 1993). In Arestis and Sawyer (2003a), we critically examine the significance of this shift in terms of monetary policy, which led us to question the effectiveness of monetary policy. In the same paper we also explore the role of fiscal policy, and argue that within the ‘new consensus’ there is barely mention of fiscal policy.4 We strongly suggest there that fiscal policy should be reinstated, and conclude that ‘fiscal policy remains a potent tool for offsetting major changes in the level of aggregate demand’ (p. 19). This chapter aims to consider further that particular conclusion (see also, Arestis and Sawyer, 1998). We begin by considering this ‘new consensus’ and the limited nature of its analysis. We then consider fiscal policy at length within this theoretical framework. We find the proposition of this thinking, that fiscal policy provides at best a limited role, unconvincing. The two sections that follow examine the possibility of crowding-out and the Ricardian equivalence theorem (RET). We argue that, under specified conditions, fiscal policy is a powerful tool for macroeconomic policy. A short review of quantitative estimates of fiscal policy multipliers is provided in the section that follows, before the final section that summarizes the argument and concludes. 105


The ‘new consensus’ in macroeconomics The ‘new consensus’ in macroeconomics has been summarized in terms of a simple model with the following three equations (adapted from Meyer, 2001; but see also, McCallum, 2001; and Clarida et al., 1999; it is also discussed in Arestis and Sawyer, 2002b and 2002c): Ygt a0 a1Ygt1 a2Et(Ygt1) a3[Rt Et( pt1)] s1 pt

b1Ygt

b2 pt1 b3Et(pt1) s2,

(with b2 b3 1)

Rt (1 c3)[RR* Et(pt1) c1Ygt1 c2( pt1 pT)] c3Rt1

(9.1) (9.2) (9.3)

where Yg is the output gap, R is nominal rate of interest, p is rate of inflation, pT is inflation rate target, RR* is the ‘equilibrium’ real rate of interest, that is the rate of interest consistent with zero output gap which implies from equation (9.2), a constant rate of inflation, si (with i 1, 2) represents stochastic shocks, and Et refers to expectations held at time t. Equation (9.1) is the aggregate demand equation with the current output gap determined by past and expected future output gap and the real rate of interest. Equation (9.2) is a Phillips curve with inflation based on current output gap and past and future inflation. Equation (9.3) is a monetary policy operating rule with the nominal interest rate based on expected inflation, output gap, deviation of inflation from target and the ‘equilibrium’ real rate of interest. The lagged interest rate represents interest rate ‘smoothing’ undertaken by the monetary authorities (see, for example, McCallum, 2001).5 From the perspective of this chapter, equation (9.1) is of particular significance. There is no explicit mention of fiscal policy, though changes in the fiscal stance could be seen as reflected in a change in a0. But proponents of this model have produced a number of arguments that suggest that the use of discretionary fiscal policy should be seen as the exception rather than the rule. The norm for fiscal policy should be to let automatic stabilizers operate in an environment of budgets balanced over the business cycle, and the operation of those stabilizers may be reflected in the coefficients a1 and a2. A number of arguments have been put forward to make the case against the use of discretionary fiscal policy and of long-term budget deficits. The most important, and rather more widely accepted by the proponents of the case, are those of crowding-out and of the RET, and given their significance we return to both below. Further arguments against discretionary fiscal policy relate to what have been labelled as ‘institutional aspects of fiscal policy’ (Hemming et al., 2002a): model uncertainty, in that longer and more uncertain lags prevail than it was thought previously; there is the risk of procyclical behaviour in view of cumbersome parliamentary approval and implementation; increasing taxes or decreasing government expenditure during upswings may be politically unrealistic, and this may very well generate a deficit bias; spending decisions may be subjected to irreversibility, which

Reinventing Fiscal Policy 107

can lead to a public expenditure ratcheting effect; and there may be supply-side inefficiencies associated with tax-rate volatility. We also devote a section to these ‘institutional aspects of fiscal policy’ below.

Fiscal policy in the ‘new consensus’ We introduce fiscal policy explicitly into the discussion through the expansion of the equations of the model outlined in the previous section. The government sector is explicitly included though, for simplicity reasons, retaining the closed economy nature of the model, and the capacity level of output, which is labelled Y*. With a simple consumption function of the form: Ct d1 d2(1 t)Yt1 [Rt Et( pt1)]

(9.4)

where the symbols are as above, with the addition of C, consumer demand, and t, the income tax rate. The investment function is of the form: It d3 d4Et(Yt1) [Rt Et(pt1)]

(9.5)

where I is investment demand and government expenditure is labelled G. This leads to: Yt (d1 d3) G d2(1 t)Yt1 [Rt Et( pt1)] d4 Et (Yt1) [Rt Et( pt1)]

(9.6)

With the output gap incorporated, this can be written as: (Yt Y*) (d1 d3) G [d2(1 t) (d4 1)]Y* [d2(1 t)](Yt1 Y*) d4Et(Yt1) Y*) ( )[Rt Et(pt1)]

(9.7)

It is now evident that the ‘equilibrium’ rate of interest (for a zero output gap) is given by:

[Rt Et(pt1)]

[d2(1 t) (d4 1)] * (d1 d3) G Y ( ) ( ) [( )]

(9.8)

It is then clear that the ‘equilibrium’ rate of interest depends on government expenditure, and that there is not a unique ‘natural rate’ of interest.6 It is, of course, possible to take the balanced budget case, and then the


‘equilibrium rate’ of interest would be given by:

[Rt Et(pt1)]

(d1 d3) (d2 d4 1) * Y ( ) ( )

(9.9)

It is also evident that the ‘equilibrium rate’ of interest depends on the parameters of the consumption and investment functions. The evidence from the US and the UK (for example) during the 1990s suggests that those parameters can undergo substantial changes in the form of rises in the propensity to consume (driving the household savings rate close to or below zero) and in the propensity to invest. The empirical investigation of the effectiveness of fiscal policy is generally undertaken in the context of econometric models that could be viewed as elaborations of the ‘new consensus’ model. The resulting econometric model is much larger and involves many leads and lags which do not appear in the ‘new consensus’ model, as presented above, but the econometric models generally impose the existence of a supply-side equilibrium (say the NAIRU or non-accelerating inflation rate of unemployment) which is equivalent to the zero output gap for which inflation is constant.7 With a policy regime that pushes the economy towards the supply-side equilibrium (reflected in equation (9.3) above for the determination of the rate of interest) there is little room for output to substantially diverge from the supply-side equilibrium. Hence, any fiscal stimulus is soon dissipated in the context of the model, leading to the empirical conclusion that fiscal policy is ineffective. In view of the constraints imposed by the nature of macroeconometric models (for example, the existence of a supply-side determined equilibrium in the form of the NAIRU), it may be surprising that any positive effects of fiscal policy are observed. The effects generally found for fiscal policy may be explicable in terms of the starting point for the simulations (say in terms of unemployment) relative to the supply-side equilibrium. Clearly if unemployment is initially higher than the NAIRU, there is scope for a fiscal stimulus, which would (in the context of the model) push unemployment down towards the NAIRU. But it could be expected that any conclusions drawn on the effects of fiscal policy would be sensitive to the starting point used. The ‘new consensus’ model (or equivalent) provides little role for fiscal policy. It is assumed that there is a feasible ‘equilibrium rate’ of interest which will secure a level of aggregate demand equal to the capacity level of output (which itself is compatible with constant inflation).8 It is, however, pertinent to think about the effectiveness of fiscal policy in the context of a major shift in the coefficients of equations (9.4) and (9.5). Suppose, for example, there is a change in ‘animal spirits’ or technological opportunities for investment, which leads to a reduction in d3 of d. For fiscal policy alone to offset the reduction would require a change in government expenditure of d. It should be noted that here there would be no ‘crowding-out’ due to a


change in the rate of interest, which is under the control of the Central Bank, nor due to output being constrained to be at the capacity level. This leads us to the question of the possibility of crowding-out and the effectiveness of fiscal policy.

Crowding-out is not inevitable There have been four distinct sets of arguments to the effect that fiscal policy will be ineffective, under the general heading of ‘crowding-out’.9 The first, in the context of the IS-LM analysis, was a ‘crowding-out’ due to a rise in interest rates following a fiscal expansion. This was based on an exogenous money supply and the interest rate equating the demand for and supply of money. In that context, though, it was recognized that a sufficient increase in the supply of money alongside an increase in government expenditure could prevent the rise in the interest rate. In the context of endogenous money with the interest rate set by the Central Bank, this form of ‘crowding-out’ would arise from the deliberate action of the Central Bank. That is to say, if the Central Bank, operating on an ‘independent’ basis, responds to a fiscal expansion by raising interest rates, then there would be some form of crowdingout. Its extent would depend on the size of the interest rate rise, its feed through to other interest rates, the interest rate responsiveness of expenditure, and the phase of the business cycle. But the key point here is that any ‘crowding-out’ depends on the response of the monetary authority: it does not occur through the response of the markets. Even if the rate of interest were allowed to increase, there is still the question of the investment elasticity with respect to the rate of interest. Chirinko (1993) and Fazzari (1993; 1994–95), for example, argue very strongly that the impact of the rate of interest on investment is modest at most. Sales growth (the accelerator effect) and cash flow effects are the dominant variables in the determination of investment. It is, in fact, generally recognized that activity variables, especially output, have ‘a more substantial impact on investment’ (Chirinko, 1993, p. 1881). So that even if expansionary fiscal policy raised interest rates, crowding-out would not materialize. The second line of argument relates to the role of savings in fiscal policy.10 Consider the following identity in terms of outcomes: DS PI GD CA

(9.10)

where DS is domestic savings, PI is private investment, GD is government deficit and CA is current account surplus (or minus current account deficit). It is then argued that crowding-out occurs because higher aggregate demand due to an increase in deficit ‘absorbs’ savings, which reduces investment (see, for example, Cunningham and Vilasuso, 1994–95). The possibility of ‘international crowding-out’ is also raised. This may come through the


exchange rate: it is postulated that higher interest rates associated with the fiscal expansion cause capital inflows which appreciate the exchange rate, deteriorate the CA (smaller surplus or higher deficit), thereby offsetting the increase in aggregate demand that emanates from fiscal expansion (see Hemming et al., 2002a, for more details on international crowding-out). A related argument has been proposed. Rewrite (9.10) to read as: DS FS PI GD

(9.11)

where the symbols are as above, with the exception of FS which stands for foreign saving (equivalent to deficit in CA). An increase in government deficit (GD), then, ‘signals a decline in government saving. As a result, either investment falls, foreign savings rise, or some combination of these occurs. Put differently, either crowding out occurs, international crowding out occurs or both’ (Cunningham and Vilasuso, 1994–95, p. 194).11 Clearly, both arguments relating to (9.10) and (9.11) are flawed. Consider the argument related to (9.11) first. This formulation of the crowding-out argument treats DS as exogenously given. However, DS should be treated as endogenous in that its size responds to changes in, inter alia, government expenditure. Then an increase in GD could be expected to lead to an increase in DS. This could also happen when we come to the argument of (9.10). For in both cases, it is possible that with a higher government deficit, increases in income and investment occur, as well as the economy’s saving, rather than a reduction of investment. Consequently, expansionary fiscal policy will boost savings since it raises income and investment, rather than reducing savings (see also, Gordon, 1994). In the context of where interest rates are set by the Central Bank, the effect of budget deficit on interest rates depends on the reactions of the Central Bank. International crowding-out is unlikely to materialize under the circumstances explored here. Fiscal policy influences the level of economic activity, some of which spills over into imports. The exchange rate may be affected by the change in the level of economic activity; but the precise effect is not clear. A rise in imports could be expected to depress the exchange rate, but the rise in economic activity may generate optimism about the state of the economy thereby tending to raise the exchange rate. There may be a direct effect of fiscal policy on the exchange rate in so far as the exchange market operators react against expansionary fiscal policy and sell the currency. However, fiscal policy may very well result in increasing imports, opening up a trade deficit and thereby producing international crowding-out. To the extent, however, that the rest of the world increases its appetite for the country’s exports, no international crowding-out need occur (see Fazzari, 1993, for more details). The counter-argument is that all this may be true in the short run, and only under conditions of excess capacity. But it is the short run in which we


live (and ‘in the long run we are all dead’!) and conditions of excess capacity are a general (though not universal) feature of the market economy.12 In the long run, it is argued that the dynamics of wages and prices ensure that fiscal policy crowds out private investment or increases foreign indebtedness (via its impact on CA in equation (9.10)). This mechanism is due to the downward-sloping aggregate demand schedule (falling prices, given the money stock, raise real balance thereby increasing aggregate demand).13 A fiscal expansion leading to higher levels of economic activity is postulated to lead to rising prices and wages, thereby reducing private demand. A number of arguments, however, can be advanced to suggest that falling prices can go hand in hand with falling aggregate demand. Redistribution of income and wealth from debtors to creditors follows in the context of unanticipated price falls. On the assumption that debtors have a higher propensity to spend than creditors, the redistribution of real wealth caused by deflation lowers aggregate demand (see, for example, Tobin, 1993). Lower income reduces cash flows relative to debt service commitments, thereby increasing the probability of insolvency (Fisher, 1933, and Minsky, 1975, are good examples). In addition, there are the anticipated deflation effects, which may raise expected real interest rates, which dampen expenditure and prevent the occurrence of the aggregate demand effects discussed above (DeLong and Summers, 1986). More significantly, the downward-sloping aggregate demand schedule depends on the existence of ‘outside money’, and credit money (the dominant form in an industrialized society) is largely ‘inside money’.14 The inevitable conclusion is that it is by no means clear that the effectiveness of fiscal policy is short-lived and damaging in the long run. The third form of ‘crowding-out’ arose from a combination of the notion of a supply-side equilibrium (such as the ‘natural rate of unemployment’ or the NAIRU) and that the level of aggregate demand would adjust to be consistent with that supply-side equilibrium. In the context of an exogenous money supply, this came through the assertion of a ‘real balance’ effect, with changes in the price level generating changes in the real value of the stock of money, thereby generating changes in the level of aggregate demand.15 In the context of endogenous money, it would come through the adjustment of interest rate by the Central Bank. This would occur, as indicated above, if the Central Bank adopts some form of ‘Taylor’s rule’ (provided, of course, that interest rates are effective in that regard). As has been argued above, fiscal policy has an effect on the level of aggregate demand, and ‘crowding-out’ only occurs if it is assumed that the supply-side equilibrium must be attained (in order to ensure a constant rate of inflation) and that the level of aggregate demand would anyway be equivalent to the supply-side equilibrium. In the absence of some powerful automatic market forces or a potent monetary policy, which can ensure that the level of aggregate demand moves quickly to be consistent with the supply-side equilibrium, then fiscal policy has a clear role to play.


The path of aggregate demand can itself influence the supply-side equilibrium. The size and distribution of the capital stock is a determinant of the productive capacity of the economy, and a larger capital stock would be associated with the supply-side equilibrium involving a higher level of output and employment. The level of aggregate demand (including the change in economic activity and profitability) has an impact on investment expenditure, and thereby on the size of the capital stock (Arestis and Biefang-Frisancho Mariscal, 2000). The supply-side equilibrium may form an inflation barrier at any point in time, but it is not to be seen as something immutable and unaffected by the level of aggregate demand. The fourth route of ‘crowding-out’ comes from the Ricardian equivalence theorem. We may clarify RET in a bond-financed increase in household taxes, holding government expenditure constant. RET makes the assumption of equivalence between debt and taxes, and that consumers are forward looking. Consumers are also assumed to be fully aware of the government’s intertemporal budget constraint, and recognize that a tax increase today will be followed by lower taxes in the future imposed on their infinitely lived families. Consumers decrease their savings in the knowledge that they will not have to pay more in the future (the debt will be less). The increase in taxes is associated with a decrease in savings. Permanent income, therefore, does not change as a result of the tax increase. In the absence of liquidity constraints and with perfect capital markets, consumption does not change (Barro, 1974). There is, thus, equivalence between taxes and debt. This implies that an increase in government saving resulting from a tax increase, is fully offset by lower private saving, so that aggregate demand is not affected. Raising taxes will have no effect; the policy is totally frustrated and the fiscal multiplier is zero. Similarly, a reduction in taxation in the present is viewed as the prospect of future taxation (which is equivalent in present value terms) leaving the public no better off in wealth terms. The reduction in present taxation may stimulate consumer expenditure but the prospect of future taxation reduces consumer expenditure by an equivalent amount.16 A range of objections have been raised against the RET. The major proponent of the RET, Barro (1989, p. 40), lists five major theoretical objections that have been raised against the Ricardian conclusions. The first is that people do not live forever, and hence do not care about taxes that are levied after their death. The second is that private capital markets are ‘imperfect’ with the typical person’s real discount rate exceeding that of the government. The third is that future taxes and incomes are uncertain. The fourth is that taxes are not lump sum, since they depend typically on income, spending, wealth and so on. The fifth is that the Ricardian result hinges on full employment.17 Whilst the first four listed are, in our view, significant and valid objections to RET, it is the fifth which is particularly relevant here. Given the importance


of the RET we discuss it at length in the next section. We concentrate, though, on the fifth theoretical objection to which we have just referred.18

The Ricardian equivalence theorem Barro’s (1989, pp. 47–8) discussion of the fifth objection is rather brief (two paragraphs). He states that in standard Keynesian analysis … if everyone thinks that a budget deficit makes them wealthier, the resulting expansion of aggregate demand raises output and employment, and thereby actually makes people wealthier … This result does not mean that budget deficits increase aggregate demand and wealth in Keynesian models. If we had conjectured that budget deficits make people feel poorer, the resulting contractions would have made them poorer. Similarly, if we had started with the RET notion that budget deficits did not affect wealth, the Keynesian results would have verified that conjecture. The odd feature of the standard Keynesian model is that anything that makes people feel wealthier actually makes them wealthier (although the perception and actuality need not correspond quantitatively). This observation raises doubts about the formulation of Keynesian models, but says little about the effect of budget deficits. Moreover, in equilibrium models that include unemployment (such as models with incomplete information and search), there is no clear interplay between the presence of unemployment and the validity of the Ricardian approach. In the simplest Keynesian model: Y C I a cY I or, Y

aI 1c

If ‘feeling wealthier’ means that a or c rise, then income (Y) rises, and people are indeed ‘wealthier’. Clearly if an action by government (increasing expenditure, lowering taxes) generates adverse expectational responses (for example, leading to falls in consumer expenditure or in investment) then the government action has less effect, and the overall impact may be zero or negative. When taxation is reduced, people do have more money to spend, and so it is not unreasonable to believe that they will feel wealthier, will spend more and income will rise. Thus, it can be postulated that lower taxation will (in general) make people feel wealthier and spending will rise.


If the RET proposition held, then the size of the budget deficit is irrelevant for the level of aggregate demand. In particular, a balanced budget would be compatible with full employment (or more generally with the supply-side determined equilibrium), and hence (for a closed economy) savings and investment would be equal at full employment. In those circumstances, there would be no reason for fiscal policy: the problem of any deficient aggregate demand would have been solved. But it could also be noted that if there is a discrepancy between intended savings and investment, then that discrepancy can never by overcome through the use of fiscal policy. If, for example, savings would exceed investment at a level of income corresponding to the supply-side equilibrium, that difference could never be dealt with if the RET hypothesis held. However, when fiscal policy is approached in ‘functional finance’ terms, that is a budget deficit is run by the government because there is a difference between savings and investment at the desired income level, then the RET approach is scarcely relevant. In the absence of a budget deficit, the excess of savings over investment cannot occur (and the discrepancy is dealt with through a fall in income, reducing savings until brought into line with income). In this regard it can also be noted that much of the variation in the budget position of government occurs as a result of fluctuations in private demand, with the operation of the ‘automatic stabilizers’ of fiscal policy. Barro (1989, pp. 38–9) also argues that abstracting from chain-letter cases where the public debt can grow forever at the rate of interest or higher, the present value of taxes (and other revenues) cannot change unless the government changes the present value of its expenditures. This point amounts to economists’ standard notion of the absence of a free lunch – government spending must be paid for now or later, with the total present value of receipts fixed by the total present value of spending. Hence, holding fixed the path of government expenditure and non-tax revenues, a cut in today’s taxes must be matched by a corresponding increase in the present value of future taxes. The ‘chain-letter case’ can be viewed in the following way. Take a budget deficit (primary, that is, excluding interest payments on debt) to GDP ratio of d, then it can be readily shown that the government debt to GDP ratio would converge on b d/( g r) where g is the rate of growth of GDP and r is the (post-tax) real rate of interest on government debt. If g r, then the debt to GDP will stabilize though the amount of outstanding debt will continue to rise (in line with GDP). But, if g r, then the debt to GDP ratio would not stabilize and attempts to run a continuous budget deficit would lead to escalating government debt. It should, though, be noted that if g r, then any size of deficit will lead to escalating debt to GDP ratio, though obviously the build-up will be slower the smaller is the budget deficit. On the


other hand, if g r, then any size of budget deficit can be sustained. The limits on the budget deficit could then arise if the rate of interest on government borrowing rose with the size of the budget deficit. The impact of a budget deficit on the rate of interest may well depend on the purpose of the budget deficit. When the budget deficit is viewed in terms of ‘functional finance’, that is the deficit is run for the purpose of securing a high level of economic activity and does so by absorbing the excess of private savings over investment, then the budget deficit need not put upward pressure on the rate of interest. It can be agreed that the response to an increase in government expenditure (not matched by a change in taxation) would include a commensurate increase in savings. However, that increase in savings can come from a change in the level of income (the Keynesian view) or a change in savings behaviour (the RET view). For a closed economy, G T S I, and hence S G T I. For simplicity assume that T and I are constant, then s⌬Y ⌬sY ⌬G. The Keynesian emphasis is on ⌬Y, whereas the RET is on ⌬s (savings propensity rises as consumption propensity falls in the face of government expenditure and the prospect of future interest payments and taxation).

Institutional aspects of fiscal policy We have argued that fiscal policy appropriately applied does not lead to crowding-out, and in that sense fiscal policy will be effective.19 But there may be other causes that can produce ineffectiveness in fiscal policy. These other causes have been summarized in the second section above under the general title of ‘institutional aspects of fiscal policy’. This section explores some of the issues which arise. The first issue concerns what may be termed ‘model uncertainty’: the operation of fiscal policy requires forecasts of the future course of the economy, and uncertainty over forecasts increases the difficulties of making decisions over fiscal policy. It increases the likelihood that fiscal policy would turn out to be inappropriate. Some have argued that in terms of model uncertainty, there is evidence that longer and more uncertain lags have prevailed recently than was previously thought the case (Hemming et al., 2002a, p. 8). Model uncertainty is, of course, not new in economics and economic policy in particular. Friedman’s (1959) notion of long and variable lags in monetary policy is perhaps the best known. This clearly shows that long and variable lags are not a reflection of fiscal policy alone. Indeed many of the issues raised here would also apply to monetary policy: where there may also be model uncertainty and long and variables lags between policy announcement and effect. Indeed, monetary policy and fiscal policy both draw on the forecasts of macroeconometric models, and uncertainty over the models would apply with equal force to monetary policy as to fiscal policy. Further, monetary policy (in the form of interest rate decisions) involves


frequent decision-making (for example, monthly for the Bank of England, every six weeks for the Federal Reserve) and attempts fine tuning. Fiscal policy, in contrast, typically involves infrequent decisions (often annual), and could be described as more like ‘coarse tuning’.20 It could be argued that the ‘fine tuning’ nature of monetary policy means that it suffers more from problems of model uncertainty than does fiscal policy. The second issue relates to the argument that fiscal policy is in practice procyclical rather than counter-cyclical.21 In particular, it has long been argued that the various lags of decision-making, implementation and impact may mean that fiscal policy which is intended to stimulate the economy during a downturn may come into effect when the economy has already recovered (and similarly for fiscal policy designed for a boom period coming into effect when the economy has turned down). The strength of this argument depends on the relationship between the length of the business cycle and the lags of fiscal policy. For example, a four-year business cycle and a two-year fiscal policy lag would indeed lead to fiscal policy being pro-cyclical. The notion of the pro-cyclical nature of fiscal policy is justified by resort to arguments relating to the cumbersome parliamentary design, approval and implementation. We may actually distinguish between inside and outside lags in this context. Inside lags refer to the time it takes policymakers to appreciate that fiscal policy action is necessary and to make the required decisions. Clearly, inside lags depend on the political process and the effectiveness of fiscal management. Outside lags refer to the time that it takes for fiscal measures to affect aggregate demand (Blinder and Solow, 1974). Discretionary policy measures, particularly when they involve policy departures, new forms of taxation and expenditure initiatives, are likely to be subject to long inside lags. Variations in tax rates and in social security benefits can potentially be made with relatively short inside lags.22 But automatic stabilizers, by their nature, involve little by way of inside lags. Outside lags are expected to be more variable than inside lags and would vary, depending on the fiscal measure utilized, on the institutional set-up of the economy in question and the period under investigation. One difference between monetary policy and fiscal policy arises from the former being much less subject to democratic decision-making than the latter. Changes in tax rates require parliamentary or Congressional approval; changes in interest rates do not. But long and variable outside lags may be a feature of monetary policy as much as (or more than) fiscal policy. The inside lags of fiscal policy could be substantially reduced by the adoption of a ‘fiscal policy rule’ (Taylor, 2000) analogous to a ‘monetary policy rule’ (Taylor, 1993). To the extent that this is the right rule (that is, places much emphasis on full employment), there could be a role for such a rule; especially so if the rule relates to the fiscal stance, leaving the issue of composition of taxation and of public expenditure to be determined through the democratic process.


The third issue is the idea that fiscal policy may entail a ‘deficit bias’. This may be due to a number of factors. Increasing taxes/decreasing government expenditure during upswings may be politically unrealistic. Alesina and Perotti (1995) refer to a number of institutional factors to explain the possibility of a deficit bias. Voters and policymakers may be unaware of the government’s intertemporal budget constraint,23 and as a result favour budget deficits; they may wish to shift the fiscal burden to future generations; policymakers may wish to limit the room of manoeuvre of future governments strategically in terms of fiscal policy; political conflicts may delay fiscal consolidation in terms of sharing the burden of adjustment amongst various social groups, thereby producing a deficit bias; spending decisions may be subjected to irreversibility, which can lead to a public expenditure ratcheting effect. The presence of a deficit bias does not necessarily make fiscal policy any less effective, though it may constrain governments to engage in further deficit spending in the face of a recession. It has been argued that large and persistent deficits may be a reflection of this deficit bias. But those deficits have to be measured against what is required. The persistence of unemployment in market economies suggests a general lack of aggregate demand, and hence a requirement for fiscal stimulus. Any tendency for savings to outrun investment also requires a budget deficit to mop up the excess net private savings. We can then distinguish those budget deficits which are required to sustain demand and to mop up excess savings to ensure desirable levels of economic activity, which we will call necessary deficits. In contrast, unnecessary budget deficits are that part of deficits which take economic activity too high (on some criteria such as beyond full employment). This distinction clearly implies that a bias in favour of necessary deficits is consistent with the argument advanced in this chapter, whereas any bias towards unnecessary deficits is not. The fourth issue arises from the notion that supply-side inefficiencies associated with tax-rate volatility are possible. This issue is strongly related to the way in which changes in taxes affect the supply of labour, and also changes in capital taxes affect saving and investment. These considerations are expected to have a significant impact on internationally mobile labour and capital. However, ultimately these considerations depend heavily on the empirical evidence adduced on the impact of tax changes on the supply of labour and capital, and thereby on growth. This empirical issue, however, has yet to be validated. Such limited evidence that exists, has not yet provided clear-cut conclusions (see, for example, Blundell and MaCurdy, 1999; Hemming et al., 2002a). A further comment worth making is this. Active monetary policy involves interest rate volatility (as compared with a passive monetary policy which changed interest rates infrequently), which would have supplyside inefficiencies. If fiscal policy is successful, then demand volatility is reduced, and demand volatility would generate supply-side inefficiencies in


that the level of supply would be continually changing, not to mention the inefficiency of excess capacity. A final issue that belongs to the ‘institutional aspects’ is the level and degree of economic development. It is the case that most of the literature on the effectiveness of fiscal policy has focused on developed countries. Agénor et al. (1999) argue that because the developing world is more likely to be influenced by supply shocks, fiscal policy as a tool of demand management is most likely to be used far less frequently in developing than in developed countries. A supply shock, however, is often taken to mean a cost change (for example, oil price), but one that has a demand dimension to it (in case of oil, imports change and so on). Clearly, a supply shock change cannot affect the level of economic activity unless it causes demand to change as well. Within the AS–AD model, an adverse shift in the AS curve can be offset in terms of economic activity by a shift in the AD – albeit at the expense of a higher price level (and leaving aside the question of how the supply side would be identified). In the case of developing countries, it may be that collection of taxation and so on is more difficult, but it would also seem that there may be less call for fiscal deficits: if developing countries are characterized by low savings and high demand for investment, then S – I would be negative, and hence G – T would also be negative. This is the classic argument that governments in developing countries run surpluses in order to generate savings, which the private sector is unwilling or unable to undertake. Even so, it is suggested that the availability and cost of domestic and external finance is a major constraint on fiscal policy. It follows that access to financing should determine to a large extent the size of the fiscal deficit. An increase in the fiscal deficit beyond a level that can only be financed on unacceptable terms may be associated with severe crowding-out effects. Relaxing these constraints, therefore, enables fiscal policy to have significant stimulative effects (Lane et al., 1999). An additional factor that enhances the effectiveness of fiscal policy in these countries is the relatively high marginal propensity to consume, which can increase the size of the impact of fiscal policy significantly. This analysis suggests that the deficit bias discussed above may be relatively higher in developing countries. In fact, Hemming et al. (2002a, p. 12) provide a list of the causes of the relatively high deficit bias in developing countries. Governance, as it relates to poor tax administration and expenditure management, is probably the most important and significant item on the list. In terms of the distinction drawn above, this would be ‘unnecessary’ deficit bias.

Quantitative effects of fiscal policy This section draws on published work on the empirics of fiscal policy. We do not offer our own empirical work but rely instead on already published evidence. We may distinguish between evidence adduced from developed


and from developing economies. This distinction is necessary partly for the reasons alluded to at the end of the last section, but also for reasons which have to do with data deficiencies in developing countries. For all these reasons there is rather less evidence on the short-run impact of fiscal policy for developing rather than for developed countries (Hemming et al., 2002a). We begin with the available evidence on developed countries. Following Hemming et al. (2002a), we comment on three substantive components of the available evidence on developed countries. There are, to begin with, estimates of dynamic multipliers that are designed to determine the possible empirical impact of fiscal policy on economic activity. These dynamic multipliers are derived from macroeconomic model simulations and small model calibrations, as well as reduced-form equations. Studies which draw from specific episodes of fiscal contraction in an attempt to identify expansionary fiscal contractions comprise the second category. The third category comprises of studies that attempt to assess the determinants of dynamic multipliers. Consequently, interest in this concentrates upon relationships between fiscal policy on the one hand, and other variables, such as interest and exchange rates, investment, consumption and so on, on the other. On the first issue, Hemming et al. (2002a) summarize the evidence adduced from these studies. It is suggested that short-term multipliers are positive, ranging from 0.1 to 3.1, with expenditure multipliers being in the range of 0.6 to 1.4, and tax multipliers in the range of 0.3–0.8. Long-term multipliers are smaller than short-term multipliers, undoubtedly reflecting some form of crowding-out. Another recent study (Hemming et al., 2002b, p. 4) summarizes the argument along similar lines: ‘Estimates of fiscal multipliers are overwhelmingly positive but small. Short-term multipliers average around a half for taxes and one for spending, with only modest variation across countries and models (albeit with some outliers). There are hardly any instances of negative fiscal multipliers, the exception being that they can be generated in some macroeconomic models with strong credibility effects.’ Small model calibrations, essentially dynamic general equilibrium models that analyse steady-state long-run effects of fiscal policy, produce results that show output to respond positively to (unanticipated) increase in government expenditure (where permanent changes have larger effects than temporary changes). Reduced-form equation results are broadly similar. On the second category of studies, Hemming et al. (2002b) examine fiscal policy during recessions in advanced countries to conclude that (i) fiscal policy during recessions in closed economies is effective but with a small fiscal multiplier; (ii) fiscal policy is not so effective in open economies during recessions, especially when flexible exchange rates prevail; (iii) fiscal expansions can be more effective when it is expenditure-based, big government, there is excess capacity, a closed economy or an open economy with a fixed exchange rate regime, and expansionary expenditure is accompanied by


monetary expansion.24 In terms of the determinants of fiscal multipliers, the third category identified above, Hemming et al. (2002a, p. 36) conclude that ‘there is little evidence of direct crowding out or crowding out through interest rates and and the exchange rate. Nor does full Ricardian equivalence or a significant partial Ricardian offset get much support from the evidence.’ Finally, the evidence on developing countries is not dissimilar to that obtained for developed economies. If anything fiscal multipliers tend to be rather higher in the case of developing rather than developed economies (see, for example, Hemming et al., 2002a, p. 33). The overall conclusion of this rather brief summary of the empirical evidence on the effectiveness of fiscal policy is encouraging. Fiscal multipliers and other tests tend to provide favourable evidence for fiscal policy. Especially so in view of the argument that in most, if not all, of the studies referred to that summarize the results reported in this chapter, there is a long-run constraint built into the models utilized for the purposes of the empirical exercises. Such constraints, which we labelled above as NAIRU constraints, by their very nature and definition, substantially contain the long-run values of the fiscal multipliers.

Summary and conclusions We have argued in this chapter that shifts in the level of aggregate demand can be readily offset by fiscal policy. Consequently, fiscal policy remains a powerful instrument of regulating the level of aggregate demand. Fiscal policy ‘can and should be called upon as a key part of the remedy’ when the economy needs aggregate demand boosting, and ‘when the economy’s resources are underutilised’ (Fazzari, 1994–95, p. 247). Even when the economy’s resources are fully utilized, we would still argue that to the extent fiscal policy can affect the capital stock of the economy (Arestis and Biefang-Frisancho Mariscal, 2000), it can also have long and lasting effects in this case.

Notes This chapter was first published as P. Arestis and M. Sawyer, ‘Reinventing Fiscal Policy’, Journal of Post Keynesian Economics, 26(1) (2003), 4–25. 1. Work on the importance of fiscal policy has been undertaken in the past at the Levy Economics Institute. Of particular importance are the papers by Godley and McCarthy (1997) and Godley (1999, 2001). The role of fiscal policy has been studied in this work within a consistent stock/flow model, where it is very effective in terms of enabling imbalance in the private sector’s balance sheets to be corrected (see also, Minsky, 1982, 1991). 2. The generic term ‘Central Bank discount rate’ is used to denote the rate of interest at which the Central Bank is willing to supply funds. It covers rates such as the ‘repo’ rate (European Central Bank), the Federal Funds rate (USA, Federal Reserve System), the discount rate (UK, Bank of England), and so on.

Reinventing Fiscal Policy 121 3. The ‘equilibrium rate’ is where savings and investment are brought into equality at full employment or some other supply-side equilibrium level of employment or output. 4. With the implication, presumably, that fiscal policy does not matter, whereas the focus is on monetary policy and the use of interest rate policy to target inflation. 5. Variations on this theme could be used; for example, interest rate ‘smoothing’ in equation (9.3) is often ignored, as is the lagged output gap variable in equation (9.1) so that the focus is on the influence of expected future output gap in this equation. It is also possible to add a fourth equation to (9.1)–(9.3) reported in the text. This would relate the stock of money to ‘demand for money variables’ such as income, prices and the rate of interest, which would reinforce the endogenous money nature of this approach with the stock of money being demand-determined. Clearly, though, such an equation would be superfluous in that the stock of money thereby determined is akin to a residual and does not feed back to affect other variables in the model. We have explored this issue and others related to whether the stock of money retains any causal significance at some length in Arestis and Sawyer (2002c). 6. The ‘natural rate’ of interest could be said to be unique if there was no effect of government expenditure on demand, which would be the equivalent of invoking RET, and this is further discussed below. 7. See Arestis and Sawyer (2002a) for our summary of the Bank of England model and its similarities with the ‘new consensus’ model. 8. The word ‘feasible’ is used in the sense of involving a positive nominal rate of interest compatible with exchange rate targets. 9. These arguments are examined in much more detail in Arestis and Sawyer (2003a). 10. Our second line of argument on the crowding-out issue, draws mainly on Cunningham and Vilasuso (1994–95) and Fazzari (1994–95). 11. In fact Cunningham and Vilasuso (1994–95) argue strongly that ‘demand management policies may be largely ineffective, and in some cases, contribute more to the problems than to the solutions’ (p. 187). The main reason given is the ‘structural, institutional, and regulatory changes’ since the 1970s, which ‘have altered the rules of the game, with the result that aggregate policy measures have failed to stimulate total spending’ (p. 188). Fazzari (1994–95) rebuffs this proposition on both theoretical and empirical grounds. 12. If full employment (or some other desired level of economic activity) can be reached and sustained by private aggregate demand, there would be few who would advocate stimulating fiscal policy. But the advocates of fiscal policy take the view that full employment is a rare occurrence and that private aggregate demand is often insufficient to sustain full employment (Say’s law does not operate). 13. It should be noted that the extent of crowding-out is, of course, affected by price flexibility. In general terms, it can be argued that ‘Price flexibility, even if it is limited in the short run, will tend to narrow the range of values taken by fiscal multipliers, and in particular to limit the influence of the exchange rate regime’ (Hemming et al., 2002a, p. 5). 14. Even when there is ‘outside money’ (high-powered money) and the relevant measure of the money stock is a multiple of high-powered money (determined by the size of the credit multiplier), the amount of money in existence depends on people’s willingness to hold that money. The stock of money is demand-determined. If prices fall, then the demand for money falls, and the stock of money falls, and there is no real balance effect. 15. This could be a long adjustment process, but it is the ‘automatic’ one invoked in the context of the NAIRU.

122 John Kenneth Galbraith and the Future of Economics 16. An important assumption of the process discussed in the text is that Ricardian behaviour implies full consumption smoothing to offset intergenerational redistribution imposed by government debt policy. Tax burden is redistributed among generations with families reversing the effect of this redistribution through bequests. However, the more realistic case of partial consumption smoothing invalidates Ricardian behaviour (Mankiw, 2002). 17. We might add further objections to the list. Less than perfect foresight; partial liquidity constraints; a non-altruistic desire to pass some of the current fiscal burden to future generations (Mankiw and Summers, 1984; Blanchard, 1985) are a few of them. There may also be significant distributional effects, assumed to be negligible by the RET proponents (see below in the text for relevant arguments). Furthermore, empirical work on the RET produces evidence that is mixed at best (Cunningham and Vilasuso, 1994–95). A more recent study reaches even more negative conclusions for the RET; clearly, ‘There is little evidence of direct crowding out or crowding out through interest rates and the exchange rate. Nor does full Ricardian equivalence or a significanct partial Ricardian offset get much support from the evidence’ (Hemming et al., 2002a, p. 36). 18. There are interest rate premia and credibility effects as well as uncertainty considerations that can affect the size of the fiscal multipliers. With fiscal expansions and debt accumulation, risk premia that reflect the risk of default or increasing inflation risk reinforce crowding-out effects through interest rates (Miller et al., 1990). They may also raise fears of future balance-of-payments problems, and thereby lead to foreign investment reduction and capital outflows. Similarly, to the extent that a fiscal expansion is associated with increased uncertainty (in that future deficits have a negative effect on confidence), households may accumulate precautionary savings and firms may delay irreversible investment (Caballero and Pyndick, 1996). 19. This is to recognize that an attempted fiscal expansion in the context of a fully employed economy would involve ‘crowding-out’ to some degree. The extent of the ‘crowding-out’ would depend on how far supply can respond to increase in demand, and even at what is regarded as full employment there can be some elasticity of supply (firms hold some excess capacity, there are ‘encouraged’ worker effects and so on). 20. This refers to discretionary fiscal policy: it could be said that the automatic stabilizers are operating all the time. 21. The operation of the ‘automatic stabilizers’ provides a counter-cyclical component of fiscal policy. The pro-cyclical argument applies particularly to the discretionary changes in fiscal policy. 22. This is not entirely true in that it may not be the case in all parliamentary systems. In the UK for example, the fiscal measure of a change in the duty on alcohol, tobacco, petrol and so on is made quickly and implemented within hours (often 6 p.m. on budget day). It is subject to retrospective approval by parliament. 23. This appears to accept the intertemporal budget constraint as a reality, which may not be the case. In another paper (Arestis and Sawyer, 2003b), we argue that this depends on whether the rate of interest is higher or lower than the rate of growth. 24. An interesting case that has been discussed in the literature (initiated by Giavazzi and Pagano, 1990) is the case of Ireland and Denmark where, it is alleged, contractionary fiscal policy is associated with expansion in economic activity. We would dispute this result on the basis that it is other factors which explained the expansion of economic activity; it is, thus, the expansion that enabled budget deficits to

Reinventing Fiscal Policy 123 be smaller than otherwise. This is a classic case of ‘simultaneity bias’ (Eichengreen, 1998). Also, omitted variables may very well be responsible for the results obtained in these fiscal consolidation episodes. Exchange rate depreciations that normally accompany fiscal contractions may be more responsible for the expansion in economic activity rather than the fiscal action itself (Hemming et al., 2002a, p. 25). More specifically in the case of Ireland, Walsh (2002, p. 1) argues that a number of factors contribute to the expansion, ‘a low exchange rate, the inflow of FDI to high productivity sectors, and wage moderation following the return to centralised wage agreements in 1987. Labour market reforms, including a tightening of the social welfare regime and a switch of spending from income support to active labour market policies, played a positive role.’

References P.-R. Agénor, C.J. McDermott and E.S. Prasad, ‘Macroeconomic Fluctuations in Developing Countries: Some Stylised Facts’, IMF Working Paper 99/35 (Washington DC: International Monetary Fund, 1999). A. Alesina and R. Perotti, ‘The Political Economy of Budget Deficits’, Staff Papers, International Monetary Fund, 42(2) (1995), 1–31. P. Arestis and I. Biefang-Frisancho Mariscal, ‘Capital Stock, Unemployment and Wages in the UK and Germany’, Scottish Journal of Political Economy, 47(5) (2000), 487–503. P. Arestis and M. Sawyer, ‘Keynesian Policies for the New Millennium’, Economic Journal, 108 (1998), 181–95. P. Arestis and M. Sawyer, ‘The Bank of England Macroeconomic Model: its Nature and Implications’, Journal of Post Keynesian Economics, 24(4) (2002a), 529–45. P. Arestis and M. Sawyer, ‘Can Monetary Policy Affect the Real Economy?’, Levy Economics Institute of Bard College, Working Paper, 355 (2002b). P. Arestis and M. Sawyer, ‘Does the Stock of Money have any Significance?’, Levy Economics Institute of Bard College, Working Paper, 363 (2002c). P. Arestis and M. Sawyer, ‘On the Effectiveness of Monetary Policy and of Fiscal Policy’, Levy Economics Institute of Bard College, Working Paper, 369 (2003a). P. Arestis and M. Sawyer, ‘The Case for Fiscal Policy’, Levy Economics Institute of Bard College, Working Paper, 382 (2003b). R.J. Barro, ‘Are Government Bonds net Wealth?’ Journal of Political Economy, 82 (1974), 1095–117. R.J. Barro, ‘The Ricardian Approach to Budget Deficits’, Journal of Economic Perspectives, 3(2) (1989), 37–54. O.J. Blanchard, ‘Debt, Deficits and Finite Horizons’, Journal of Political Economy, 93 (1985), 223–47. A. Blinder and R. Solow, ‘Analytical Foundations of Fiscal Policy’, in A. Blinder et al. (eds), The Economics of Public Finance: Essays (Washington: The Brookings Institution, 1974). R. Blundell and T. MaCurdy, ‘Labour Supply: a Review of Alternative Approaches’, in O. Ashenfelter and D. Card (eds), Handbook of Labour Economics, Vol. 3A (Amsterdam and New York: Elsevier, 1999). R. Caballero and R.S. Pyndick, ‘Uncertainty, Investment, and Industry Evolution’, International Economic Review, 37(3) (1996), 641–62. R.S. Chirinko, ‘Business Fixed Investment Spending: a Critical Survey of Modeling Strategies, Empirical Results and Policy Implications’, Working Research Paper 93–01 (Federal Reserve Bank of Kansas City, 1993).

124 John Kenneth Galbraith and the Future of Economics R. Clarida, J. Galí and M. Gertler, ‘The Science of Monetary Policy: a New Keynesian Perspective’, Journal of Economic Literature, 37(4) (1999), 1661–707. S.R. Cunningham and J. Vilasuso, ‘Is Keynesian Demand Management Policy still Viable?’ Journal of Post Keynesian Economics, 17(2) (1994–95), 231–48. J.B. DeLong and L. Summers, ‘Is Increased Price Flexibility Stabilizing?’ American Economic Review, 76 (1986), 1031–44. B. Eichengreen, ‘Comment on “The Political Economy of Fiscal Adjustments” ’, Brookings Papers on Economic Activity, 1 (Washington: Brookings Institution, 1998). S.M. Fazzari, ‘Working Capital and Fixed Investment: New Evidence in Financing Constraints’, Rand Journal of Economics, 24(3), 328–42. S.M. Fazzari, ‘Why Doubt the Effectiveness of Keynesian Fiscal Policy?’ Journal of Post Keynesian Economics, 17(2) (1994–95), 231–48. I. Fisher, ‘The Debt-Deflation Theory of Great Depressions’, Econometrica, 1 (1933), 337–57. F. Giavazzi and M. Pagano, ‘Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries’, in O.J. Blanchard and S. Fischer (eds), NBER Macroeconomics Annual 1990 (Cambridge, Massachusetts: MIT Press, 1990). W. Godley, ‘Seven Unsustainable Processes: Medium-Term Prospects and Policies for the United States and the World’, Levy Economics Institute Special Report (1999). W. Godley, ‘Fiscal Policy to the Rescue’, Levy Economics Institute Policy Note, no. 1 (2001). W. Godley and G. McCarthy (1997), ‘Fiscal Policy will Matter’, Challenge, 41(1), 38–54. D. Gordon, ‘Must We Save Our Way Out of Stagnation? The Investment/Saving Relation Revisited’, mimeo, New School for Social Research (1994). R. Hemming, M. Kell and S. Mahfouz, ‘The Effectiveness of Fiscal Policy in Stimulating Economic Activity: a Review of the Literature’, IMF Working Paper 02/208 (Washington DC: International Monetary Fund, 2002a). R. Hemming, S. Mahfouz and A. Schimmelpfennig (2002), ‘Fiscal Policy and Economic Activity in Advanced Economies’, IMF Working Paper 02/87 (Washington DC: International Monetary Fund, 2002b). J.M. Keynes, Treatise on Money (London: Macmillan, 1930) (page references refer to The Collected Writings of John Maynard Keynes, V, London: Macmillan, 1980). J.M. Keynes, The General Theory of Employment, Interest and Money (London: Macmillan, 1936). T.D. Lane, A. Ghosh, J. Hamann, S. Phillips, M. Schulze-Ghattas and T. Tsikata, ‘IMF-Supported Programs in Indonesia, Korea, and Thailand: a Preliminary Assessment’, IMF Occasional Paper, No. 178 (Washington DC: International Monetary Fund, 1999). G.N. Mankiw, ‘The Savers-Spenders Theory of Fiscal Policy’, American Economic Review, 90(2) (2002), 120–5. G.N. Mankiw and L.H. Summers, ‘Do Long-Term Interest Rates Overreact to Short-Term Interest Rates?’, NBER Working Paper, no. 1345 (Cambridge, Massachusetts: National Bureau of Economic Research, 1984). B.T. McCallum, ‘Monetary Policy Analysis in Models without Money’, Federal Reserve Bank of St Louis Review, 83(4) (2001), 145–60. L.H. Meyer, ‘Does Money Matter?’, Federal Reserve Bank of St Louis Review, 83(5) (2001), 1–15. M. Miller, R. Skidelsky and P. Weller, ‘Fear of Deficit Financing – is it Rational?’, in R. Dornbusch and M. Draghi (eds), Public Debt Management: Theory and History (Cambridge and New York: Cambridge University Press, 1990). H.P. Minsky, John Maynard Keynes (New York: Columbia University Press, 1975).

Reinventing Fiscal Policy 125 H.P. Minsky, Can ‘It’ Happen Again? Essays on Instability and Finance (Armonk, NY: M.E. Sharpe, 1982). H.P. Minsky, ‘Financial Crises: Systemic or Idiosyncratic?’, Levy Economics Institute Working Paper no. 51 (1991). J.B. Taylor, ‘Discretion versus Policy Rules in Practice’, Carnegie-Rochester Conference Series in Public Policy, 38 (1993), 195–214. J. Taylor, ‘Reassessing Discretionary Fiscal Policy’, Journal of Economic Perspectives, 14(3) (2000), 21–36 J. Tobin, ‘Price Flexibility and Output Stability: an Old Keynesian View’, Journal of Economic Perspectives, 7 (1993), 45–66. B.M. Walsh, ‘When Unemployment Disappears: Ireland in the 1990s’, CESIFO Working Paper, No. 856, Category 4: Labour Markets (2002).

10

Alternatives for the Policy Framework of the Euro Philip Arestis and Malcolm Sawyer

Introduction The euro was introduced as a ‘virtual’ currency in 1999, and completely replaced the national currencies of the 12 participating countries in early 2002. In considering policy arrangements for the euro, there is now (at the time of writing in late 2004) nearly six years of experience of the eurozone on which to draw, and to some degree experience from the preceding decade as countries sought to meet the convergence criteria for membership of the eurozone. Table 10.1 provides a summary of some key figures for the eurozone as a whole since 1999. Growth has been sluggish since 2000 and unemployment has remained high at 8 per cent or above (and with considerable variation between countries and regions). Inflation has been above (albeit not much above) the 2 per cent target for most of the time since 1999. Budget deficits have generally risen, and many countries have exceeded the 3 per cent of GDP limit under the Stability and Growth Pact,1 and the cyclically adjusted budget deficit has averaged nearly 2 per cent of GDP (and under the SGP, this figure would be zero). The economic slowdown from 2001 onwards (which has had relatively little impact on the unemployment rate) has had the readily predictable effects on the budget deficit position: economic slowdown lowers tax receipts and raises some forms of public expenditure, leading to widening budget deficits. Previous estimates by the EU suggest that for each 1 per cent slowdown in growth, budget deficit (relative to GDP) rises by between 0.5 and 0.9 per cent (Buti et al., 1997). It should not then have come as a surprise that budget deficits rose past the 3 per cent limit in a number of countries in the face of economic slowdown. Countries which exceeded the 3 per cent limit were criticized and censured by the Council on Economic and Financial Affairs (ECOFIN) on many occasions, and various promises and commitments were made to reduce budget deficit over the forthcoming years. Changes in government in two countries (Portugal and Greece) resulted in the incoming government declaring that previously issued statistics on the size of the budget deficit were wrong and understated the size of the deficit. 126

Alternatives for the Policy Framework of the Euro 127 Table 10.1: Recent macroeconomic data for the eurozone

Annual rate of growth of GDP (%) Unemployment rate (%) Annual rate of inflation (%) Budget deficit as percentage of GDP Cyclically adjusted budget deficit

1999

2000

2001

2002

2003

2004

2.8

3.7

1.7

0.9

0.5

1.6

9.4

8.4

8.0

8.4

8.8

8.8

1.2

2.1

2.4

2.3

2.1

1.7

1.3

⫺0.1

1.7

2.3

2.7

2.8

1.1

1.5

2.0

2.1

1.7

1.6

Note: Figures for 2004 are forecast as on June 2004. Source: OECD, Economic Outlook, June 2004.

Although in a number of countries, the budget deficit rose, the figures for the cyclically adjusted budget deficit suggest that this was the operation of the automatic stabilizers, and that if anything fiscal policy was being tightened. In general, national governments have been constrained from using active fiscal policy to counter the economic slowdown. The operational difficulties of the SGP have become self-evident, and the rules which it has sought to impose have been widely broken. The European Central Bank (ECB) is the only federal economic agency, but its remit is the control of inflation which has been persistently above the target level. The ECB appears to have been slow to recognize the beginnings of the slowdown in economic activity, and when it did recognize the slowdown did not cut interest rates in an aggressive manner on a par with the Federal Reserve. But the ECB in terms of its own mandate was faced with inflation at or above its target level alongside a economic slowdown: attention to its mandate and to establish ‘credibility’ with the financial markets pushed it towards maintaining a tight monetary policy. The European Convention began work in early 2002 to draw up what is widely referred to as a European Constitution. The Convention reported in June 2003, and after its proposals were not accepted by national governments in the summit held in December 2003, a revised version was accepted by all 25 national governments in June 2004. At the time of writing, the Treaty (Treaty establishing a Constitution for Europe: document CIG 86/04 available on the website of the European Union) awaits ratification, whether through parliamentary votes and/or national referenda. The work of the European Convention provided a timely opportunity to fundamentally reform the macroeconomic policymaking frameworks of the


eurozone. It was timely because the strains and problems of the SGP were becoming so clear to all with many countries having exceeded the 3 per cent GDP budget deficit limit in time of economic slowdown. But the opportunity was spurned. From the reports of the working groups of the Convention there appears to have been no serious consideration of alternatives. The macroeconomic policy frameworks will be locked into a Constitution which will be difficult to change in the future, requiring agreement of all countries concerned. This had been the previous situation, but the drawing up of the Constitution did provide a window of opportunity which is unlikely to occur again for many years to come.

Present policy framework The present policy and institutional framework for the eurozone can be readily summarized. The European Central Bank (ECB) which is ‘independent’ of the political authorities in the European Commission and national governments and of the European Parliament is entrusted with using monetary policy to pursue ‘price stability’ which it has interpreted as inflation below 2 per cent per annum and that ‘it shall support general economic policies in the Union in order to contribute to the achievement of the Union’s objectives’. The monetary policy instrument is the use of interest rates (and it forgoes forms of monetary policy such as credit controls). There is a requirement for the EU budget to be balanced and hence no fiscal policy is exercised at the EU level (and the EU budget is itself rather small at just over 1 per cent of EU GDP). The fiscal policy of national governments is (in principle) subject to conformity with the Stability and Growth Pact which imposes an upper limit of 3 per cent of GDP on budget deficits, with the view that budgets will be broadly in balance or small surplus over the business cycle. Automatic exemption was in place for falls of GDP of more than 2 per cent and discretionary exemptions for falls in output of between 0.75 per cent and 2 per cent, which would represent very major recessions. A system of non-interest bearing deposits which could turn into fines was also in place, but has not been invoked despite a number of budget deficits exceeding 3 per cent (in face of economic slowdown but not of declining output). This policy framework can, in our view, be understood by reference to the ‘new consensus in macroeconomics’ (which we have discussed extensively elsewhere, for example, Arestis and Sawyer, 2003a, 2004a). This ‘new consensus’ can be summarized in the following three equations: Ygt ⫽ a0 ⫹ a1Ygt⫺1 ⫹ a2E (Ygt⫹1 ) ⫺ a3 [Rt ⫺ Et ( pt⫹1)] ⫹ s1 pt ⫽

b1Ygt

⫹ b2 pt⫺1 ⫹ b3 Et ( pt⫹1 ) ⫹ s2 (with b2 ⫹ b3 ⫽ 1)

Rt ⫽ RR* ⫹ Et ( pt⫹1 ) ⫹

c1Ygt⫺1

⫹ c2 ( pt⫺1 ⫺ p ) T

(10.1) (10.2) (10.3)

Alternatives for the Policy Framework of the Euro 129

where Yg is the output gap, R is nominal rate of interest, p is inflation, and pT is inflation target, RR* is the ‘equilibrium’ real rate of interest (that is the rate of interest consistent with zero output gap which implies from equation (10.2) a constant rate of inflation), and si (with i ⫽ 1, 2) represents stochastic shocks. Equation (10.1) is the aggregate demand equation; equation (10.2) is a Phillips curve; and (10.3) is a monetary policy operating rule (in effect replacing the old LM curve). There are three equations and three unknowns: output, interest rate and inflation. This model has a number of additional, and relevant, characteristics. Equation (10.1) resembles the traditional IS, but expenditure decisions are seen to be based on intertemporal optimization of a utility function. There are both lagged adjustment and forward-looking elements; the model allows for sticky prices (the lagged price level in the Phillips curve relationship) and full price flexibility in the long run. The term Et(pt⫹1) in equation (10.2) reflects central bank credibility. A central bank that credibly signals its intention to achieve and maintain low inflation will be ‘rewarded’ by lower expectations on the rate of inflation. The inclusion of term Et(pt⫹1) in equation (10.2) indicates that it may be possible to reduce current inflation at a significantly lower cost in terms of output than otherwise. It contains the neutrality of money property, with inflation determined by monetary policy (that is the rate of interest), and equilibrium values of real variables are independent of the money supply. The final characteristic we wish to highlight is that money has no role in the model; it is merely a ‘residual’, and this is more extensively discussed in Arestis and Sawyer (2003b, 2005). This model is notable for in effect ignoring fiscal policy though a shift in the parameter a0 could be used to represent a change in the fiscal position. Monetary policy through interest rate changes is presumed to be effective in influencing the level of aggregate demand and thereby the rate of inflation (which is viewed as a demand-pull rather than cost-push phenomenon). Further, the rate of interest can be varied such that the level of demand is consistent with a supply-side equilibrium (where the output gap is zero). There is a form of classical dichotomy here as well in that monetary policy has no long lasting effects on the real side of the economy though there are short-run effects on output. This framework represents the economy as essentially stable around a level of output for which the output gap is zero, and in which inflation is demand- (rather than cost-) determined and is addressed through variations in the rate of interest. There is no role for fiscal policy which is excluded from the model with the emphasis on the role of monetary policy.

European Central Bank and monetary policy The argument for an independent Central Bank with a remit to control inflation is based on two premises. First, and as reflected in the ‘new consensus


macroeconomics’ outlined above, there is a separation between the monetary side and the real side of the economy akin to the classical dichotomy, and monetary policy can target inflation without impacting on the real side (employment, growth and so on) of the economy. This was recently expressed by Mervyn King, Governor or the Bank of England when he said that ‘Monetary policy determines inflation and the supply capacity of the economy determines the rate of growth. In the short run, however, it is reasonable to suppose that when the economy is running at above-normal levels of capacity utilisation there is upward pressure on inflation, and the opposite to hold when the economy is running below capacity’ (speech, 12 October 2004). Second, (unelected) central bankers and their economist advisers are perceived as more inflation-averse than elected politicians, and have a reputation for being tougher on inflation. When faced with a short-run trade-off between inflation and unemployment, the central bankers will be less tempted than the politicians, it is argued, to set interest rates (and monetary policy more generally) in a way that favours reductions in unemployment rather than reductions in the rate of inflation. Central bankers are deemed to be ‘more conservative’ (Rogoff, 1985) than politicians and less likely to be tempted by the (short-term) gains from lower unemployment. We reject these arguments. Monetary policy can have effects on the real side of the economy. It is widely recognized that it will do so in the short run through the effects of interest rates on the level of aggregate demand (as reflected in the ‘new consensus’ model). But, we would argue that it can have significant effects on the exchange rate and on the level of investment, and as such have potentially long lasting effects. Indeed, if monetary policy does not impact on the exchange rate and investment, it is likely to have little impact on the level of aggregate demand. Further, monetary policy has limited impact on inflation and is a weak policy instrument for the control of inflation (Arestis and Sawyer, 2004a). Fiscal policy also has effects on aggregate demand, exchange rate and so on and indeed we would argue has in some sense more effect. As both fiscal and monetary policy are impacting on the level of aggregate demand, and also both policies are impacting on a range of other economic variables of policy importance, this suggests that fiscal and monetary policy should be coordinated. This is difficult to achieve when the Central Bank is independent of political influences and not answerable to any political authorities. An independent Central Bank with the task of targeting inflation has become the ‘conventional wisdom’ of the past decade or so. A number of countries have (to a greater or lesser extent) moved towards such arrangements. We would though argue that not only is the case for an independent Central Bank rather weak, but also it has the status of being something of a current fad. Two decades ago, controlling the growth of the money supply was seen as the (rather painless) answer to inflation, and was similarly given


‘conventional wisdom’ status. From that perspective, building an independent Central Bank with control of inflation as its sole specific objective into a Constitution which is difficult to readily change is a folly when the fashion for an independent Central Bank is likely to change. It was indicated above that a major argument for an independent Central Bank was that the Central Bank would singlemindedly pursue inflation control and would not be able to influence and be unconcerned with the real side of the economy. This would further imply that the Central Bank should have no particular views on supply-side policies. But we find that the ECB regularly comments on policies other than monetary policy and advocates courses of action which lie well outside of its remit. A few recent examples illustrate this and the essentially neo-liberal agenda which is promoted by the ‘independent’ Central Bank. As regards fiscal developments, the latest budgetary news is a source of concern. While some euro area countries will maintain a sound budgetary position, a significant number are expected to record deficits close to or above 3 per cent. The aggregate euro area fiscal deficit-to-GDP ratio is expected to increase somewhat, as is the debt-to-GDP ratio. In the coming years, important challenges for the consolidation of public finances will have to be faced. Member States need to renew their consolidation efforts and should not rely on one-off measures, so as to comply with their commitments under the Stability and Growth Pact and to foster confidence. They must also set the right priorities in public finances, towards structural reform, innovation and competitiveness. This would very much support the Lisbon agenda and thereby promote economic growth, foster job creation and reduce unemployment. Concerning the European fiscal framework, the Governing Council is convinced that substantial improvements in the implementation of the Stability and Growth Pact are possible and would be beneficial. At the same time, the Governing Council warns against changes to the text of the Treaty or the Regulations which form the basis of the Pact. The Pact is key to ensuring macroeconomic stability on a sustainable basis. It is a framework which is necessary to preserve sound fiscal policies in the euro area, for which strict surveillance and effective peer pressure on national budget policies are indispensable. (ECB, 2004b, p. 6) In order to decisively overcome the obstacles towards greater employment growth and to reduce the trend or structural level of unemployment, further comprehensive labour market reforms are of the essence. (ECB, 2004b, p. 7) Given the signs that the economic recovery will continue, it is particularly important that fiscal policies and structural reforms play their part in


improving the economic fundamentals of the euro area. It is regretful that recent fiscal developments have not been helpful in this respect. A growing number of countries are reporting significant imbalances and fiscal consolidation efforts fall disappointingly short of commitments. In order to strengthen confidence in a sustainable upswing, it is now essential that clarity about the future course of consolidation of fiscal policies is re-established in all countries concerned. This requires credible measures with an emphasis on structural expenditure reform so that imbalances are redressed, tax/benefit systems become more growth-friendly and social security systems are put on a sound financial footing. These measures, together with a revived momentum towards effectively implementing structural reforms in labour and product markets, would provide very valuable support to the current economic upswing. (ECB 2004a, p. 6) A credible strategy of fiscal consolidation combined with structural reform should also contribute to long-term fiscal sustainability and higher potential growth by improving supply conditions. In particular, reforms of taxbenefit systems could increase incentives to work and invest while reducing pressures on social budgets. Reforms of the pension and health care systems are urgently needed in many countries to raise labour force participation and prepare for the future fiscal costs of population ageing. Furthermore, reducing inefficient public spending can help to finance tax cuts. (ECB, 2004a, p. 60) The use of monetary policy for the control of inflation presupposes that monetary policy is an effective instrument for that purpose and we have argued elsewhere that it is not so (Arestis and Sawyer, 2004a). We could also note that a further argument for the independence of the Central Bank is that it can be given the remit to control inflation and be answerable for the achievement of that objective. The Bank of England (Monetary Policy Committee), for example, has to explain in an open letter to the Chancellor of the Exchequer any failure to keep inflation within 1 per cent of the target rate, and a similar requirement is in place in New Zealand. In contrast, the ECB does not have to answer for its failure to meet its objective, and notably the ECB has failed to meet the inflation target in most years (as can be seen from the figures in Table 10.1). Monetary policy inevitably suffers from the ‘one-size-fits-all’ problem. It is well known that the setting of an interest rate which rules across many economic areas poses difficulties – the rate which is appropriate for a country experiencing high demand and perhaps inflationary pressures is not the same as that appropriate for one facing low demand and perhaps deflation. Indeed, monetary policy may address the average inflation picture but cannot address differences in inflationary experience across the euro area countries. There is evidence of significant disparities in inflationary experience despite the convergence of inflation that was required by the Maastricht criteria


(and indeed a number of countries would not now satisfy the inflation convergence conditions of the Maastricht Treaty).2 Further, the impact of interest rate changes is likely to differ markedly across countries. A major feature of the first six years of the euro (since its introduction as a virtual currency in January 1999) is the large movements in its value, notably against the dollar, but not confined to that. From a starting value of 1 euro ⫽ $1.18 it fell almost continuously to reach a low of $0.82 in late 2000. After a period around this low value, it began a climb, starting in April 2002, to regain and then surpass its opening value, and to peak at $1.28 (in early 2004 and again in October). It is often difficult to account for these movements in the exchange rate – we can certainly say that they do not reflect changes in ‘fundamentals’ (see our attempt to understand the initial fall in the value of the euro, Arestis et al., 2002). In a general sense the euro/dollar exchange rate may reflect sentiment on the relative prospects of the two economies. The recent decline in the value of the dollar may be associated with a realization of the large scale of the American current account deficit. These swings in the euro/dollar exchange rate do not only impact on the United States and the eurozone countries since many countries link their currency with either the dollar or the euro, and consequently their own exchange rate position is much affected by the euro/dollar exchange rate oscillations. These large movements in the exchange rate are not conducive for decisionmaking with regard to participation in trade or to undertaking foreign investment. The volatility of the exchange rates not only discourages trade but also exacerbates the vulnerability of national economies to external events. As the exchange rate fluctuates, imports and exports, and then the distribution of employment and output between countries, are subject to ups and downs. The importance of the exchange rates between the dollar, euro and the yen, and the harmful effects of the volatility of exchange rates strongly point towards the development of mechanisms which could help to stabilize the trilateral exchange rates. The volatility between the three major currencies affects most international trade since many currencies are linked with one (or more) of those major currencies. The existing volatility, associated with speculative bubbles in the exchange markets, could well be having detrimental effects on trade and foreign direct investment.3 Any attempt to stabilize the exchange rate of the euro would necessarily involve the ECB and other Central Banks, and coordination between the Central Banks would be particularly important. Interest rates would be used to influence the exchange rates, but it is interest rate differentials that are particularly relevant; hence the need to coordinate interest rate decisions in order to arrive at the required interest rate differential. But the reliability of the effect of interest rate changes on the exchange rate weakens the usefulness of interest rates in this regard. Interest rates are currently used to target the rate of inflation, though much of the effect of interest rates on inflation may come through the exchange rate. The policy indicated here requires a


broadening of the remit of Central Banks to clearly include an exchange rate target. The interest rate instrument is likely to be rather ineffectual in this regard, and hence direct intervention by Central Banks in the exchange markets would generally be required. The ability of a single Central Bank to intervene in the exchange markets is limited by its own reserves. The combination of Central Banks is in a much stronger position to intervene, in part because they have a greater volume of reserves. But the main reason is that while a Central Bank is limited by its own foreign reserves, the Central Bank of the currency which is not under pressure can buy to an unlimited extent the currency under pressure. Any policy aiming to establish stable exchange rates between the major currencies would require some significant institutional changes within the EU, including changes in the objectives of the ECB to include that of the external value of the currency; and interest rates would have to be set with regard to their effects on the exchange value of the euro. Monetary policy has become virtually synonymous with variations in the interest rate, which have an uncertain effect on the rate of inflation and economic activity. Alternative forms of monetary policy should also be considered (Arestis and Sawyer, 2005). Explicit forms of credit control implemented by the Central Bank, or other government agencies, could be used to supplement interest rate policy. There are well-known difficulties with the use of credit controls. They can be evaded (legally or otherwise) through switching from regulated to unregulated forms of credit including the development of products which fall outside the range of regulation and the switch of lending to overseas sources. Credit controls may have some effect in restraining credit and thereby expenditure, but the relaxation of credit controls may do little to stimulate expenditure during a downswing. Credit controls may have a role to play in slowing down the development of asset price bubbles, which may be worthwhile in so far as the extent of the subsequent downturn is a function of the extent of ‘irrational exuberance’. These are circumstances which may be better tackled by controls over the volume of credit rather than attempting to prick the bubble through traditional monetary policy measures that use the price mechanism of interest rate increases. Appropriate forms of credit control may be focused on sectors where ‘overexuberance’ is developing, rather than using the blunt instrument of interest rate changes which impacts on all sectors of the economy. Credit controls may be implemented in a variety of forms, and those which operate through reserve ratio requirements would appear to be feasible. The major changes which are required in respect of monetary policy are: (i) A reformulation of the objectives of the ECB to include high and sustainable levels of employment and economic growth (and indeed these objectives should also be firmly embedded in the European Constitution). (ii) The ECB must be made accountable to the European Parliament, and its statutes changed so that it can clearly be involved in the co-ordination


of fiscal and monetary policies, and indeed that ultimately it can take instructions from other European bodies such as ECOFIN. There are some other changes which would also be desirable. Any reference to the growth of the money supply should be discarded in recognition that a Central Bank cannot in any way control the growth of the money supply. The development of alternative instruments of monetary policy should also be considered. The role of the ECB in securing stability in the European financial system should be emphasized and a clear requirement made that the ECB acts as a lender of last resort.

Stability and Growth Pact The operational problems of the SGP are well known, with a number of countries now breaking the 3 per cent of GDP limit on budget deficits. The argument for some form of SGP governing the macroeconomic policies of national governments comes from a realization that there are spillover effects from one country’s fiscal policy into other countries. It is often said to have its origins in the suspicions of some countries (for example, Germany) that other countries would be ‘profligate’ (for example, Italy) to their individual and collective detriment. It is, of course, one of the ironies that it was Germany that was one of the first to break the 3 per cent deficit rule – in part because of their financial requirements for reunification. This line of argument appears to have been based on the idea that if one country ran ‘excessive’ deficits it would place upward pressure on the interest rate on that government’s bonds. But those bonds would be denominated in euros and the upward pressure on interest rates would spread to other countries. This line of argument is faulty in two respects. First, if one country borrows ‘excessively’, which in this context would mean at a level which brings into some doubt its ability to repay and meet interest payments, then its credit rating would suffer and it may well be faced by higher interest rates on its government bonds. But unless there is some ‘association of guilt’, there should not be a spillover into the credit rating of other governments. In a similar vein individual states within the United States have differing credit ratings, and one state’s relatively poor credit rating does not lead others to have poor ratings. Second, there is little evidence that budget deficits and interest rates are linked. At least in the short run, the key interest rate is set by the Central Bank and other interest rates are built up on that key rate. Any association between budget deficit and interest rate would then arise from the policy responses of the Central Bank to the budget deficit position. Further, as argued in Arestis and Sawyer (2003c, 2004b) when governments pursue functional finance, that is running budget deficits in order to ‘mop up’ private net savings, then there would be no upward pressure on interest rates through the capital market. Finally empirical evidence does not suggest that budget deficits do have


a major impact on interest rates. For example, in a paper which is generally hostile to Keynesian macroeconomic policies, Cunningham and Vilasuso (1994–95, p. 190) have to concede that ‘[u]nfortunately, empirical studies examining the relationship between interest rates and fiscal deficits are far from conclusive’ and that ‘whether fiscal deficits are associated with higher interest rates has yet to be resolved in the economics literature’ (p. 191). And in a similar vein, ‘[t]he lack of supporting empirical evidence linking interest rates to budget deficits is troublesome’ (Wyplosz, 1991, p. 168). Further, ‘the empirical results on interest rates support the Ricardian view [that there is no effect of budget deficits on real interest rates]. Given these findings it is remarkable that most macroeconomists remain confident that budget deficits raise interest rates’ (Barro, 1989, p. 48). If the argument is deployed that (government) borrowing puts upward pressure on interest rates, the argument has to be extended to cover all forms of borrowing since it could be expected that all forms of borrowing place the same degree of upward pressure on interest rates, which would lead to suggestions that all forms of borrowing should be subject to upper limits! There is, however, a basic requirement for some coordination of fiscal policy across member countries. In part this arises from a recognition that fiscal policy has a significant impact on the well-being of economies. There are (at least) two reasons for supporting coordination. First, the eurozone (or EU) as a whole requires a mechanism for responding to adverse economic shocks which impact on all economies – that is shocks which are widespread rather than being limited to a few countries. A coordinated fiscal policy is required to confront a coordinated shock. Second, there are important spillovers between countries in the integrated economies of the EU: expansion of demand in one country raises demand for the product of other countries, and in the EU context where there is relatively little trade outside of the EU most of the demand effects will be felt by other member countries. Coordination of fiscal policy would mean that one country’s fiscal policy would take into account the effects of fiscal policy in other countries. The question then arises as to what type of coordination should be sought and the mechanisms of coordination to achieve the coordination. There are (at least) two broad approaches to fiscal policy. The first, which is closely reflected in the present SGP, is to aim for some form of balanced budget, albeit allowing the budget position to vary over the business cycle. The second is to use the budget deficit in pursuit of economic objectives such as high levels of employment. The first approach is concerned with the budget being balanced over some time horizon and the objective of fiscal policy becomes the balance of the budget. There is some recognition that there may be some ‘automatic stabilizers’ in play such that in an economic downturn, the budget position tends to move into deficit and that helps to cushion the economic downturn. But there is no recognition that the general achievement


of high levels of demand may require budget deficits (in the case where a high level of demand would generate a surplus of savings over investment). The second approach views fiscal policy as one of the instruments of economic policy, which can be used to strive for specified economic objectives. A budget deficit or surplus (or indeed balance) is not then sought to meet some predetermined figure but rather is used in conjunction with other policies to maintain high levels of demand in the economy. One of our major criticisms of the SGP is that some predetermined budget deficit limit is imposed, whether or not that budget deficit well serves the macroeconomic objectives. By focusing on limits on budget deficits, what should be the other objectives of macroeconomic policy, such as high levels of economic activity, are overlooked. There have been many calls to operate the SGP in a ‘more flexible’ manner.4 The flexibility may take the form of raising the upper limit on budget deficits, taking a more relaxed view on countries whose deficit exceeds 3 per cent (or whatever limit is set). But these calls do not address the major issues. At present the SGP has in place rules which are only observed in the breach, bringing the notion of rules into disrepute, and a so-called more flexible approach would not resolve that issue except through obscuring the rules sufficiently that no one knew what they were. But any rule which maintains the notion that national governments should be constrained to balance the budget over the cycle or to limit the size of deficit in any particular time period does not address the major problems of the SGP. The SGP in effect imposes a ‘one-size-fits-all’ fiscal policy on all countries, no matter what their economic circumstances are. There is no reason to think that a balanced budget over the business cycle suits all countries (or indeed any). A well-known identity (though generally forgotten by advocates of the SGP) drawn from the national income accounts tells us that: (Private Savings minus Investment) plus (Imports minus Exports) plus (Tax Revenue minus Government Expenditure) equals zero, which is in symbols: (S ⫺ I) ⫹ (Q ⫺ X) ⫹ (T ⫺ G) ⫽ 0

(10.4)

Individuals and firms make decisions on savings, investment, imports and exports. For any particular level of employment (and income), there is no reason to think that those decisions will lead to (S ⫺ I) ⫹ (Q ⫺ X) ⫽ 0

(10.5)

But if they are not equal to zero, then (G ⫺ T), the budget deficit, will not be equal to zero, since (G ⫺ T) ⫽ (S ⫺ I) ⫹ (Q ⫺ X)

(10.6)


The SGP in effect assumes that any level of output and employment is consistent with a balanced budget (G ⫺ T ⫽ 0), and hence compatible with a combination of net private savings and the trade position summing to zero. But no satisfactory justification has been given for this view. Another suggestion for amending the SGP is that the budget deficit constraint be shifted from the present one of an upper limit of 3 per cent of GDP and that the budget should be balanced over the cycle to one in which these limits apply to the current account of the budget, with investment funded by borrowing. As a practical matter, this would represent an improvement in that more leeway would be available for budget deficits to be used for fiscal policy purposes. However, it still does not overcome the major problems of the SGP. First, it retains in place the view that the budget (albeit the current account) should be in overall balance and that the budget position should conform to some arithmetical rule. It relates the size of the budget deficit to the needs for public investment which shift over time. Second, for these purposes this distinction between the current account and the capital account is irrelevant. For an individual it may be recommended that borrowing be limited to capital expenditure on the basis that the anticipated financial returns from the capital expenditure will be sufficient to meet the interest payments on the borrowing. But, in general, the government does not receive a direct financial return on its capital expenditure, since it does not sell the output produced by the capital equipment. There can be indirect returns in so far as government investment (for example, in infrastructure) aids growth and thereby high tax returns. But some forms of government investment (for example, in defence equipment) clearly do not aid growth, and many forms of government current expenditure such as education and health do contribute to growth and higher future taxes. Third, a rule such as balancing the budget (whether current account or total) over the cycle with an upper limit on deficit in any particular year necessarily runs into the ‘one-size-fits-all’ problem. There is no reason to think that the appropriate size of the capital account and the appropriate size of the budget deficit would coincide. Some countries would have more requirements and uses of capital investment than others, and some countries would have need of greater budget deficits than others. There is no reason to think that the requirements for public investment would match the requirements for budget deficit. Public investment should be determined by the costs and benefits of such investment, and the budget deficit by reference to striving to attain macroeconomic objectives such as full employment. The second approach to fiscal policy indicated above can be linked with a ‘functional finance’ approach (Lerner, 1943; Kalecki, 1944) in which budget positions should be set to pursue macroeconomic objectives including the highest sustainable level of employment. Budget deficits should be incurred in so far as they are necessary to achieve these objectives, and not subject to arbitrary rules (such as balanced budget over the cycle).


Under the present arrangements, national fiscal policies could be said to be coordinated by the Stability and Growth Pact, though subordinated may be a better word than coordinated (except that as it has turned out the rules of the SGP have frequently been broken). The rationale for the present form of coordination comes from the notion of spillover effects between national economies and the interests of one country in the effects of other countries’ fiscal policy. In the approach taken here, the case for coordination of fiscal policies arises from the following considerations: (i) When the eurozone (or EU) is impacted by shocks (for example, a general rise in the price of oil) which affects all of the economies (albeit not to the same extent), a coordinated response to a generalized shock is appropriate. (ii) There are likely to be substantial spillover effects between national economies given the extent of trade between them, and hence a fiscal stimulus in one country will raise demand in neighbouring countries. The setting of fiscal policy is one country then needs to take into account what is happening to fiscal policy in neighbouring countries. (iii) Monetary and fiscal policies both affect the level of aggregate demand, exchange rate and perhaps the rate of inflation, and that points towards coordination between monetary and fiscal policies. The coordination of national fiscal policies faces many difficulties. A major one arises from the question of what are the aims of fiscal policies and what are perceived to be the effects of fiscal policy. Under the present arrangements it could be said that the aim of fiscal policy is a balanced budget and that the perceived effects of budget deficits are generally negative (for example, leading to high interest rates and inflation). It is clearly difficult for two (or more) individuals (or countries) to coordinate their activities if the purpose and effects of coordination are matters of dispute between the parties concerned. Thus, we would argue, coordination of national fiscal policies needs to be based on a shared set of objectives – and here we would advocate the inclusion of the objectives of high and sustainable levels of demand and economic activity. Coordination would also benefit greatly from shared views on the need for active fiscal policy and on the effects of fiscal policy. And this requires a sharp change from the prevailing ‘conventional wisdom’ embedded in the SGP. A rather more direct form of coordination of fiscal policy would come from the development of EU fiscal policy. The development of such a policy would require a large increase in the scale of the EU budget and the ability of the EU to operate a budget deficit (or indeed a budget surplus). The requirement for a significant EU budget was acknowledged in the MacDougall Report of 1977 (Commission, 1977, vol.I: 14) which estimated an amount of 7.5 per cent of EU GDP as necessary to manage a monetary


union. Goodhart and Smith (1993) and Currie (1997) argue that a rather lower figure for the EU budget, provided that it was well targeted to aid stabilization, would suffice, but their figures of around 2 per cent would still be double the current level of the EU budget. We would favour a somewhat larger figure, say of the order of 5 per cent, which would include measures to enhance investment and economic development in the less prosperous regions. But the significant point here is the need for an EU budget which is not constrained to be balanced as at present and which can be utilized for EU-wide stabilization purposes.

Concluding remarks At the heart of our approach is the view that the achievement of full employment and sustainable and equitable growth should be the major objectives for economic policy in the European Union. The achievement of these objectives requires, among other matters, the use of macroeconomic (monetary and fiscal) policy to secure high levels of aggregate demand and the building of adequate productive capacity. Calls for more ‘flexible’ labour markets are largely irrelevant where full employment, which requires high levels of demand and of capacity, is concerned. Thus we argue for a reorientation of macroeconomic policy with the major objectives of full employment and sustainable growth, with a full role being played by fiscal and monetary policy in the pursuit of those objectives.

Notes 1. In 2003, four countries recorded budget deficits of over 3 per cent, namely Germany (3.8 per cent of GDP), Greece (4.6 per cent), France (4.1 per cent) and the Netherlands (3.2 per cent); Portugal had brought their deficit down from over 4 per cent to 2.8 per cent in 2003. 2. In the year to September 2004, the rate of inflation varied from 0.2 per cent in Finland to 3.2 per cent in Spain: on the basis of the members of the eurozone the average of the three lowest inflation countries was 1.1 per cent and three countries had inflation more than 1.5 per cent above that reference level. 3. One recent review, undertaken for HM Treasury in the UK, concluded that ‘even from this subset of evidence, is that negative impacts are not very large’. But they go on to say that ‘estimates of the maximum gains to trade from the complete elimination of exchange rate volatility are in the region of 15 per cent, while the consensus estimate of these studies is typically less than 10 per cent’ (HM Treasury, 2003, p. 28). 4. For example, under an article headlined ‘Paris and Berlin Seek Relaxation of Fiscal Rules’, the Financial Times, 27 October 2004, reported that ‘France and Germany will push for a substantial relaxation of the stability and growth pact that would go beyond amendments to European fiscal rules that have been proposed by the European Commission’ and ‘Gerhard Schröder, the German chancellor, said after a joint meeting of the French and German cabinet. “Member states should be given more room, for instance to invest in research and development.” ’


References P. Arestis and M. Sawyer, ‘Macroeconomic Policies of the Economic and Monetary Union: Theoretical Underpinnings and Challenges’, International Papers in Political Economy, 10(1) (2003a), 1–54. P. Arestis and M. Sawyer, ‘Does the Stock of Money Have any Causal Significance?’ Banca Nazionale del Lavoro, 56(225) (2003b), 113–36. P. Arestis and M. Sawyer, ‘Reinventing Fiscal Policy’, Journal of Post Keynesian Economics, 26(1) (2003c), 4–25. (Chapter 9 in this volume.) P. Arestis and M. Sawyer, ‘Can Monetary Policy Affect the Real Economy?’ European Review of Economics and Finance, 3(3) (2004a), 9–32. P. Arestis and M. Sawyer, ‘On Fiscal Policy and Budget Deficits Intervention’, Journal of Economics, 1(2) (2004b), 65–78. P. Arestis and M. Sawyer, ‘The Nature and Role of Monetary Policy when Money is Endogenous’, Cambridge Journal of Economics (forthcoming 2005). P. Arestis, I. Biefang-Frisancho Mariscal, A. Brown and M. Sawyer, ‘Explaining the Euro’s Initial Decline’, Eastern Economic Journal, 28(1) (2002), 71–8. R. J. Barro, ‘The Ricardian Approach to Budget Deficits’, Journal of Economic Perspectives, 3(2) (1989), 37–54. M. Buti, D. Franco and H. Ongena, Budgetary Policies during Recessions: Retrospective Application of the ‘Stability and Growth Pact’ to the Post-War Period (Brussels: European Commission, 1997). Commission of the European Communities, Report of the Study Group on the Role of Public Finances in European Integration, chaired by Sir Donald MacDougall, Economic and Financial Series no. A13 (Brussels, 1977). S.R. Cunningham and J. Vilasuso, ‘Is Keynesian Demand Management Policy Still Viable?’ Journal of Post Keynesian Economics, 17(2) (1994–95), 231–48. D. Currie, The Pros and Cons of EMU (London: HM Treasury, July 1997). First published by the Economist Intelligence Unit, January 1997. ECB (2004a), Monthly Bulletin, June 2004. ECB (2004b), Monthly Bulletin, October 2004. C.A.E. Goodhart and S. Smith, ‘Stabilization’, European Economy, Reports and Studies no. 5/1993, The Economics of Community Public Finance (1993), 417–55. HM Treasury (2003), EMU and Trade (London: HMSO, 2003). M. Kalecki, ‘Three Ways to Full Employment’, in Oxford University Institute of Statistics, The Economics of Full Employment (Oxford: Blackwell, 1944), pp. 39–58. A. Lerner, ‘Functional Finance and the Federal Debt’, Social Research (February, 1943), 38–51. K. Rogoff, ‘The Optimal Degree of Commitment to an Intermediate Monetary Target’, Quarterly Journal of Economics, 100(4) (1985), 1169–90. C. Wyplosz, ‘Monetary Union and Fiscal Policy Discipline’, European Economy, the Economics of EMU: background studies for European Economy, no. 44 (1991).

11

Promoting Growth and Welfare in a Changing Europe: Economic Analysis and Policy Jean-Luc Gaffard

European Union economic performances: the data and the debate The problem that is common to all European economies is how to maintain full employment, social achievements and levels of welfare. The common answer is growth and innovation, that is, access to the most advanced technologies – the way to revamp the growth process. As to achieving this, there is today a prevailing consensus, derived mainly from unfavourable comparison with the performance of the US economy, which consists in promoting the emergence of a new institutional framework and enhancing potential growth rates. The desire to improve poor European economic performance since the mid-1980s that gave rise to the Single Market Programme and more recently led to the so-called Lisbon process has failed. The late 1980s and the late 1990s are the only two episodes of relatively high growth in the past two decades. Overall growth slowed from the 1980s in spite of the implementation of far-reaching reforms in both the macro-environment (consolidation of public finances and lower inflation) and micro-environment (Single Market Programme, Uruguay Round and labour market reforms). First of all, the macroeconomic performance of the EU has been disappointing in comparison to the US. Instead of growing faster than the US through the assimilation of existing technologies and organizational designs, as in the post-war period, the EU has achieved a lower growth rate and a higher unemployment rate than the US. Since 1970, the GDP per capita gap between the EU-15 and the US has remained roughly constant. While US growth has generated employment and maintained working hours, Europe’s employment performance has been weak and working hours have fallen consistently. The labour supply in the US has increased substantially because of demography and higher participation rates. While the EU population grew by a mere 0.4 per cent per annum between 1991 and 2000, that of the US increased by 1.2 per cent. At the same time, the EU employment rate (the share of 142

Promoting Growth and Welfare in a Changing Europe 143

population of working age actually employed) increased by only 1 percentage point while that of the US increased by 5 percentage points. With average working hours also increasing, the US labour input continued to rise strongly throughout the 1990s. This stimulated growth as well as a strong increase in labour productivity in the latter part of the decade. Then, during that period, for the first time in three decades, growth in US labour productivity and in total factor productivity (TFP) outstripped that of the EU, while the US was forging ahead. Within the EU, performances during the 1990s were by no means homogeneous. The so-called cohesion countries exhibited higher growth rates and converged on the EU average. A slow-growth group, made up of Germany, France and Italy, had a significant impact on the overall performance because of their high weighting in the EU economy. A mixed group, composed of Finland, the Netherlands and the UK exhibited a relatively high growth rate. According to the prevailing consensus, such bad performances in Europe are the result of institutional mistakes that prevented the economy from simultaneously reaching all the standard policy objectives: high growth rate, full employment, price stability and external balance. Thus, Europe was unable to enter the new age, that is, the age of the so-called knowledge economy, despite the huge transformation that has taken place over many years. This consensus is built on a theoretical framework that focuses on the structural properties of the economy, that is, mainly on technologies and institutional rules that govern behaviours and the working of the markets. This framework considers macroeconomic interventions to ensure stability and balanced public budgets as a preliminary step, once the economy is stabilized, to structural reforms aimed at favouring innovation processes. In particular, macro-governance should consist in promoting separate and independent institutions, each of them being in charge of a unique objective: the European Central Bank has to maintain price stability, and is not concerned with growth and employment issues; the Growth and Stability Pact is supposed to enforce fiscal deficit limits; and the competition policy is conducted by the Commission with the task of promoting free trade and minimizing monopolistic distortions. The intended structural reforms, on the other hand, are those reckoned to allow the realization of a perfectly competitive market, the focus being on the labour market, whose rigidities are stressed as a main obstacle to the working of competition. This is the recipe proposed for making innovative choices, so as to be at the frontier of technological development, and hence to gain access to higher growth and full employment: in fact actually to gain access to the knowledge economy. However, as a capitalistic society, Europe has always been knowledgebased. Thus the first question is not whether Europe will be knowledge-based or not, but rather what response Europe will make to the challenges posed by the huge transformation of its environment. The second question is whether Europe will be able to capture the potential gains of wealth associated with


the development of new technologies and market extensions. This, in the macroeconomic conventional wisdom, is dependent, as we have observed, on the existence of given conditions that will assure the required behaviours. The substantial departures from all sorts of steady-state behaviours exhibited by the larger European countries since the mid-1970s, and more recently by Japan, render it conceptually difficult to maintain some of the fundamental propositions of macroeconomic conventional wisdom. First of all, there is not a unique attractor (the potential growth rate) towards which transition economies have been evolving, which would be defined with respect to the properties of technological change and institutions. In the long run, countries that are similar in terms of fundamentals (that is, technology, preferences) do not necessarily converge to the same steady-state path where per capita income (a welfare measure) is equalized across countries. Oscillations no longer appear as deviations from a fixed trend – the potential growth rate – determined beforehand by technologies and institutions. They are, rather, one way in which an out-of-equilibrium growth process can be realized. Coordination failures affect productivity, investment and employment, all typically endogenous variables in the growth process. The chains of various events taking place in the shorter run affect the potential rate of growth of any economy. Thus active economic policies – aimed at regulating existing dynamic mechanisms, or at supplementing them with compensating mechanisms – are required to interact dynamically so as to correct distortions that may result from an initial shock, thus re-establishing the internal consistency of the economy and rendering a smooth evolution of it viable. The required mix of interventions, on the other hand, should not be implemented once and for all. It must be modified along the way, closely following and adapting to a process that, being affected by a variety of perturbations, takes on shape and direction as it goes. In this perspective, the EU needs to exhibit better coordination, which, of course, has institutional implications, but not necessarily the same as those derived from the previous analysis. In fact, in an imperfect world, it is not possible to establish analytically a unique ranking of alternative institutional arrangements. It cannot be proved that the closer the economy is to the benchmark (that is, perfect competition and the more flexible world) the more efficient it will be.

Why has Europe been growing so slowly? Institutions and technology Standard analysis of the economic performance in Europe consists in characterizing the properties of a given attractor and so relates long-run performance to the nature of technologies and institutions. In the first three decades after World War II, Europe achieved a remarkable catching-up process, combining high growth, full employment, and high


levels of social protection. The institutions and policies developed in this period seem to have been appropriate to the conditions of the time. The main idea that prevails today is that the ability of these institutions and structures to deliver growth and welfare performance has declined as the European economy has reduced the distance to the technological frontier. Overall, such institutions are considered as an obstacle to innovation. In brief, institutions that would be appropriate for imitation would not be appropriate for innovation. According to this analysis (Acemoglu et al., 2002), for these thirty years, Europe was catching-up with the US through investment and factor accumulation, and through imitation of leading-edge technologies. This corresponded to the generalization of an already mature technology and well-known organizational patterns, previously discovered and experimented with in the US. In this context, significant economies of scale associated with standardized products resulted in industry structures dominated by large firms partly protected both in product and financial markets. These firms developed longterm relations with suppliers of funds. They also offered long-term relations and job security to their workers. New entry and the competitive drive that it gave were not crucial. In this context, macroeconomic policy was only aimed at managing the aggregate demand. Microeconomic management was reduced to regulating firms operating in industries characterized as natural monopolies and promoting national champions in some other industries without really considering competition issues. According to this view, this system breaks down as the patterns of both consumption and production change, and shift towards different types of goods and services, more customized, and requiring a different form of industrial organization. Briefly, once European countries had moved closer to the technology frontier and also with the occurrence of new technological revolutions in communication and information, innovation at the frontier would have become the main engine of growth. This in turn called for new organisational forms, less vertically integrated firms, greater mobility, both intra- and inter-firm, greater flexibility of labour markets, a greater reliance on market finance and a higher demand for both R&D and higher education. However, these necessary changes in economic institutions and organisations have not yet occurred on a large scale in Europe and it is this delay in adjusting our institutions which accounts to a large extent for our growth deficit. (Sapir et al., 2003, p. 29) This translates into the following key conditions for removing the poor record of job creation in Europe. ●

To the extent that rivalry among firms and strong fluctuations in their market shares make it easier to innovate at the frontier, the new growth regime


●

●

requires the elimination of all the obstacles to this rivalry and a free entry. The regulatory environment must encourage start-ups, be conducive to the challenging of established positions, and stimulate entry and exit. To the extent that selection among projects and also among more or less skilled managers is needed for sustaining innovation at the frontier, the new growth regime requires developing stock markets and promoting the mode of governance associated with them in order to guarantee the opportunity for innovators to appropriate a huge fraction of the revenues of their innovation. To the extent that microeconomic instability, and hence hiring and firing of employees are the main aspect of the innovation process, the new growth regime requires facilitating the match of supply and demand for the different skills in different industries and different locations by enabling firms to hire and fire more easily. This will be the key condition for improving the poor record of job creation in Europe.

In this context, macro-stability, far from being the result of a well-managed process of change, appears as the precondition of such a process, assimilated to the introduction and the acceptance of so-called structural reforms. This macro-stability is regarded as a set of rules or behaviours that achieve monetary stability and fiscal discipline, and are given once and for all, being supposed efficient at whatever moment they are applied. Implicitly, attractors associated with each set of technologies and institutions toward the economy are supposed to converge. Several attractors exist, which implies that societies have to choose between them, that is, between low growth and high unemployment on the one hand, or high growth and low unemployment on the other. Indeed, according to the most extreme defenders of this consensus: a critical point has been reached in a number of European countries, not so much because of the overall macroeconomic performance (the current slowdown is milder than the previous one) but because of budgetary problems (including the adverse consequences of labour market rigidities for the financing of valuable benefits such as pensions and health care as well as for long-run living standards) and the feeling that ‘globalisation’ is making the burden of labour rigidities unbearable. (EEAG, 2004, p. 3) This renders it all the more necessary and urgent to carry out structural reforms that concern labour markets. In this view, the only obstacle is presumed to be a political one: the main beneficiaries of the existing system have the capacity to blockade the reforms that reduce or eliminate their revenues. So what is at stake is the identification of a set of policies to reduce unemployment that would meet much less political opposition. ‘This includes


liberalising product markets; introducing a simple “firing tax” that would be paid to the worker as severance payment instead of the current system of legal procedures; replacing welfare payments for the poor with in-work benefits such as earned income tax credits; and ensuring that the search activity of the unemployed be tightly monitored with sanctions in the form of reduced benefits if search is not active’ (ibid., p. 3). Moreover, if measures aimed at improving the Stability and Growth Pact are insufficient or hard to carry out, the EU member states should introduce an institutional reform that would consist in delegating ‘the actual decision-making process regarding variations in actual public deficits or specific taxes around levels determined by Parliament to an independent Fiscal policy Committee’ (ibid., p. 7). These considerations can and must be challenged, first from an empirical and historical viewpoint. Reconstruction and catching-up cannot be assimilated to steady growth. Most of the difficulties that European economies faced in this period are the same as those faced by economies engaged in an innovation process properly defined as an out-of-equilibrium process. On the other hand, the macroeconomic policy in that period was far from being reduced to the management of an aggregate demand. It was also, and mainly, a policy that successfully managed the supply side of the economy, thanks to an appropriate management of productive (financial and human) resources (Hicks, 1959). On the other hand, in the last two decades structural reforms and adoption of fixed policy rules have not prevented increasing unemployment and productivity slowdown in European countries.

Why has Europe been growing so slowly? Structural change and coordination failures In fact, the key issues to be addressed might not revolve around the possibility of convergence towards some pre-determined equilibrium growth path. They might be about the nature of growth regimes in the history of our economies and their relevant stability features. As a matter of fact, the central stylized fact revealed by international comparisons is the diversity of evolution across countries that have already faced the same kind of shocks and have had access to the same technologies. This diversity is closely related to the nature and the profile of the accumulation process. The diversity of growth regimes can be analysed with reference to the position and the movement of the economy within the framework space defined by the growth rate of labour productivity and the growth rate of investment per employee (Böhm and Punzo, 2001). It is possible to contrast economies that have reached a nearly steady state (when the growth rate of productivity is more or less equal to the growth rate of investment per employee) with economies that experiment with structural changes defined as alternations between two growth regimes, respectively characterized by a high and a low growth rate of investment per employee with respect to the growth rate of


productivity. Such alternations reveal the existence of changes in growth regimes, that is, structural fluctuations. In the case of the US economy, there is no clear trace of significant changes in growth regimes during the last two decades. On the other hand, most European countries, as well as Japan, were exhibiting wild and recurrent changes in growth regimes (Böhm et al., 2001; Gaffard and Punzo, 2005). Such a high degree of structural instability may account for their poor employment and productivity performance vis-à-vis the US; and it can largely be explained by coordination failures that concern both individual behaviours and economic policy. Some crucial episodes in the growth process of the different countries lend support to such conjecture. Most European countries, and notably France, Germany and Italy, experienced fairly irregular growth from the late 1970s onwards. This has taken the form of alternating growth regimes. In the 1980s, as the major shortcoming of coordination failures, including economic policy failures, real constraints emerged which, being too stringent, implied that recovery would raise inflation pressures, boost inflation expectations, and hence suggested restrictive monetary policies. In reality, the lack of productive resources following the first negative (oil prices) then positive (technological) supply shocks has to be deemed to be responsible for the stagflation phenomenon. Restrictive monetary policies implemented with the aim of curbing a rate of inflation perceived to be too high, had the side effect of making the productive resource constraints ever more severe. Abrupt switches in growth regimes, as appear in the investment–productivity framework space, have been the typical outcome (Böhm et al., 2001; Gaffard and Punzo, 2005). Such structural instability factored out into a productivity slowdown and a rising NAIRU (nonaccelerating inflation rate of unemployment). Later on, attention was focused on inflation performance. A stable price level and above all a strong exchange rate (particularly in France) became primary objectives, pursued through a restrictive monetary policy, and eventually a lower inflation process did prevail. During the 1990s, share prices normalized by productivity more or less held their ground in Germany, France, Italy and Spain, while they were strongly increasing in the US (Fitoussi et al., 2000). This confirms that liquidity constraints remained high on this side of the Atlantic, while being relaxed on the other. In the EU-area to come, while the economy needed a more intense accumulation of capital, investment was sacrificed with the consequence of progressively lowering the notional growth rate, that is the output growth rate compatible with nonaccelerating inflation (on this concept see Hicks, 1977, p. 99). Inappropriate economic policies were responsible for the irregular and low growth performance. As a benchmark, let us take the Netherlands which, instead, does show a kind of convergence towards a quasi steady state in the late 1980s and the 1990s. The crucial episode is the long-lasting expansion that began in the middle of the 1980s. The inflation trend rose from 1987 to 1991, but this did


not trigger any immediate, counterbalancing policy response. Thus, steady growth continued through to 1992 whereas most of the European countries went deep into recession. Inflation run-up was not permanent, at any rate. The episode is therefore significant in so far as it reveals the working of a superior coordination mechanism whose main aspects are, on the one hand, a loose banking policy with respect to the price level, and on the other hand, regulated wage movements. As is well documented, the point of departure of this new procedure was the 1982 Wassenaar agreement on wage restraints accepted by Dutch unions. This agreement outlined a concerted income policy, which has successfully dampened the inflationary effects of final demand pressures and has also permitted the Central Bank to implement a comparatively less restrictive monetary policy. Such a policy mix, then, could be aimed at boosting investment spending at a time when it was necessary. On the other hand, since the early 1980s, the Netherlands has seen its rate of employment rise, clearly mimicking the rise in share prices (normalized by productivity) (see Fitoussi et al., 2000). This, of course, may lend support to the theory that sees a key role played by asset prices in employment determination, an idea that belongs to equilibrium models. But it also may be used as evidence in support of a distinct conjecture, namely that releasing liquidity constraints – here thanks to stock market bubbles that push capital costs down – allows firms to fare better through transition to the new technologies and thus capture the associated productivity gains. Let us take, as another example, the United Kingdom, which also appears to have managed to steer relatively clear of the severe growth regime instability of other countries. After experiencing pronounced structural fluctuations from 1978 and 1994, similar to those experienced by France, Germany and Italy, it seems to have regained a stability corridor (Böhm et al., 2001; Gaffard and Punzo, 2005). The crucial junction in the UK’s evolution appears to have been between the late 1980s and the early 1990s; starting with a strong expansion in the late 1980s, the boom in borrowing being its widely accepted explanation. Due to a lucky combination of financial liberalization, high confidence and high asset prices, this ignited and sustained a boom of both investment and consumption. At the same time, the Bank of England refrained from tightening policy immediately after inflation started to rise. The historical experience of the UK in the early 1990s can be likened to that of the US in the early 1980s: policy easing in response to recession. The truly important difference between most European countries and the US is likely to be this: in the US the rate of investment has remained constant and investment has always actually increased following supply shocks. This has mainly been due to the fact that ‘policy has not generated bouts of severe inflation and so has not had to generate bouts of recession to control it’ (Romer, 1999, p. 32). On the other hand, at the same time, the stock market bubble pushed capital costs down and allowed firms to carry out their desired investments. As a consequence, the rate of growth consistent with


price stability has risen, and correlatively the NAIRU has decreased. The US economy did not experience structural fluctuations to the same extent as some other, perhaps core EU, countries (Böhm et al., 2001; Gaffard and Punzo, 2005). However, the US investment boom in the late 1990s was unsustainable. Higher productivity growth in the late 1990s encouraged firms to become over-optimistic about future returns. The inevitable result was over-investment in new technologies in view of reasonable profit expectations. In other words, excessive liquidity levels would have favoured equally excessive investment in the new sectors. Now, as profits are starting to plunge, share price evolution is going into reverse and firms are being forced to cut their investment plans. Recent evolution and the connected policy issues for the Japanese economy can easily be accommodated within this same analytical framework. At the beginning of 1991, the Japanese economy entered an extended period of slow growth, eventually leading to a definite recession, that is still ongoing. Slowdown and then actual contraction have been viewed as the correction and backfiring of an unsustainable boom, whereby the actual growth rate would have been for a while above the potential one. Similar explanations have imputed the fundamental cause of the slowdown to the reduction in the rate of potential output as coming from a change in the demographic as well as in the total productivity factor trends. However, estimates of the gap between actual and potential output consistently conclude that it cannot exceed 4 or 5 per cent, so that not only demand policies as they are currently recommended, but perhaps to a greater extent, policies promoting a better inter-temporal coordination between supply and demand, do have an important role to play. To see why, consider the beginning of the 1990s: there was an evident break in inter-temporal coordination the main aspect of which was an excessively low consumption ratio while increased savings were not being converted into productive investment. This resulted in dramatic growth regime switches and related structural fluctuations (Böhm et al., 2001; Gaffard and Punzo, 2005). To appreciate the contrast: until 1985 the Japanese economy had been basically near a steady state. Thereafter, it clearly exited from its own stability corridor to experience a structural fluctuation, with irregular alternating growth regimes. To summarize, the different productivity trends in Europe and the US in the 1990s and the apparent disappearance of the productivity paradox in those years in the US confirm the scenario that focuses on coordination failures. On the one hand the poor performance of productivity in Western Europe is the result of a reduced process of accumulation (also characterized by strong fluctuations) due to a tight monetary policy, and more generally to a wrong policy management. On the other hand a stable and substantial rate of investment is behind the positive productivity trend in the US. Ex post, this is an obvious explanation of the difference. But behind these different accumulation processes, different coordination mechanisms have been at


work, the one actually sustaining this process, the other failing to do so. Different coordination mechanisms that cannot be reduced to the properties of technology or the character of incentive systems but involve the harmonization over time of all the elements involved in the adjustment process. This scenario also leads to the conjecture that good coordination of the process of accumulation of capital, not price flexibility, is the main reason for the satisfactory performance of the United States, although the behaviour of prices may have helped. Strong wage flexibility associated with a strong increase in personal inequalities has not resulted in perturbations of economic activity because strong growth made possible by good coordination mechanisms has led to a huge creation of jobs and hence to stability of wage shares. In Europe, where the restrictive policies adopted have checked the process of capital accumulation, strong fluctuations of the wage shares in gross national products due to mistakes in economic policy have contributed to exacerbating the existing distortions, instead of helping to reduce them.

The real challenge of the economic transformation of Europe The economic transformation of Europe, involving technological change, enlargement of the EU and competition with emerging economies (China, India) and the US, requires a new deal to promote growth and enhance social welfare and cohesion. The key issue to be addressed is not the realization of the institutional conditions supposed automatically to enable the choice of best technology practices and hence the convergence towards a predetermined optimal growth path. We have to look at growth as the result of an adaptive process that allows discovery of the relevant information and hence captures the potential gains associated with the development of new technologies and market extensions. The real issue is about the necessarily complex set of conditions that regulate the process of accumulation and restructuring of capital and hence determine the actual growth rate of the potential output. This set cannot be reduced to the choice of an institutional arrangement presumed optimal. Thus, contrary to the current consensus, macroeconomic stability, far from being regarded as a prerequisite of growth – as a set of rules aimed at guaranteeing monetary stability and fiscal discipline – will result from a process that requires discretionary interventions. The rationale of these interventions is quite the opposite of that presiding over the measures making up the policy consensus previously expounded. In this perspective, monetary policies should be aimed at promoting banking behaviours and structures that sustain necessary investment instead of maintaining a devastating constraint on firms’ behaviours in order to maintain full price stability. The protection of employment, and more generally institutional rules that favour social cohesion, should be viewed (and amended) as a means of allowing the economy to deal with turbulence;


hence guaranteeing the effectiveness of the learning process. Competition and regulatory policies should be oriented in such a way as to consider market imperfections as integral and necessary aspects of the production and the dissemination of knowledge in a market economy, that is, as the natural features of an economic process driven by creative destruction. Cohesion policies should make it compatible to promote growth in each region or country and maintain an economic and political equilibrium between them. Monitoring monetary and financial constraints Bringing down inflation was the explicit goal of monetary policies in Europe during the 1980s and the 1990s. This led to a remarkable nominal convergence. But what was the impact of monetary stability on economic growth? The prevailing evidence points to lower investment and lower growth rates as the main effect of such a stabilization. As a matter of fact, accumulation and the restructuring of productive capacity following a supply shock are characterized by coordination problems concerning, in the first place, the production process but extending to all economic activity (Amendola and Gaffard, 1998, 2003). The main aspect of the problem is insufficient investment in productive capacity with respect to the requirements of an economy facing technological changes to be maintained in a quasi steady state with full employment. In a fully coordinated economy the appropriate required investment would be immediately and spontaneously achieved without inflation and unemployment. Otherwise, an external intervention is necessary to contain inflation and absorb unemployment. The main problem is to provide the required flow of productive resources over time so as to keep a balanced structure of productive capacity and thus progressively eliminate market imbalances. The process of restructuring of productive capacity necessarily results in inflationary pressures (and/or deficits in the trade balance in open economies) because the goods on which the wages will be spent cannot be provided out of the product of the labour that is newly employed. The Central Bank then has a choice. It can try to curb inflation as soon as possible, with the consequence of exacerbating the initial negative impact of the shock on output and employment. In this case, the investment necessary to carry out the innovation process cannot be realized. We will have less production and less labour demand. This may in fact result in a lower inflation if not a price deflation and in cumulative unemployment. This is the recent experience of the major European countries as the result of the policies followed to comply with the Maastricht rules and the ECB policy of pursuing the target of price stability. In conclusion, restrictive monetary policy has been one of the major obstacles to a successful transition because it has created an inappropriate volatility of investment spending. Moreover, targeting (and realizing) a too low rate of inflation has made it impossible to reduce the real interest rate and by so doing to favour the growth process.


The Central Bank can, alternatively, decide on an accommodating monetary policy characterized by the acceptance of a transitory inflation aimed at enhancing the growth process in the future, thus simultaneously re-absorbing inflation and unemployment. In this case, the possibility of keeping a balanced structure of productive capacity will re-establish the coordination of economic activity and make the innovation process viable, with positive results in terms of productivity and employment (Amendola and Gaffard, 1998, 2003). If we look at the European experience, we see that a substantial loosening of monetary conditions in the late 1980s and the late 1990s preceded the only two episodes of relatively high growth in the past two decades. The accommodating monetary policy seems to have been the major factor, though not the only one, behind recent European growth, while Europe is really facing a structural change. While European policymakers (and distinguished scholars) like to blame all the euro area’s economic woes on inflexible labour markets and high taxes, the major difference between the EU and the US with respect to their performances is that over the past three years America has enjoyed much looser monetary and fiscal policies which have bolstered consumer spending. Adjusting for the impact of the economic cycle (deficits widen in downturns as tax revenues shrink), America’s structural budget has shifted from a surplus of 1 per cent of GDP in 2000 to an estimated deficit of 4 per cent this year. Over the same period, the euro area has seen no net fiscal stimulus. Interest rates have fallen by 5.5 percentage points in America, twice the fall in the eurozone. A weaker dollar is also helping to boost American exports and company profits. The combined stimulus has helped to cushion what would otherwise have been a much steeper downturn in the United States. In the same vein, while Japan is blamed for the rather light structural reform that has been carried out, for the first time in a decade, in early 2000 it enjoyed an upswing that could actually last. The real explanation is that the Bank of Japan’s monetary policy has now become steadily and credibly expansionary. The Bank of Japan has used an unorthodox monetary policy, printing a lot of money through a ‘quantitative’ easing policy, while the interest rate is zero. Moreover the central banker has said that this accommodating monetary policy will not stop until year-to-year inflation has been positive for a good while. In other words, the Central Bank has adopted an inflation target that has been determined with respect to a growth rate objective. Briefly, if monetary policy continues to be expansionary, and if government does not repeat the mistake of raising taxes, then recovery should be lasting. Indeed, such a policy will be efficient, as it will make corporate restructuring and more general structural changes easier. According to the tenets of the new orthodoxy, even in the case of a recovery enhanced by easy monetary policy, countries should engage in structural reforms (privatization, deregulation). We intend to prove that these reforms may result in turbulence that hampers growth and innovation instead of boosting them.


Maintaining protection of employment and social cohesion The prevailing policy consensus stresses the flexibility of the labour market as the primary object of policy intervention. Today’s prevailing view in the literature and in most political circles is that the possibility of hiring and firing freely, besides offering wages at a freely chosen level, is an incentive to investment in more advanced and more productive technologies. As regards this issue, most labour market theories hold that employment protection, that is, administrative and legal constraints and the benefits and payments made to laid-off workers, increases the length of unemployment and makes the labour market less reactive and more stagnant. The main idea is that risk-averse employers are likely to take into account the potential future costs of hiring before deciding whether or not to hire workers. It follows that the extent of job reallocation should be lower in countries with strict employment protection than in more flexible ones, and hence the growth rate should be lower. To avoid paying firing costs the countries with a rigid labour market will then tend to produce goods with a relatively established and hence stable demand. They will thus concentrate on ‘secondary’ innovations, aimed at improving existing products: less risky but bringing about lower increases in productivity. Along this line goes the explanation of the different productivity performances in the recent past in the United States (where primary innovations are stimulated by low firing costs due to a flexible labour market) and in Europe (where strong employment protection and high firing costs have favoured mainly secondary innovations aimed at just improving existing products: less risky but bringing about lower productivity gains). First, it is worth mentioning that labour market rigidity in certain countries is, to say the least, doubtful. Contrary to the common belief, countries with substantial employment protection like France and Italy exhibit stronger flexibility and dynamism of the labour market – measured by gross worker turnover – than the UK and even the USA, whose labour markets are pointed out as outstanding examples of flexibility. In the same way the data show that the gross worker turnover in so-called high-tech sectors (communication, computers, biotechnology and so on) is lower than in sectors believed to be more traditional and characterized by secondary innovations (construction, transportation, instruments, automobile tyres and so on). Indeed, according to more general empirical studies, there is a close negative correlation between protection of employment and the length of unemployment, as well as a negative correlation between employment protection and flows between employment and unemployment and vice-versa. However, there is no correlation between protection of employment and the unemployment rate. Moreover, there is no negative correlation between the extent of job reallocation (the labour turnover) and the strictness of labour market regulations. In other words, labour mobility is not lower in some ‘rigid’ European


labour markets than in the US. As a matter of fact, some of the most rigid European labour markets are characterized by sizeable job-to-job shifts, which coexist with a large job reallocation rate and a low unemployment turnover (see Boeri, 1999). Therefore, the labour market institutions of most European countries would not inhibit the mobility of workers in response to changing patterns in supply and demand. Employment protection would not be an obstacle to technological change and growth. The real effect of employment security regulations and of the partial reforms recently carried out that extend the number of short-term contracts and make the labour market more flexible would be only to favour a segmentation of this market and the appearance of a new category of workers: the ‘short-term’ workers. This segmentation might even be an obstacle to workers’ mobility and growth by preventing voluntary quits from ‘solid’ jobs (ibid., p. 85). However, behind the scene, what the tenets of the current orthodoxy always promote is the moderation of wages. The proof is that the main criticism concerning partial reforms and the introduction of two categories of workers consists in deploring their failure to change wage mechanisms: this strategy would increase the protection of insiders (permanent workers), thus creating excess wage pressure and eventually reducing unemployment (Bentolila and Dolado, 1994). Thus, the problem really lies in the effect of wage moderation and wage flexibility on the viability of the economic process. In our perspective that implies considering coordination issues beyond the state of labour markets, a high turnover associated with a weak protection of employment would likely entail decreasing wages without guaranteeing any creation of jobs, and may even induce inappropriate wage flexibility and strong turbulence on the labour markets. On the other hand, a more important point, favourable market (in particular, labour market) conditions are supposed not only to foster investment but also favour the ‘right’ investment, that is, the choice of the technology leading to primary innovation. That is to say that the underlying production theory implies that the new productive capacity and its adequate utilization (the technological gains) are the automatic result of the availability of given productive resources and of the way in which they are combined (the technology), which also determines the efficiency with which these resources are used in the process of production. This view mistakes the distinction between growth and technical change and, as a consequence, the role of the market in this context. As a matter of fact there is no automatic economic gain resulting simply from scientific or technical advances. Actually obtaining the returns of innovation depends not so much on the intrinsic characteristics of given technologies as on the coordination of economic activity, both at the micro and the macro level, through which innovation is carried out. The adoption of technologies that potentially allow for substantial productivity gains may actually result in a waste of productive resources, as the recent crisis in some sectors of the ‘new economy’ demonstrates. What really


matters is not to choose to invest in a primary innovation, but to realize the conditions under which the potential gains of the adoption of new production technologies, even when these lead to the appearance of an increasing variety of goods and services, are actually transformed into effective economic returns. The working of labour markets – the higher or lower flexibility/ rigidity, the wage policy pursued, more employment protection or less, and so on – must therefore be looked at in the perspective of the viability of an economic process that has its own evolution and might or might not achieve its ends depending on the successful working of the required coordination mechanisms. In this light, especially when we consider that learning is a main aspect of a thorough innovation process, flexibility rather discourages long-term investment in human capital by employers, since the worker may not stay in the firm, and also discourages investment in firm-specific skills by workers, since they may not be a fair return for that investment in the absence of job security. Contrary to what has often been considered, it is not true that, at a time of rapid change and a need for adjusting both production and skills quickly, flexibility in the sense of lessening the protection of employment comes to the fore. As a matter of fact, restructuring depends on learning and learning goes well not because turbulence is systematically favoured but because it ends in stabilized structures. Rebuilding a comprehensive competition policy Since the late 1980s the European Commission has been using competition policy as a tool for liberalizing markets. This policy plays an essential role in ensuring that market opening does lead to the achievement of potential productivity and variety gains. It increasingly questioned whether mergers and acquisitions were indeed guided to promote innovation. It exercises control over public aid to avoid distortions through subsidies to some companies. It has been active in promoting a reorientation from aid to individual companies or sectors to less distorting horizontal measures addressing specific market failures. It acknowledges the evolving dimension of the markets and promotes rivalry, new entry, and hence turbulence at the micro level that is supposed to sustain macroeconomic stability. It goes hand-in-hand with deregulation and privatization. This policy is defined with respect to a benchmark, the state of perfect competition, which implies that it is aimed at systematically approaching this state in each industry. In other words, it is defined and applied in isolation, and it is supposed to participate as such in welfare maximization. Things are much more complex. The difference between competition policy in Europe and in the US is that in the latter case this policy interacts with the other dimensions of public intervention in a way that privileges innovation and growth in an imperfect world; it is not systematically aimed at establishing a world that would be as close as possible to perfect competition. When defining competition as a process, it is not only aimed at equalizing supply and demand in a given market and technological environment, but


also has to adapt both structure and technology to opportunities created by expanding markets. Through this adaptive process, rivalry is the means for productivity gains to be transformed into lower prices for the benefit of consumers and normal profits for the benefit of entrepreneurs. This rivalry does not preclude the stabilization of the market structure. Thus, several firms can coexist on the market, despite the existence of increasing returns, remaining differentiated not so much because they supply differentiated goods, but because they are each one at a different step of the life cycle of the production process. This is a situation in which competition causes the rate of investment in product development to rise or fall towards the level at which this investment yields only a normal return. It is also a situation in which the prices charged by the firms reflect decreasing average costs so as to allow the benefits from innovation to be distributed to consumers. Finally, this is a situation in which the stability of market shares is obtained: there are in fact neither new entries nor exits from the market. All these considerations not only qualify a dynamic equilibrium, but also what should be the competitive conditions consistent with the effective realizations of the innovation gains and hence with increasing returns (Amendola et al., 2003). Indeed, the main issues to be addressed are about the conditions that allow innovative firms to be successful and the industry to reach the required stable structure. As a matter of fact, resource constraints largely determine the viability of evolution processes and the emergence of appropriate industrial structures. Let us take the case of the sectors of the so-called new economy. In these sectors, banks and financial markets, more interested in the perspective of growing markets than in current profits, have allowed an excessive capacity competition. As a consequence, a shakeout has occurred, following a strong decrease in the market value of shares. Monopoly practices (and regulatory practices) setting bounds on price and investment behaviours would have helped the industry converge to the appropriate structure. On the other hand, excessive flexibility made the shakeout unavoidable, thus involving huge welfare losses. Thus no structural criterion that would be a guideline for competition policy applies. The automobile industry and the personal computer industry offer clear evidence of this by exhibiting very similar patterns of evolution, despite their strong difference from a technological viewpoint (Mazzucato, 2002). Both have experienced ‘a high degree of turbulence during the first 30 years: high entry and exit rates, short firm life spans, radical innovation, and rapidly falling prices’. Both have experienced ‘the highest stock price volatility during these periods in which the forces of creative destruction were the strongest’ (ibid., p. 343). In fact, a lesson emerges from this study. The working of markets, including financial markets, is essential in the determination of outcomes. It is much more important than the nature of the product and the technology, which only appear at the end of the process. Apparently, the shakeout occurred shortly after the emergence of a dominant design, that of mass production. But this does not mean that


this design is the cause of the shakeout. On the contrary, it is the result of this process, which is necessarily a selection process. Although competition between technologies is without any doubt an important aspect of technological change, the result of this competition is not determined by the intrinsic characteristics of these technologies but by the working of coordination mechanisms. Thus, similarities and differences between the EU and the US should be attributed less to the market structures and behaviours themselves than to their articulation with the monetary and financial conditions. The common belief that the United States experienced a much bigger bubble than the eurozone is false, so far as the corporate sector is concerned. During the late 1990s, European companies went on an even bigger borrowing and investment binge than did corporate America. Total corporate investment (capital and financial) in the euro area rose from 14 per cent of GDP in 1997 to 24 per cent in 2000, eclipsing America’s investment boom. European firms’ corporate-financing gap (investment minus internal funds) rose from 4 per cent of GDP in 1997 to a record 14 per cent in 2000 and most of that was filled by debt rather than equity financing. Corporate debt has risen much more dramatically than in America from 60 per cent of GDP in 1997 to 76 per cent in 2002. This legacy of over-borrowing and over-investment is currently holding back growth in the eurozone. Only general conditions of competition can explain these structural cycles that have been much more accentuated in Europe than in the US. As regards the entry process, they also explain that the main difference between the US and the EU does not lie in the number of firms that has been created in each industry (for example, biotechnologies) but in the post-entry employment growth which is much faster in US than in EU companies. Not only entry-exit processes per se but also the growth performance in the years after entry matter. An entry-exit process is necessary but it must result in a new stabilized market structure that promotes growth. Thus, the nature of the selection procedure is at stake, which implies an assessment of the exact role played by imperfect competition in this procedure and also of the influence of policies that contribute to determining the resource constraints. Empirical analysis of the pre-exit performances of manufacturing firms shows that exiting firms are not always the less productive ones (Bellone et al., 2003; Nishimura et al., forthcoming). This might be due to the way both financial resources and human resources are really allocated between the different firms. That is, this might be attributed to labour market working and labour organization, and to banking policy. In other words, the emergence of competitive and efficient structures does not depend on competition policy only. This calls for a deeper understanding of the role of competition and regulation policies. In our view a competition policy is no longer devoted to maintaining a given market structure presumed optimal. A regulation policy is no longer devoted to artificially creating industry conditions that would


be equivalent to the optimal ones. Out of equilibrium, a market structure that maximizes the growth of productivity emerges as the result of the working of coordination mechanisms that are nothing but market connections (imperfections). A regulation policy may help to establish these connections, while a competition policy should be devoted to their control. These connections are not market failures in the standard sense. They must not be removed but put into place, and this may require monopolistic practices. In short, a regulation policy needs to favour the emergence of market structures that foster innovative choice. A competition policy should repress misconducts that are an obstacle to innovation processes. As a matter of fact, the same structure that promotes an innovative choice may lead firms to capture rents to the detriment of consumers. This is the reason why competition policy must complete a regulation policy. This is also the reason why it cannot be reduced to an intangible rule referring to an optimal market structure. Finally, competition and regulation policies cannot be dissociated from macroeconomic policy. Growth processes require interventions that must be narrowly articulated one with the other. It is not true, as the prevailing growth philosophy goes, that growth would result from full competition joined to a neutral macroeconomic policy. Contrary to common belief, we need monopoly practices that articulate with active public policies in order to make viable innovation processes. Maybe here lies the main difference between the EU and the US. Rebuilding cohesion policies: the new geographic challenge The majority of the theoretical models dealing with the international context repeatedly stress technology and institutions in the standard way as the ‘fundamentals’ determining both the growth rate of different countries and the spatial distribution of economic activities. The relevant attributes of technology in this case are local externalities, transport costs, costs of communication of new ideas and knowledge and R&D spillovers (Krugman and Venables, 1995; Martin and Ottaviano, 1999; Baldwin et al., 2001). The way to take advantage of technology when dealing with different countries and regions of the world is the same as that advocated for given economies: a perfectly competitive market, as assured in this case by a full liberalization of world trade. True, there is the necessary inequality resulting from the processes of agglomeration as a consequence of trade liberalization, and the increasing returns associated with this agglomeration, but inequality does not hamper all the countries engaged in international trade from taking advantage of it. Thus, for example, in most models people from less developed countries are supposed to benefit from welfare gains due to the lower prices of new consumption goods (with the underlying implicit assumption that the loss of ‘industry’ most likely resulting from international competition does not result in persistent unemployment).


These models miss the crucial question: what are the internal and external coordination conditions that allow the effective appropriation of the potential returns of technology, that is, those which make viable the process on which growth actually depends? They also miss another crucial question: to what extent do the relative size of the region or country and the demand complementary threshold make sense in the adjustment process? In fact, the real difference between countries in Europe lies not in the nature of an institutional arrangement that would be more or less close to the benchmark, but in the coordination conditions, which, in the euro area, are strongly related to the size of each country, and their implications for the rationality of policy reaction. A small open country can always react efficiently to a negative macroeconomic shock by reducing taxes and moderating wage increases, and hence attracting foreign capital flows. This is justified by the fact that the demand for its goods and services is mainly an external one. Although small countries exhibit low unemployment rates, balanced budgets, and also higher inflation rates than the average, it is not a solution for large countries to adopt similar measures through structural reforms. A large country that would adopt the same adjustment measures in relation with the same given rules would be engaged in a pro-cyclic policy that would result in a cumulative downswing and higher unemployment because the larger part of the demand is internal. This conflict is at the heart of issues that the EU has to face. It explains political divergence between Germany, France or Italy, on the one hand, Austria, Ireland or the Netherlands on the other hand. It might become more acute with enlargement and the required catching-up of the new member states, most of which are small countries. Within the EU, countries are not all converging towards the same pattern of growth. Moreover, as a result of strong dynamic interdependencies, this generates perturbations that hamper the overall growth process. This is so because institutional architectures and policies do not focus on improving coordination among different countries.

Conclusion Reference to the comparison of the US and Europe’s performances, which is today the leitmotiv of all arguments on economic policy, confirms the scenario focusing on coordination failures that we have drawn. On the one hand, poor growth and productivity performance in Western Europe results from a reduced process of accumulation (also characterized by strong fluctuations) due to a tight monetary policy, and more generally to a wrong policy management. On the other hand, a stable and substantial rate of investment is behind the positive productivity trend in the US. Ex post, this is an obvious explanation of the difference. But behind these different accumulation processes, different coordination mechanisms have been at


work, the one actually sustaining this process, the other failing to do so. Different coordination mechanisms that cannot be reduced to the properties of technology, price (and wage) flexibility or the character of incentive systems, but involve the harmonization over time of all the elements involved in the adjustment process. Institutions matter. However, they have to be considered in relation to the adjustment process required by structural change rather than in relation to the presumed performance in the long run. Their role has to be altogether redefined, to be one of helping reduce the irregularity in the growth process generated by e.g. technology shocks and generally innovation, rather than in determining the growth trend. They do contribute to the latter by accomplishing the former task. Effective institutional systems contribute to regular dynamic patterns, not those that just incorporate stronger incentives for growth. The reason is that innovation in its variety of forms is by its very nature a break up and implies a discontinuity: e.g. a break up in the existing production structure and markets. It brings about adjustment costs and specific problems of coordination between economic activities. Depending on the way these new problems are dealt with, an economy’s growth is more or less regular and accordingly the productivity and output gains reaped out of innovation greater or smaller. The challenge is to render the technological and institutional evolution as gradual as possible. This being their appropriate role, economic policy needs only go the same way. (Gaffard and Punzo, 2005)

Note This paper owes very much to my collaboration with Mario Amendola.

References D. Acemoglu, P. Aghion and F. Zilibotti, ‘Distance To Frontier, Selection, and Economic Growth’, NBER Working Paper, no. 9066 (2002). M. Amendola and J.-L. Gaffard, Out of Equilibrium (Oxford: Clarendon Press, 1998). M. Amendola and J.-L. Gaffard, ‘Persistent Unemployment and Co-ordination Issues: an Evolutionary Perspective’, Journal of Evolutionary Economics, 13 (2003), 1–27. M. Amendola, J.-L. Gaffard and P. Musso, ‘Viability of Innovation Processes, Emergence and Stability of Market Structures’, in M. Gallegati, A. Kirman and M. Marsili (eds), The Complex Dynamics of Economic Interaction, Proceedings of the WEHIA Conference (Berlin: Springer Verlag, 2003), pp. 49–77. R. Baldwin, P. Martin and G. Ottaviano, ‘Global Income Divergence, Trade, and Industrialization: the Geography of Growth Take-offs’, Journal of Economic Growth, 6 (2001), 5–37.

162 John Kenneth Galbraith and the Future of Economics F. Bellone, P. Musso and M. Quéré, ‘Analysing the Pre-exit Performances of French Manufacturing Firms over the Last Decade’, Comparative Analysis of Enterprise (micro) Data Conference, London (2003), September 15–16. S. Bentolila and J. Dolado, ‘Labour Flexibility and Wages’, Economic Policy, 18 (1994), 55–99. T. Boeri, ‘Enforcement of Employment Security Regulations, On-the-job Search and Unemployment Duration’, European Economic Review, 43 (1) (1999), 65–89. B. Böhm and L. F. Punzo, ‘Productivity–Investment Fluctuations and Structural Change’, in L. F. Punzo (ed.), Cycle, Growth and Structural Change (London: Routledge, 2001). B. Böhm, J.-L. Gaffard and L.F. Punzo, ‘Industrial Dynamics and Employment in Europe’, Research Report, European Commission, Targeted Socio-Economic Research Programme (2001). EEAG (European Economic Advisory Group at CES-IFO), Report on the European Economy 2004, Center of Economic Studies and Ifo Institute for Economic Research, Munich (2004). J.-P. Fitouss, D. Jestaz, E.S. Phelps and G. Zoega, ‘Roots of the Recent Recoveries: Labor Reforms or Private Sector Forces’, Brookings Papers on Economic Activity, 1 (2000), 237–311. J.-L. Gaffard and L.F. Punzo, ‘Economic Integration and Cross-country Convergence: Exercises in Growth Theory and Empirics’, forthcoming in F. Farina and E. Savaglio (eds), Inequality and Economic Integration (London: Routledge, 2005). J. R. Hicks, Essays in World Economics (Oxford: Clarendon Press, 1959). J. R. Hicks, Economic Perspectives (Oxford: Clarendon Press, 1977). P. Krugman and A.J. Venables, ‘Globalization and the Inequality of Nations’, Quarterly Journal of Economics, 110 (4) (1995), 857–80. P. Martin and G. Ottaviano, ‘Growing Locations: Industry Location in a Model of Endogenous Growth’, European Economic Review, 43 (2) (1999), 281–302. M. Mazzucato, ‘The PC Industry: New Economy or Early Life Cycle’, Review of Economic Dynamics, 5 (2002), 318–45. K. Nishimura, T. Nakajima and K. Kiyota, ‘Does the Natural Selection Mechanism Still Work in Severe Recession’, Journal of Economic Behavior and Organization (forthcoming). C.D. Romer, ‘Changes in Business Cycles: Evidences and Explanations’, NBER Working Paper, no. 6948 (1999), February. A. Sapir et al., ‘An Agenda for a Growing Europe: Making the EU Economic System Deliver’, European Commission, Brussels (2003).

Part III Economies in a Global Context: a Programme of Action


12

The Future of the International Financial System Paul Davidson

Despite the continuing support for the ‘Washington Consensus’ within the IMF, the World Bank and the US Treasury, most astute observers of the international financial system recognize that there is something seriously wrong with the existing system. Although many recognize the symptoms of a severe malady in the system, few realize what the fundamental flaws of the system are. Accordingly, few can prescribe the correct medicine to cure the illness or a vaccine to protect the international financial system from relapse. The calls for some changes to the international financial system appear to come from many economists. For example, in an issue of World Development (2000) there was a symposium where economists, including Irma Adelman, Joe Stiglitz (who was then with the World Bank), Jim Tobin, Barry Eichengreen, Stanley Fischer (who was then with the IMF) and myself recommended reforms. Most of these recommendations are what I call plumbing reforms, which attempt to put a patch on the current liquidity-leaking international financial system (for example, transparency, a Tobin Tax, the IMF as lender of last resort, uniform bankruptcy laws and so on) without altering the architectural foundation. As I point out in my book, Financial Markets, Money and the Real World (2002) all these (marginal) plumbing solutions fail to remove the fundamental flaws in the system. The global economy is at a crossroads. It can try to muddle through with the existing defective international financial system, hoping that marginal plumbing patches will limit the depressionary forces of recurrent currency crises to developing nations while sparing the major economies of the world. Or we can produce a new financial architecture that eliminates international financial crises and makes possible the potential of global full employment.

The Washington Consensus is the ‘conventional wisdom’ John Williamson coined the term ‘Washington Consensus’ in 1989, and although it means different things to different people1 – and apparently even different things, or at least different interpretations and emphasis, to 165


John Williamson at different times – the term does tend to reflect the conventional wisdom regarding the policies necessary for an efficient international financial system. The Washington Consensus refers to ten reforms recommended for all developing nations (Williamson, 2002): 1. 2. 3. 4. 5. 6. 7. 8. 9.

Fiscal discipline Reordering public expenditure priorities Tax reform. Liberalizing financial markets2 A competitive exchange rate Trade liberalization Liberalization of inward foreign direct investment Privatization Abolition of regulations that impede entry and exit of firms and market competition 10. Securing property rights The ‘three big ideas’ underlying these reforms are, according to Williamson, ‘macroeconomic discipline, a market economy, and openness to the world’ (Williamson, 2002). These ideas reflect the conventional wisdom regarding the conditions necessary for global prosperity and stability. As I will argue below (and in more detail in my book Financial Markets, Money and the Real World, 2002) it can be shown that what most orthodox economists mean by a policy of fiscal discipline will neither (1) avoid the possibility of current account crises3 (in the 1990s, the US current account deficit worsened), nor (2) produce a fully employed national or global economic system. Trying to implement the consensus reforms with their emphasis on fiscal discipline, the liberalization of financial markets, and the free market competitive exchange rate has created some severe problems for emerging market nations. So far the developed world has avoided the contagious effects of these problems. But if this is true, then why do so many intelligent economists (including Nobel Prize winners) and policymakers endorse the ‘three big ideas’ of the Washington Consensus. My immediate response to this query is embodied in Keynes’s (General Theory, 1936, p. 158) quip: ‘Worldly wisdom teaches it is better for reputation to fail conventionally than to succeed unconventionally.’

The fundamental flaws of the existing international financial system In the Spring 2003 issue of Harvard Relations Council International Review, Nobel Prize winner Joseph Stiglitz stated what by now should be obvious to all ‘Something is wrong with the global financial system … international financial crises or near crises have become regular events.’ Noting that there

The Future of the International Financial System 167

have been 100 currency crises in the last 35 years, Stiglitz states ‘the question is not whether there will be another crisis, but where it will be’. According to Stiglitz: ‘This much is clear: the International Monetary Fund (IMF), whose responsibility it is to ensure the stability of the global financial system, has failed miserably in its mission to stabilize international financial flows, arguably making matters worse.’ Thirty-five years ago, however, marked the beginning of the breakdown of the most successful international financial system4 in the history of mankind, the Bretton Woods system. Unfortunately, this fact did not stimulate Stiglitz to raise the following questions: (1) Despite the existence of the same IMF during the quarter century after World War II, why did the Bretton Woods financial system tend to avoid international financial crises? (2) What was it about the international financial system during the Bretton Woods period that encouraged (or at least did not hinder) year-after-year of unparalleled rates of increase in the real GDP per capita for every nation this side of the Iron Curtain?5 (3) Why were there such unparalleled growth rates even though every major nation, including the United States, instituted some form of international capital flow restrictions during the Bretton Woods period? Instead Stiglitz focuses on the argument that under the current international financial system international capital flows are a primary cause of these recurrent international payments crises as every prudent nation (except the United States) strives to maintain a surplus of exports over imports, that is, each nation tries to obtain a net positive financial savings position from its annual internationally earned income. Any net financial savings obtained are added to the nation’s foreign reserves. Since the global economy is, in essence, on a ‘dollar standard’, additions to a nation’s foreign reserves are held primarily in the form of US Treasury bonds. Washington Consensus advocates might respond that the 35-year-old currency crisis disease described by Stiglitz occurs because: (1) national governments have been profligate and do not exercise the necessary fiscal discipline, while (2) simultaneously having permitted, or even encouraged, fixities (rigidities) in labour and product markets, and (3) governments have insisted that nations utilize a managed fixed exchange rate that does not represent a competitive long-run equilibrium exchange rate – or what John Williamson, in earlier years, referred to as ‘FEER’. (Williamson has championed the establishment of a FEER – fundamental equilibrium exchange rate – target zone for the exchange rate, that is, a zone based on a fixed ‘competitive’ rate plus or minus 10 per cent. Williamson has argued that FEER would simultaneously achieve internal and external balance.6)


The Washington Consensus is supported analytically by mainstream economists’ macro models that implicitly assume the ergodic axiom which allows that private sector decision-makers have rational expectations,7 and that therefore unfettered private decisions in markets reliably predict future economic outcomes. Consequently, if the government maintains fiscal discipline and unfettered financial, product, exchange rate and labour markets, then the nation can never be afflicted with a currency crisis since ‘liberalized’ markets immediately compute and establish the equivalent of FEER and thereby achieve both internal balance at full employment8 and external balance.9 This belief in the ubiquitous efficiency of free markets leads to the Ronald Reagan query ‘Why should bureaucrats in Washington [or any other seat of government] know better than the individual on how to spend the earned income of the individual?’ In the absence of the ergodic axiom, as Nobel Laureate John Hicks (1977, p. vii) has noted, decision-makers ‘know’ that the future is uncertain. Once an uncertain future is recognized in one’s model, then, as Keynes’s liquidity preference theory suggests, markets cannot always reliably predict the future. This can lead to what some economists call financial market bubbles. What both advocates of the Washington Consensus and critics such as Stiglitz fail to recognize is that since the global economy is a closed economy, there is an obvious connection between the problems caused by the propensity to oversave in the closed economy of The General Theory and the ubiquitous desire of all nations (except the United States) to pursue export-led growth policy for the purpose of accumulating additional foreign dollar reserves. This international oversaving propensity creates persistent high rates of involuntary unemployment and liquidity problems for the global economy – and this is true whether the global economy is on a fixed or a flexible exchange rate system. For just as Keynes (1973) noted in his response to Dunlop and Tarshis in the 1939 Economic Journal, significant involuntary unemployment equilibrium can occur whether the price system is perfectly flexible or has built-in fixities. In other words, in a global economy context, Keynes’s analytical framework indicates that non-liberalized labour, product and exchange rate markets and persistent government deficits are neither a necessary nor a sufficient condition for the global economic system to have a depressionary bias that can lead to liquidity (currency) crises.

What is the problem and what should we do about it? Stiglitz states: ‘At the center of the failures of the global financial system is the global reserve system.’ Some countries, for example, Japan and China, successfully run persistent export earning surpluses. Stiglitz correctly notes that one country’s surplus must be some other nation or nations’ deficit. Annual saved increments in a nation’s foreign reserves represent earned


international income that is not used to buy the products of the surplus nation’s trading partners. In essence, when any nation runs persistent goods and services payments surpluses to accumulate foreign reserves, it is as if this nation is playing a game of Old Maid and passing the black queen of unemployment and indebtedness to its trading partners. Under the existing international financial system, nations stuck with the Old Maid must use a combination of previously saved foreign reserves and/or international loans to pay for their current period of excess of imports and to service their existing international debts. Ultimately, as its foreign reserves dwindle and its international indebtedness increases, a deficit nation finds it increasingly difficult, if not impossible, to service its outstanding international debt obligations. To prevent default, the IMF can make new loans to the indebted nation. The IMF loans require deficit nations to adopt ‘Washington Consensus’ reforms where (1) all domestic financial, labour and product markets must be freed of institutional rigidities (including a government social safety net), and (2) the nation must ‘tighten its belt’, that is, run fiscal surpluses and tight monetary (high interest) policies. These belt-tightening policies depress the nation’s economy in the hope that the consequently impoverished population will drastically reduce purchases of all goods and services including imports. As the deficit nation tightens its belt, it tends to depress the export industries of its trading partners. Moreover, the nation’s increased international indebtedness (as the IMF loans are added to the existing loans) enlarges the deficit nation’s annual international debt service payments. Adding to this burden is any decline in the nation’s exchange rate, as domestic residents and foreign investors attempt to move their funds to a safe haven in another country. Almost inevitably, the indebted nation cannot free itself from the increasing weight of its hard currency international debts – except by default. The result is a moribund economy, such as Argentina in 2002. Citing John Maynard Keynes as the inspiration for his 2003 solution to this currency crisis (liquidity) problem, Stiglitz suggests creating ‘global greenbacks’ (known as special drawing rights – SDR) to be issued as handouts (grants in Stiglitz’s terminology) to developing countries and other countries in times of international financial difficulties. These SDRs can be converted into hard currencies to service debts, buy imports, or supplement foreign reserves. Unfortunately, such handouts are merely palliatives and not the solution to the problem. Moreover, some countries will become SDR addicts, and when the handouts end, the economic withdrawal symptoms will be even more deadly. The cure lies in creating a new international financial architecture, as President Clinton called for after the 1998 Russian debt default. Unfortunately Clinton’s clarion call went against the ‘Washington Consensus’ and therefore was never seriously studied by Washington’s international economic


decision-makers. Stiglitz’s ‘global greenbacks’ solution fails to provide a new architecture because he ignored some basic guidelines that Keynes indicated were essential to avoid international financial problems and global recessionary forces in the post-World War II era.

Keynes and the international financial system Keynes argued that the ‘main cause of failure’ of any traditional international financial system, whether it was based on fixed or flexible exchange rates, was the inability of the payments system actively to foster continuous global expansion when persistent payment imbalances occurred. Keynes wrote that this failure: can be traced to a single characteristic. I call close attention to this, because I shall argue that this provides a clue to the nature of any alternative which is to be successful. It is characteristic of a freely convertible international standard that throws the main burden of adjustment on the country which is in the debtor position on the international balance of payments – that is on the country which is (in this context) by hypothesis the weaker and above all the smaller in comparison with the other side of the scales which (for this purpose) is the rest of the world. (Keynes, 1980, p. 27) Keynes concluded that an essential design improvement in any international financial system requires transferring a major responsibility for payments adjustment from the debtor to the creditor position. Keynes (1980, pp. 168–9) also indicated: ‘We need a quantum of international currency … [which] is governed by the actual current [liquidity] requirements of world commerce, and is capable of deliberate expansion … We need a method by which the surplus credit balances arising from international trade, which the recipient does not wish to employ can be set to work … without detriment to the liquidity of these balances.’ Accordingly, in Financial Markets, Money and the Real World (Davidson, 2002), I have embedded Keynes’s essential suggestions in a proposal to create an international clearing union that is designed: (1) To prevent a lack of global effective demand due to any nation(s) oversaving by either holding excessive idle foreign reserves or draining reserves from the system. (2) To provide an automatic mechanism for placing a major burden of payments adjustments on the surplus nations – since after all, the surplus


nation is in the better economic position to solve any persistent payments imbalance. (3) To prevent financial crises while providing each nation with the ability to monitor and, if desired, to control movements of flight capital, or movements of funds earned from illegal operations (for example, drug money) or movements to avoid national taxes or to finance terrorist operations. (4) To expand the liquidity of the international financial system as global capacity warrants. (5) To encourage debtor nations to work their way out of debt rather than await handouts, or bailouts, or to default on their international obligations. There are eight basic elements in my clearing system proposal: 1. The unit of account and ultimate reserve asset for international liquidity is the International Money Clearing Unit (IMCU). All IMCU’s are held only by Central Banks, not by the public, in accounts on the books of the clearing union institution. 2. Each nation’s Central Bank is committed to guarantee one-way convertibility from IMCU deposits at the clearing union to its domestic money. Each Central Bank will set its own rules regarding making available foreign monies (through IMCU clearing transactions) to its own bankers and private sector residents.10 Small-scale smuggling of currency across borders and so on can never be completely eliminated. But such movements are merely a flea on a dog’s back – a minor, but not debilitating, irritation. If, however, most of the residents of a nation hold and use a foreign currency for domestic transactions and as a store of value (for example, it is estimated that Argentineans held over $5 billion in US currency at the turn of the century), this is evidence of a lack of confidence in the government and its monetary authority. Unless confidence is restored, all attempts to restore economic prosperity will fail. Since Central Banks agree to sell their own liabilities (one-way convertibility) against the IMCU only to other central bankers and the International Clearing Agency while they simultaneously hold only IMCUs as liquid reserve assets for international financial transactions, there can be no draining of reserves from the system. Ultimately, all major private international transactions clear between Central Banks’ accounts in the books of the international clearing institution. Proviso 2 permits a nation to institute international financial flow regulations or controls. The primary function of capital flow regulations is to prevent sharp changes in the bull–bear sentiment from overwhelming the market by preventing rapid changes in exchange rate price trends; such volatility can have devastating real consequences.


There is a spectrum of different capital controls available. At one end of the spectrum are controls that primarily impose administrative constraints either on a case-by-case or expenditure category basis. These controls include administrative oversight and control of individual transactions for payments to foreign residents (or banks) often via oversight of international transactions by banks or their customers. Mayer (1998, pp. 29–30) has argued that the 1997 East Asian currency problem was largely due to the interbank market that created the whirlpool of speculation and that what is needed is ‘a system for identifying … and policing interbank lending’ and banks’ contingent liabilities resulting from dealing in derivatives. Echoing the Post Keynesian theme that the economic financial system is not ergodic, Mayer (1998, p. 31) declared ‘The mathematical models of price movements and covariance underlying the construction of these [contingent] liabilities simply collapsed as actual prices departed so far from “normal” probabilities.’ Other capital controls include (a) policies that make foreign exchange available but at different exchange rates for different types of transactions and (b) the imposition of taxes (or other opportunity costs) on specific international financial transactions, for example, the 1960s’ United States Interest Equalization Tax. Finally there can be many forms of monetary policy decisions undertaken to affect net international financial flows, for example, raising the interest rate to slow capital outflows, raising bank reserve ratios, limiting the ability of banks to finance purchases of foreign securities and regulating interbank activity as suggested by Mayer. The recent experience of the IMF, as lender of last resort in the East Asian currency crisis, imposing the same conditions on all nations requiring loans for international liquidity purposes should have taught us that in policy prescriptions one size does not fit all situations. Accordingly, the type of capital flow regulations a nation should chose from the spectrum of tools available at any time will differ depending on the specific circumstances involved. In this brief chapter it would be presumptuous of me to catalogue what capital regulations should be imposed for any nation under any given circumstances. Nevertheless, it should be stressed that regulating capital movements is a necessary but not a sufficient condition for promoting global prosperity. 3. The exchange rate between the domestic currency and the IMCU is set initially by each nation – just as it would be if one instituted an international gold standard. Since enterprises that are already engaged in trade have international contractual commitments that would span the change-over interval, then, as a practical matter, one would expect that the existing exchange rate structure (with perhaps minor modifications) would provide the basis for initial rate setting. Provisos 7 and 8 below indicate when and how this nominal exchange rate between the national currency and the IMCU would be changed in the future.


4. Contracts between private individuals will continue to be denominated in whatever domestic currency is permitted by local laws and agreed upon by the contracting parties. Contracts to be settled in terms of a foreign currency will therefore require some announced commitment from the Central Bank (through private sector bankers) of the availability of foreign funds to meet such private contractual obligations. 5. An overdraft system will be established to make available short-term unused creditor balances at the clearing house to finance the productive international transactions of others who need short-term credit. The terms will be determined by the pro bono publico clearing managers. 6. A trigger mechanism to encourage any creditor nation to spend what is deemed (in advance) by agreement of the international community to be ‘excessive’ credit balances accumulated by running current account surpluses. These excessive credits can be spent in three ways: (i) on the products of any other member of the clearing union, (ii) on new direct foreign investment projects, and/or (iii) to provide unilateral transfers (foreign aid) to deficit members. Spending by way of (i) forces the surplus nation to make the adjustment directly through the balance on goods and services. Spending by way of (iii) permits adjustment directly by the current account balance; while (ii) provides adjustment by the capital accounts (without setting up a contractual debt that will require reverse current account flows in the future). Consequently, proviso 6 provides the surplus country with considerable discretion in deciding how to accept the ‘onus’ of adjustment in the way it believes is in its residents’ best interests. It does not, however, permit the surplus nation to shift the burden to the deficit nation(s) through contractual requirements for debt service charges independent of what the deficit nation can afford.11 Moreover, as the current international debt problems of African and Latin American nations clearly demonstrate, creditors ultimately have to forgive some debt when they previously encouraged excessive debt burdens. Under the current system, however, debt forgiveness is a last resort solution acceptable only after both debtor and creditor nations suffer from faltering economic growth. Surely a more intelligent option is to develop an institutional arrangement which prevents excessive debt servicing burdens from ever occurring. The important thing is to make sure that continual oversaving12 by surplus nations cannot unleash depressionary forces and/or a building up of international debts so burdensome as to impoverish the global economy of the twenty-first century. In the unlikely event that the surplus nation does not spend or give away these credits within a specified time, then the clearing agency would confiscate (and redistribute to debtor members) the portion of credits deemed excess.13 This last resort confiscatory action by the managers of the clearing


agency would make a payments adjustment via unilateral transfer payments in the current accounts. Under either a fixed or a flexible rate system, nations may experience persistent trade deficits merely because their trading partners are not living up to their means – that is because other nations are continually hoarding a portion of their foreign export earnings (plus net unilateral transfers). By so doing, these oversavers are creating a lack of global effective demand. Under proviso 6, deficit countries would no longer have to deflate their real economy merely to adjust their payment imbalance because others are oversaving. Instead, the system would seek to remedy the payment deficit by increasing opportunities for deficit nations to sell abroad. Proviso 6 embodies Keynes’s innovative idea that whenever there is a persistent (and/or large) imbalance in current account flows – whether due to capital flight or a persistent trade imbalance – there must be a built-in mechanism that induces the surplus nation(s) to bear a major responsibility for eliminating the imbalance. The surplus nation must accept this burden for it has the wherewithal to resolve the problem. In the absence of proviso 6, under any conventional system, whether it has fixed or flexible exchange rates and/or capital controls, there can occur an international liquidity crisis (as any persistent current account deficit can deplete a nation’s foreign reserves) that unleashes global depressionary forces. Thus, proviso 6 is necessary to assure that the international payments system will not have a built-in depressionary bias. Ultimately then it is in the self-interest of the surplus nation to accept this responsibility, for its actions will create conditions for global economic expansion some of which must redound to its own residents. Failure of the surplus nation to act, on the other hand, promotes global depressionary forces which will have some negative impact on its own residents.14 7. A system to stabilize the long-term purchasing power of the IMCU (in terms of each member nation’s domestically produced market basket of goods) can be developed. This requires a system of fixed exchange rates between the local currency and the IMCU that changes only to reflect permanent increases in efficiency wages.15 This assures each Central Bank that its holdings of IMCUs as the nation’s foreign reserves will never lose purchasing power in terms of foreign produced goods, even if a foreign government permits wage-price inflation to occur within its borders. Consequently, the rate between the local currency and the IMCU would change with inflation in the local money price of the domestic commodity basket. If, however, increases in productivity lead to declining nominal production costs, then the nation with this decline in efficiency wages (say of 5 per cent) would have the option of choosing either (a) to permit the IMCU to buy (up to 5 per cent) fewer units of domestic currency, thereby capturing all (or most of) the gains from productivity for its residents while maintaining


the purchasing power of the IMCU, or (b) to keep the nominal exchange rate constant. In the latter case, the gain in productivity is shared with all trading partners. In exchange, the export industries in this productive nation will receive an increasing relative share of the world market. By altering the exchange rate between local monies and the IMCU to offset the rate of domestic inflation, the IMCU’s purchasing power is stabilized. By restricting use of IMCUs to Central Banks, private speculation regarding IMCUs as a hedge against inflation is avoided. Each nation’s rate of inflation of the goods and services it produces is determined solely by (a), the local government’s policy towards the level of domestic money wages and profit margins vis-à-vis productivity gains, that is, the nation’s efficiency wage. Each nation is therefore free to experiment with policies for stabilizing its efficiency wage to prevent inflation (or deflation). Whether the nation is successful or not, the IMCU will never lose its international purchasing power. Moreover, the IMCU has the promise of gaining in purchasing power over time if productivity grows more rapidly than money wages and each nation is willing to share any reduction in real production costs with its trading partners. Proviso 7 produces a system designed to maintain the relative efficiency of wage parities among nations. In such a system, the adjustability of nominal exchange rates will be primarily (but not always, see proviso 8) to offset changes in efficiency wages among trading partners. A beneficial effect that follows from this proviso is that it eliminates the possibility that a specific industry in any nation can be put at a competitive disadvantage (or secure a competitive advantage) against foreign producers solely because the nominal exchange rate changed independently of changes in efficiency wages and the real costs of production in each nation. Consequently, nominal exchange rate variability can no longer create the problem of a loss of competitiveness due solely to the overvaluing of a currency as, for example, experienced by the industries in the American ‘rust belt’ during the period 1982–85. Although temporary, currency appreciation can have significant permanent real costs, for example, industries may abandon markets and the resulting idle existing plant and equipment may be cast aside as too costly to maintain. Proviso 7 also prevents any nation from engaging in a beggar-thy-neighbour, export-thy-unemployment policy by pursuing a real exchange rate devaluation that does not reflect changes in efficiency wages. Once the initial exchange rates are chosen and relative efficiency wages are locked in, reductions in real production costs that are associated with a relative decline in efficiency wages are the main factors (with the exception of proviso 8) justifying an adjustment in the real exchange rate. Under proviso 7 of our proposal the IMCU would provide its holders with an invariant international monetary standard no matter whether the domestic rates of inflation in the various nations converged (or not) or accelerated (or not).


Although proviso 6 prevents any country from piling up persistent excessive surpluses this does not mean that it is impossible for one or more nations to run persistent deficits. Consequently proposal 8 below provides a programme for addressing the problem of persistent export–import deficits in any one nation. 8. If a country is at full employment and still has a tendency towards persistent international deficits on its current account, then this is prima facie evidence that it does not possess the productive capacity to maintain its current standard of living. If the deficit nation is a poor one, then surely there is a case for the richer nations who are in surplus to transfer some of their excess credit balances to support the poor nation.16 If it is a relatively rich country, then the deficit nation must alter its standard of living by reducing its relative terms of trade with its major trading partners. Rules, agreed upon in advance, would require the trade deficit rich nation to devalue its exchange rate by stipulated increments per period until evidence becomes available to indicate that the export–import imbalance is eliminated without unleashing significant recessionary forces.17 If, on the other hand, the payment deficit persists despite a continuous positive balance of trade in goods and services, then there is evidence that the deficit nation might be carrying too heavy an international debt service obligation. The pro bono officials of the clearing union should bring the debtor and creditors into negotiations to reduce annual debt service payments by (i) lengthening the payments period, (ii) reducing the interest charges, and/or (iii) debt forgiveness.18 If any government objects to the idea that the IMCU provisions provide governments with the ability to limit the free movement of ‘capital’ funds, then this nation is free to join other nations of similar attitude in forming a regional currency union and thereby assuring a free flow of funds among the residents of the currency union. Some think that this clearing union plan, like Keynes’s bancor plan, a half century earlier, is utopian. But if we start with the defeatist attitude that it is too difficult to change the awkward system in which we are trapped, then no progress will be made. Global depression does not have to happen again if our policymakers have sufficient vision to develop this Post Keynesian approach. The health of the world’s economic system will simply not permit us to muddle through.

Notes 1. Williamson (2000) claimed that the term ‘Washington Consensus’ has developed into something different from that which he intended. The Washington Consensus concept had become what is often called ‘neo-liberalism’ or ‘market fundamentalism’. Williamson indicated that Bresser Perreira patiently explained to


2.

3. 4.

5. 6.

7. 8. 9.

10.

11.

him that just because he invented the term he did not have intellectual property rights to control its meaning. (One could suggest to Williamson that just because Keynes invented the General Theory did not limit the perverse meaning that neoclassical synthesis Keynesians and New Keynesians gave to the meaning of Keynesian macroeconomics.) Williamson (2000) indicated that he ‘long ago changed my description of the fourth element of the Washington Consensus to “financial liberalization” ’. Although the term ‘financial liberalization’ means that all regulations controlling domestic as well as international capital flows should be abolished, Williamson now argues that the liberalization of international financial capital flows might have to be phased in, perhaps over decades. For example even when the Clinton administration went from fiscal deficits to fiscal surpluses. Successful in the sense that during this period the average annual real growth per capita was almost double the peak growth rate of developed nations during the period of the industrial revolution, while the average real growth rate of developing nations equalled or exceeded the industrial relolution growth rate (see Davidson, 2002, p. 2). For the figures see Davidson (2002, pp. 1–2). For an explanation see Davidson (2002, pp. 225–8). The internal balance implied an unspecified low rate of inflation that would be associated with NAIRU, while the external balance was defined as maintaining a current account balance that is ‘sustainable and appropriate’ in the medium term. The ergodic axiom is one of the restrictive classical axioms that Keynes overthrew in developing his general theory (see Davidson, 2002). Or at least the natural rate of unemployment. New Keynesians, on the other hand, often suggest that existing market fixities slow down the market’s ability to establish FEER immediately and therefore they argue for a gradual liberalization of markets, so that, in the long run at least, FEER will be established. Correspondent banking will have to operate through the International Clearing Agency, with each Central Bank regulating the international relations and operations of its domestic banking firms. Some may fear that if a surplus nation is close to the trigger point it could shortcircuit the system by making loans to reduce its credit balance prior to setting off the trigger. Since preventing unreasonable debt service obligations is an important objective of this proposal, a mechanism which monitors and can restrict such pre-trigger lending activities may be required. One possible way of eliminating this trigger avoidance lending loophole is as follows. An initial agreement as to what constitutes sensible and flexible criteria for judging when debt servicing burdens become unreasonable is established. Given these criteria, the clearing union managers would have the responsibility for preventing additional loans which push debt burdens beyond reasonable servicing levels. In other words, loans that push debt burdens too far could not be cleared though the clearing union, that is, the managers would refuse to release the IMCU’s for loan purposes from the surplus country’s account. (I am indebted to Robert Blecker for suggesting this point.) The managers would also be required to make periodic public reports on the level of credits being accumulated by surplus nations and to indicate how close these surpluses are to the trigger point. Such reports would provide an informational


12.

13.

14.

15.

16. 17.

18.

edge for debtor nations, permitting them to bargain more effectively regarding the terms of refinancing existing loans and/or new loans. All loans would still have to meet the clearing union’s guidelines for reasonableness. I do not discount the difficulties involved in setting up and getting agreement on criteria for establishing unreasonable debt service burdens. (For some suggestions, however, see the second paragraph of proviso 8.) In the absence of cooperation and a spirit of goodwill that is necessary for the clearing union to provide a mechanism assuring the economic prosperity of all members, however, no progress can ever be made. Oversaving is defined as a nation persistently spending less on imports plus direct equity foreign investment than the nation’s export earnings plus net unilateral transfers. Whatever ‘excessive’ credit balances that are redistributed shall be apportioned among the debtor nations (perhaps based on a formula which is inversely related to each debtor’s per capita income and directly related to the size of its international debt) to be used to reduce debit balances at the clearing union. As I point out (Davidson, 2002, pp. 225–8), the prosperity of the global capitalist economy in the first 25 years after World War II was in large part due to the fact that the Marshall Plan and other US foreign aid policies played the role that proviso 6 sees for the surplus nation. The efficiency wage is related to the money wage divided by the average product of labour, it is the unit labour cost modified by the profit mark-up in domestic money terms of domestically produced GNP. At this preliminary stage of this proposal, it would serve no useful purpose to decide whether the domestic market basket should include both tradable and non-tradable goods and services. (With the growth of tourism more and more non-tradable goods become potentially tradable.) I personally prefer the wider concept of the domestic market basket, but it is not obvious that any essential principle is lost if a tradable-only concept is used, or if some nations use the wider concept while others the narrower one. This is equivalent to a negative income tax for poor fully employed families within a nation. Although relative prices of imports and exports would be altered by the change in the terms of trade, the adjustment is due to the resulting income effect, not a substitution effect. The deficit nation’s real income will fall until its import surplus disappears. The actual programme adopted for debt service reduction will depend on many parameters including the relative income and wealth of the debtor vis-à-vis the creditor, the ability of the debtor to increase its per capita real income and so on.

References P. Davidson, Financial Markets, Money and the Real World (Cheltenham: Edward Elgar, 2002). J.R. Hicks, Economic Perspectives (Oxford: Oxford University Press, 1977). J.M. Keynes, The Collected Writings of John Maynard Keynes, vol. 7, edited by D. Moggridge (London: Macmillan, 1973). J.M. Keynes, The Collected Writings of John Maynard Keynes, vol. 25, edited by D. Moggridge (London: Macmillan, 1980). M. Mayer, ‘The Asian Disease: Plausible Diagnoses, Possible Remedies’, Levy Institute Public Policy Brief, no. 44 (1998).

The Future of the International Financial System 179 J.E. Stiglitz, ‘How to Reform the Global Financial System’, Harvard Relations Council International Review, 25 (2003), 54–9. J. Williamson, ‘What the Bank Should Think about the Washington Consensus’, paper prepared as background to the World Bank’s World Development Report (2000). J. Williamson, Remarks to the Center for Strategic and International Studies, 2002. World Development, 28 (June 2000), Special Section ‘Redrafting the Architecture of the Global Financial System’.

13

John Kenneth Galbraith and the Anatomy of Russian Capitalism Stanislav Menshikov

Introduction In our book Capitalism, Communism and Coexistence (first printed in the US in 1987 and subsequently translated into Russian, French and other languages), Galbraith and I assumed that the centrally-planned economy of Russia would slowly transform into a mixed system combining competitive market mechanisms with active state intervention and a well-developed social security infrastructure. Basically, we were following the concept of socio-economic convergence between capitalism and communism, a concept that was first suggested by Jan Tinbergen and John Kenneth Galbraith and that was popular in the West in the 1970s and 1980s. My own view at that time was that the Soviet system would slowly introduce many essential features of the market economy while retaining certain features of central planning, particularly in as much as it concerned longterm capital investment and the determination of basic macroeconomic proportions. I still believe today that such a course was best for my country because in the long run it permitted the optimal combination of the best and most efficient features of both capitalism and socialism and, in the short and medium term, would have helped avoid the deformation and destruction inherent in the shock transformation into capitalism. However, the political forces that came to power after the forced resignation of Mikhail Gorbachev and the dissolution of the Soviet Union, pursued a different strategy which led to the prolonged deep economic crisis of 1992–1998 which reduced Russia’s GDP by more than 40 per cent. Even today, after four years of economic recovery, the pre-reform level of GDP has not been restored. More importantly, the Russian economy, as it emerged in the last decade or so, can be likened to an inertial system that is moving along a trajectory that in the long run is self-destructive but extremely difficult to change. 180

J.K. Galbraith and the Anatomy of Russian Capitalism 181

Russia’s inertial economic system and its prospects The principal institutional features of this system are as follows: ● ●

●

●

●

The prevalence of oligopoly and monopoly over competition. The dominance of oligarchic financial–industrial groups together with a relatively weakly developed banking industry. The close fusion of the business oligarchy with the state while the role of the latter in guiding the economy remains very weak. An excessively high share of gross profit in GDP and inappropriately high inequality in the distribution of income and wealth. An excessively large share in GDP of the shadow sector, corruption and organized crime.

These features of the system have given rise to certain negative regularities in the behaviour of economic agents, as well as in macroeconomic dynamics. For instance, the prevalence of oligopoly and monopoly has created a typical orientation of businesses to maximize profits less by increasing output and sales than by maintaining inordinately high profit margins, that is, markups of price over cost. Average profit margins in manufacturing industry of even 20 per cent are considered too low to warrant large long-term investment, while the principal capital-generating sectors of the economy (all of them export-oriented industries, such as oil and non-ferrous metals) are operating at profit margins as high as 40–50 per cent. Such a behavioural mode had already emerged in the early 1990s when output was either falling or stagnating while high inflation was rampant. In such an environment, increasing production was senseless and the only rational tactic was short-term profit maximization by raising prices. In the practice of those years, cases when companies tried to beat competitors by underselling were extremely rare if not totally unknown. On the contrary, every possibility and pretext was used to raise prices even when it was perfectly feasible to increase output by squeezing competitors off the market. This was the rule for big and even middle-sized concerns, which dominated both national and regional markets and used non-economic means, often sheer force, to eliminate rivals. That was one reason, besides corruption and the spread of organized crime, why small business never grew in importance in the Russian economy. After the financial crisis of 1998, the overall competitive power of domestic producers in internal markets improved due to the drastic devaluation of the ruble, and it became possible to reduce competition of imported goods. This, for the first time since privatization, allowed profit maximization by increasing output, not simply by marking up prices. But even in these more favourable circumstances firms took care to raise output in such a way as to avoid reducing profit margins. Naturally, this helped prolong inordinately


high inflation and led to a fairly fast loss of competitive advantages created by devaluation. In foreign economies, the prevalence of oligopoly and non-price competition often strongly stimulates qualitative changes in the utility of goods and induces the quest for new products thus creating market niches that bring at least temporary rents or super-profits. In Russia, however, this mode of behaviour has not become typical. The old rule under which oligopoly and monopoly put a brake on technical progress and product differentiation still prevails. It does not mean that Russian companies wholly refute exploiting new niches in principle. No, they do so willingly but only, as a rule, when new products have already been created abroad and all that remains is to adapt them to the Russian market. Typical instances are the quick spread of cellphones and internet networks. But there are practically no examples of new products of domestic origin, save in the defence area. Even large and potentially strong companies in the automobile and civil aircraft industries where regular model changes are a must, have not been able to achieve competitive advantage and expand output of new products to satisfy available demand. One of the reasons is the strong reluctance to invest capital on a long-term basis into modernizing production equipment and building new plant. In fact, as Western experience shows, regular changes in technologies and products necessitate continuous large expenditures repayable only on a medium and long-term basis. Most Russian companies, even large ones in possession of necessary capital resources, do not have a long-term strategy of that sort. In more than a decade of its existence, Russian capitalism had not built a single brand-new large plant (that was not started in Soviet times) and has satisfied its production needs mainly by exploiting existing under-utilized capacities or formerly discovered and developed mineral resources. Even in such a highly profitable sector as oil and gas, new capital construction has been practically limited to export-oriented pipelines built and financed by the state. Only in recent months, have private oil companies expressed their intention to participate in the construction of new pipelines of export orientation (from Siberia to Murmansk for export to the US and to Da-tsin in China and the Far Eastern port of Nakhodka for export to Japan). The only large new hydroelectric Burei dam, started in Soviet times, was put into operation last year with great fanfare by the state-owned electric power monopoly with President Putin in person on hand to mark the event. Similar results in terms of stagnant technical progress and skewed capital investment are brought by the dominance of oligarchic industrial and financial groups. As a rule, these groups were created by capitalists who earned their first tens of millions in murky financial and other speculative operations. Their principal interest was not in developing and modernizing production but in capturing the most profitable former government-owned assets and using them for personal enrichment. In most cases, these were oil and metals


concerns of primary export orientation, which after being captured by a few financial groups were reorganized as oligopolies. Today five leading concerns – YUKOS, Sibneft, LUKOIL, BP-TNK and Surgutneftegaz – control 80 per cent of the Russian oil industry; two concerns – Rusal and SUAL – control 95 per cent of the aluminium industry; only one concern – Norilsk Nickel – controls practically all the production of nickel and palladium. In most groups, banks were the initial main source of primary capital accumulation that was used to buy at bargain basement prices the profitable mineral resource companies. After these new super-profit bases were taken over, they – instead of the banks – became the group centres. As to the banks, most of them, particularly after the 1998 financial crisis, were bankrupt and lost their importance as the principle source of profits. They now became auxiliary links, servicing and coordinating the cash flows of companies composing the groups. This precluded the normal development of the banking sector as a public utility industry serving the economy at large rather than limited groups of insider clients. The following is a typical description of the operations of the MDM Bank, which is part of an oligarchic group, and closely related companies: ‘Normal banking business has been absent in the bank during recent years. Loans were issued mainly to group insiders while the bank itself played the role of the exchequer for companies belonging to the group, helping optimize their cash flows for tax purposes. Well, if there is a Russian bank that did not engage in such activities, let it first throw a stone at MDM’ (www.gazeta.ru, 15 March 2003). At a certain stage, such a narrow bank specialization might satisfy the short-term interests of the principal shareholders of the groups’ companies. However, it is already coming into conflict with their longer-range interests, for instance in maximizing market capitalization with a view to selling out to foreign investors. The latter would not be greatly interested in buying closed institutions with a limited number of active clients and a narrow deposit base. That is why some groups have been acting to increase their banks’ retail business and local branch networks, opening up financial accounts to the public and separating normal commercial banking business from offshore and other money laundering operations. These developments are essential for attempts to list shares of Russian banks on international stock exchanges and thus lay the basis for boosting their market capitalization. It is clear that normalization of the Russian banking industry could well proceed without necessarily integrating it into foreign banking empires. The groups’ leaders should be vitally interested in expanding their credit activities to a much wider range of companies beyond their own insider groups. They should be particularly interested in promoting loans to small and medium-sized businesses, increasing consumer credit and mortgage loans. But these areas are slow to develop. Short-term profit maximization still largely determines narrow group servicing as the top priority.


This phenomenon is not confined to the largest centrally located banks. Regional and local banks have been following the same model by orienting their operations to the immediate needs of their principal stockholders and their companies. Thus, smaller oligarchic financial and industrial groups have become widespread at the regional and local level. Having one’s own bank is extremely advantageous for local tycoons who may have difficulty in finding access to funding from the larger banks in Moscow or St Petersburg. Living is easy under one’s own roof. Economic development is also impeded by the close fusion of the business oligarchy with government structures at all levels – central, sectoral, regional and local – while government stimulation of macroeconomic activity remains extremely weak. Contemporary market economies know two different models of interrelationship between business and the state. In one model, the government acts in the interests of the business class as a whole. By keeping equal distance from all principal business groupings the state can act in the interests of the entire system and help maintain its stability. If the system deviates from equilibrium and enters a recessionary phase the state will help correct emerging imbalances even if its corrective activities conflict with the interests of some groups of the business elite, and induce the economy to return to equilibrium. In the second model, the state is largely dependent on one or a few influential oligarchic groups. Since overall stability often conflicts with the interests of these groups the role of the state as the means to correct imbalances and disproportions is necessarily weakened. Governments in this case tend to lag behind private interests rather than lead them. This can negatively affect general economic conditions and preclude economic development at full capacity and top feasible speed. In reality, none of the two models usually exists in its pure form. In current market economies, both models are usually intertwined. But, as a rule, it is easy to see which one of them prevails. In Russia, their interrelationship is not straightforward. Some spheres are so strongly dominated by oligarchic groups that central and regional authorities are unable to influence their activities. Under Boris Yeltsin, not only his socalled ‘family’, that is, a closely related group of businessmen and government officials, was for all practical purposes subservient to a few oligarchs, but most of the government bureaucracy was subordinated to various business groups and acted in their interests. At times, the state resembled a manager for clans of businessmen and corrupted officials, interlocked with organized crime. Vladimir Putin proclaimed equal distance of the state from the oligarchs and declared his intention to act as arbiter vis-à-vis the business elite. It looked like the former direct fusion of the central authorities with concrete oligarchic groups was coming to an end. However, the Yeltsin era institution of meeting in the Kremlin with selected business leaders became even more


regular, as well as attempts to coordinate policy with the principal organizations of big business. On the other hand, there are clear signs of proximity of the president to certain new business groups that played second fiddle under Yeltsin but would like to use their newly acquired influence in order to capture profitable and not yet privatized chunks of government assets. These battles proceed with mixed results. The Mezhprombank group (allegedly close to Putin) was unable to gain control over the Slavneft oil concern, which (with the support of former prime minister Mikhail Kasyanov) was won instead by the Alfa group led by Mickhail Fridman and Viktor Vekselberg. But Alexey Miller, whom Putin appointed to run Gazprom instead of former boss and tycoon Rem Viakhirev, managed together with other men from St Petersburg to consolidate control over the gas monopoly. The same group decisively squeezed rivals out of another area – control over armaments exports. It also looks as though the electric power industry might eventually be taken over by people close to Putin. And the outcome of the Kremlin’s attack against Khodorkovsky’s YUKOS is at this point predicted to lead to the merger of that company or a large part of it into a large new oligarchic group of banks and companies controlled by Putin and his loyalists. It turns out that the government-arbiter model is closely intertwined with rivalry inside the government for redivision of property and high profit niches. But it is evident that Putin is not out to destroy the dominance of oligarchic groups. Rather, he is integrating his own sphere of business interests into the prevailing oligarchic structure. This approach is also consistent with the neo-liberal model of economic policy according to which the state should care firstly for creating a generally favourable atmosphere for economic development by conducting reforms in the interests of business, but should minimize its active intervention in the economy. This model serves as the basis of the economic policy of Putin’s government and in principle precludes any active role of the state in correcting existing imbalances and restoring macroeconomic equilibrium. One has to bear in mind that the neo-liberal model is more or less successful in economies that grow evenly, without large fluctuations and do not suffer from large structural imbalances. In such economies, the role of government intervention can indeed be minor because the market mechanism tends to spontaneously correct small temporary imbalances and fluctuations. However, the same model when applied to the Russian economy of today is not practical and is even harmful. One of the two largest structural imbalances in the Russian economy is its undue dependence on exports of energy and raw materials while other sectors, including manufacturing, are relatively undeveloped and stagnant. The basic reason for this imbalance is the skewed distribution of gross profit in the economy, which tends to be continuously reproduced and has no spontaneous mechanism for self-correction. In normally functioning competitive markets, prolonged large deviations of sectoral profit rates from


the macroeconomic average are not possible. If profitability in one sector substantially exceeds the average, capital tends to flow into that sector until profitability there is equalized. This mechanism does not work if inter-sector flow of capital is inhibited by economic, natural or other barriers. In the case of oil and non-ferrous metals in Russia, these barriers do exist. Oil deposits are captured by a narrow group of companies that use natural and geographical factors to close entrance to new competitors. Equally important is the reverse effect. Since the gap in profitability remains, excess capital created in the energy and raw materials sector fails to find its way into other sectors where profitability is much lower. A vicious circle is created, a trap that normal forces of competition cannot overpower. In the competitive model, super-profits gained due to natural rent from mineral resource exploitation are partly or wholly appropriated by the owner of the land. In Russia, as in many other countries, private property of land is recognized but the state still retains ownership rights to land that lies above the deposits of oil, gas, metal ores and so on. Exploitation of mineral resources by private companies is subject to licences granted by the state. The latter therefore has the title to all or most of the mineral rent – above normal profits earned by private leaseholders. In the early 1990s, licences for these purposes were granted at bargain basement prices, that is, practically for free. But this is not necessarily a final decision. If the government decides to extract a much larger share of the rent than it collects today, it has all the rights to do so. The exact share to be taxed is a matter of economic expediency, that is, determined by the need to equalize sector rates of profit as far as possible and practical. Even the neo-liberal minded current government seems to agree that movement in that direction is essential. The major impediment is not so much technical issues of rent taxation, but rather the active opposition of oligarchic groups that have considered themselves the owners of the nation’s mineral resources and do not wish to share their excessive incomes with other sectors of the economy. The government attack on YUKOS involves partial redistribution of oil rent to the state budget, but it solves the problem as an individual company case, not as an industry rule. Other oil companies continue to appropriate their excessive rent from oil, at least for now. The refusal or delay in resolving this issue serves to impede Russia’s economic development. GDP growth rates depend on growth of its sector components. If half or more of capital investment continues to go into energy and raw materials, then the overall growth rate of GDP will be determined by growth in that sector. But because it is export-oriented its growth rate will be tied to growth in foreign demand, that is, to average growth rates of the world economy. In this case, one can well forget the need to expand at much higher rates as demanded by President Putin. Faster rates of GDP growth are only possible under quick expansion of manufacturing, which is oriented towards domestic markets and is not


restricted by the average growth rates of the world economy. And the only means to accelerate growth in manufacturing is to re-channel excess capital created in the ‘rent’ sector into other branches of the economy. Accomplishing such redistribution without active government intervention is impossible. But the state can only perform this manoeuvre if it gets rid in deed, not only in words, of its dependence on the oligarchic groups that have saddled the ‘rent’ sector. But even apart from resolving this crucial issue, the role played by economic policy in Russia is extremely weak. The government refuses to use practically any active forms of fiscal policy. For instance, such well known ways to stimulate growth as government purchases of goods that are temporarily in poor demand or government-financed investment into infrastructure are completely ignored by the authorities. Even in tax policies – the only fiscal sphere where evidence of government intervention is seen – the state acts very indecisively and considers short-term fiscal objectives to take precedence over long-term needs to stimulate economic growth. Almost entirely absent is any trace of active monetary policy. The principle government economic activity is to promote so-called structural reforms that are centred on privatizing those parts of the economy that are still run by the state. In the process, control by oligarchic groups is strengthened even more while the stimulatory role of the state is further diminished. At the same time, the role of government in reforming such crucial spheres as the banking industry and capital markets is close to zero. Neither has the Russian government used the powerful weapon of industrial policy to help develop competitive domestic manufacturing and high-tech industries. The industrial structure remains stagnant despite quantitative growth and there is no interest shown either by business or the government in promoting the ‘new economy’, that is, computers and informatics. In terms of technical progress the country is completely stagnant. A major result of oligopoly and oligarch dominance in the economy is the permanently excessive share of gross profit in GDP and consequently the continuously low share of wages and salaries (labour income). Apart from the major sector imbalance cited above this is one of the principal reasons for the narrowness of the domestic market and the impossibility to fully utilize all capital generated inside the country. Even if the sectoral imbalance were to be corrected, the remaining disproportion between gross profit and labour income would preclude accelerated economic growth. With gross profit exceeding 40 per cent of GDP the share of labour income (after deducting net indirect taxes) stands at only 43 per cent. This explains why personal consumption expenditure is less than half of GDP. Together with the average share of gross capital investment at 16 per cent this is only 66 per cent of GDP. In other words, total output can be fully sold if government purchases and net exports amount to 34 per cent of the total. Because government purchases on the average take out another 16 per cent, a full


18 per cent has to go to net exports. This is only possible if an exorbitant part of fuel and raw materials is sold abroad at high prices. It is unrealistic to believe that this condition will remain for long. A better decision is to slowly but surely increase the share of labour income and consequently of consumer expenditure in GDP. This should help expand domestic markets for products of Russian manufacturing. The low share of labour income in GDP is another way of saying that distribution of income in Russia is extremely unequal and that inequality has sharply increased in the last decade. The gap between the top and lowest income quintiles of the population reached 6.4 times by 2000, as compared with only 2.6 in 1991. In the same period the Gini coefficient increased from 0.26 to 0.39. Regional and sector differences in average personal income are extremely large, making Moscow look like a relatively booming oasis surrounded by a provincial Sahara of widespread poverty, most of it permanent and self-reproducing. A quarter of the population is living below the official poverty line and another 45 per cent can be considered as on the brink of poverty. According to the latest surveys by retailer research organizations 60–75 per cent of the population spend practically all their disposable incomes on food. Only 15–20 per cent at the most match the definition of a middle class, reducing effective consumer purchasing power to a very small minority. To put the issue into an international perspective, Table 13.1 compares Russian figures on GDP composition with relevant US data for the decade of 1989–99. In the US, with more normal shares of gross profit and labour income, the total share of personal consumption and gross capital investment is as high as 82 per cent. Since government purchases account for 18–19 per cent on the average, practically the whole national output is sold inside the country while a relatively small export share is fully compensated by adequate imports. Table 13.1: Dynamic proportions of Russian and US economies (% shares in GDP)

Gross profit Labour income Personal consumption Gross capital investment Personal consumption and gross investment Government purchases Net exports

Russia (1998–2001)

US (1989–99)

40.7 42.9 49.7 15.7 65.4

34.9 57.2 66.8 14.9 81.7

16.5 18.1

18.9 ⫺0.6

Sources: Russian Statistical Yearbook (2002); Economic Report of the President of the US (2000).


Increasing the share of labour income and reducing the share of gross profit would allow the Russian economy to be relieved of its undue dependence on external markets and create a solid foundation for sustained economic growth oriented mainly towards the domestic market. There is no need to decrease the share of capital investment, which is large but structurally disoriented. A larger share of gross profit should be spent on modernizing and expanding productive fixed capital with the aim of reducing the capital–output ratio and increasing economic efficiency of investment. Making this turnaround within the bounds of neo-liberal economic policy is hardly possible, at least not in the short or mid-term perspective. It is therefore easy to project the direction of further economic development in Russia in the absence of necessary corrections. 1. The economy would continue at best to grow at moderate speed that would not permit a substantial reduction of the current gap between Russia and industrial nations of the West in per capita GDP and living standards. In the worst case, a drastic fall in oil and raw materials prices will put a brake on growth and make the income gap even larger, not smaller. 2. Technical progress will continue to stagnate, and most Russian industries will remain non-competitive in world markets. Russia will not be able to escape from its current position on the periphery of the world economy and will retain its extreme dependence on the industrial world for at least one or two decades. It is quite possible that control over key economic assets in the country will be captured by foreign transnational companies. 3. At average growth rates and the further decline in the share of the state in GDP, the sphere of redistribution of income will become even narrower and the conditions for financing education, medical care, science and art will become even worse. 4. At the same time and for the same reasons, it will become impossible to maintain Russia’s military potential at levels necessary to guarantee its national security. Russia’s role as a global power would further diminish due to its economic and military weakness. Such a perspective is not one to the liking of the Russian elite or the majority of its population. The question arises as to possible alternatives.

Possible alternatives and policy solutions To find alternatives to Russia’s economic inertia means determining ways to change the current mechanism described above. Maximalist ways have been suggested that amount to destroying the very foundations of monopoly and oligarchic control and making the state a truly independent and active agent helping form long-term economic processes


both in the various industrial sectors and the economy at large. These suggestions include renationalizing some key industries and operating a large government-owned sector within the framework of a mixed economy, which would largely retain the principal contours of private entrepreneurship and a market economy. It is the consensus of most Russian economists that retaining and expanding the market is necessary for maintaining equilibrium at the micro, meso and macro levels. But it is also admitted that while markets are necessary to maintain long-term proportions, they are not in a position to correct major structural imbalances when the latter tend to become too large and rigid. To make the necessary adjustments, the state should play a more active role. But a substantial number of economists would argue that large-scale renationalization at this point would be destabilizing from a political, social and economic perspective. A more realistic approach would be to try to tackle the same issue by avoiding a wholesale breakdown of oligopolies and oligarchic groups but by placing certain adequate limitations on their activities. This is possible if the state is transformed into a truly independent power that would be able and willing to induce oligarchs to adhere to certain clearly defined rules of economic behaviour and refrain from attempts to unduly impose their will on formulating policies. In practice, even this minimalist approach could lead to sharp confrontations with forces within the elite that are closely connected to the oligarchs and are defending their interests. It is no secret that most of the leading newspapers in the country belong to oligarchic groups and that at least some electronic mass media are under their strong financial influence. Some political parties fighting for seats in the parliament are known to be financed by big business. Its strong influence can be also seen at the level of important provincial governors and large city mayors. Fighting for meaningful antioligarchic reform in these conditions is extremely difficult. Yet, it is quite possible and indeed indispensable to educate the elite and the population in ways to see realistic alternatives to current economic policies and the dire need for them to be implemented in the national interest. One has to bear in mind that there is no unanimity on these issues at the top of the government. For instance, Vladimir Putin made quite a sensation three years ago in his State of the Nation address to parliament when he suggested redistributing mineral rent to other sectors of the economy. Following the president’s initiative, some taxes were indeed raised on oil companies but these changes were relatively minor and did not resolve the major imbalance issue. In the last two years, the government, while remaining under strong pressure from the oil lobby, has officially recognized the need to improve the oil and raw materials imbalance in the economy. A project was suggested to reduce taxes for manufacturing industries while retaining them at current levels for


the oil and raw materials industries. This shows some movement in the right direction but the rate of change is small, practically close to zero. Of late, the authorities have been raising the issue of reconsidering some of the results of privatization in the early 1990s. The issue become nonacademic when billionaire YUKOS shareholders Mikhail Khodorkovsky and Platon Lebedev were arrested in 2003 and brought to trial on charges of illegally appropriating government-owned assets and gross tax evasion. But, as mentioned above, the drive against YUKOS is still an exception and does not signify a drastic break with neo-liberal policies. One of the neo-liberal dogmas is that the state should not be involved in the economy. This may be true in countries where business is active in areas that are particularly crucial for maintaining a healthy economy. But in Russia this is not the case. For instance, the major structural imbalance between mineral resources and manufacturing would not have occurred had the government retained ownership of the largest oil companies instead of selling them practically for nothing. Had that happened, the issue of taxing mineral rent would not have emerged as a major structural problem. It is not true that privately-run oil companies show a better performance than government-owned concerns. A careful comparison of financial reports of privately-owned YUKOS and Sibneft with that of government-owned Rosneft shows very similar rates of reported net profitability. There is nothing particularly new in terms of products or technology that private concerns have introduced into the enormous Soviet-built oil industry since they took over. The same is true of the aluminium or nickel industries. But that is ancient history today. The most pressing problem is how to make the state the major recipient of rent earned on its oil properties. This could be done by keeping the private oil companies running as they are but changing the ways in which their incomes are taxed. A recent suggestion to tax excessive rent incomes is worth considering. A tax on mineral rent (that is, super-profit above economic or industry average) is one obvious solution. For instance, any profit exceeding the average of 20 or 25 per cent of gross revenues should be considered a super-profit and taxed at, say, 50 or more per cent compared with the current normal profit tax rate of 24 per cent. Another proposal is to introduce special taxes on capital gains of the oligarchs and on their dividends transferred out of the country. The dividend proposal is straightforward and provoked by two recent dividend payments of $1 billion each by Sibneft oil company, which is obviously pure mineral rent that has not been taxed by the government and is way above the company’s needs for domestic investment. Ninety per cent of Sibneft shares are known to belong to Roman Abramovich. The point is that the $1.8 billion paid out to this gentleman was officially taxed at only 4 per cent under the existing more than liberal tax laws. That in itself is socially unfair since the flat personal income tax rate is set at 13 per cent.


In addition, the money is being spent outside the country, including Mr Abramovich’s $300 million acquisition of Chelsea soccer club in Britain, buying a $90 million luxury yacht allegedly registered in the Bahamas and ordering a new Boeing 767 for his personal use. Large dividends in excess of $10 million should be taxed at a minimum of 50 per cent and, when transferred abroad, at an even higher rate of, say, 75 per cent. This would be a fair means of returning at least some of the mineral rent appropriated by the oligarchs due to lax taxation in former years. The capital gains tax proposal is a more tricky affair. For instance, in the case of YUKOS, which in 1995 was bought for a meagre $300 million and saw its market capitalization rise to a maximum of $33.1 billion by early August 2003, the capital gain for the major stockholders who own above 70 per cent of the total is enormous. The reasoning is that it can be taxed only if turned from paper into cash profits. However, there is an interesting precedent. In the UK, following Margaret Thatcher’s privatizations, a rule was set obliging the new owners of the privatized companies to pay a tax of 38 per cent on the capital gain in market value of their shares in the period between their initial acquisition and a certain future date. This precedent could also be used in Russia to help return part of the oligarchs’ windfall profits to the government. Alternatively, they should be taxed on the market value of their property at a rate that is certainly higher than the 1 per cent or less tax applied to personal worth and is so small that its collection is ceded to municipalities. Applying a tax on marketable personal assets of, say, 4 per cent would have Khodorkovsky pay at least $320 million annually to the federal exchequer on his $8 billion fortune. Making the tax reversible to previous years would go a long way towards compensating the state for selling YUKOS way below its market value. Another pressing issue is to make easier the transfer of excess capital from oil and non-ferrous metals into manufacturing and particularly high-tech industries. Apart from creating additional government-run financial institutions to compensate for the underdeveloped banking sector, the government should take special measures to promote the expansion of the capital market as a major channel of capital flows into capital-deficit industries. Special care should be given to reforming the banking industry into a genuine public utility, expanding the insurance business, mortgage and consumer credit, various forms of mutual and other investment funds. When private capital is unwilling to adequately invest in these activities, the government should, at least on a temporary basis, set up its own institutions to close the gap. The same is true of government concerns that could lead in developing competitive manufacturing industries where private capital is slow and reluctant to do so. The automobile, aircraft and computer industries are examples which easily come to mind. Mixed ownership could act as a good start to spur these largely dormant areas. German and French experience (Volkswagen, Renault and other examples come to mind) could be used in these exploits.


Another essential area of alternative economic policy is the consistent improvement of macroeconomic proportions in order to ascertain the normal expansion of the domestic market and adequate growth rates of the economy. The comparison with the US illustrated above shows the inordinately low share of labour income in the Russian economy. But the share of labour income in the US was not always as high as it is today. For instance, it was only 49 per cent of GDP in 1929 – practically the same low level as in Russia (see Table 13.2). However, in the following decades it increased to 58–59 per cent and has oscillated around that level in the last 30 years. If such an improvement was possible in the typical market economy of the US, it should be possible in Russia as well, and without contradicting market rules. In the US, this happened as a result of major structural and institutional changes. Most of these occurred in the first two decades after World War II and largely under the administrations of the Democratic Party (Truman, Kennedy and Johnson) which pursued reforms in the spirit of John Maynard Keynes and the welfare state. This led to a substantial increase of the share in GDP of government purchases and the larger role of trade unions in determining wages. Consequently, the structure of domestic macroeconomic demand changed drastically. In 1929, personal consumption accounted for 75 per cent of final domestic demand, gross investment for 14 per cent and government purchases for only 9 per cent. This structure is consistent with relatively low taxes that do not present a substantial deduction from either personal consumption demand or from companies’ resources for capital investment. In 1929, tax deductions accounted for only 2.7 per cent of total personal income and only 13.5 per cent of corporate gross profits. This is what big business in Russia considers an ideal macroeconomic structure today. But that 1929 structure led to the Great Depression, in which consumption demand turned out to be grossly inadequate and the economy was helpless in the absence of government anti-cyclical policies and stabilizers. That lesson has been largely forgotten today, but it is worth recalling. Russia is not at all immune from depressions of the old US type. Table 13.2: Macroeconomic proportions in the US, 1929–99 (% of GDP)

Labour income Personal consumption Gross investment Government purchases Net exports Gross profit Investment as % of gross profit

1929

1957

1981

1999

49 75 14 9 0 44 34

56 62 15 22 1 36 42

59 62 17 20 0 34 50

58 68 17 18 ⫺3 35 49

Source: Economic Report of the President of the US (2000).


But America was then so apprehensive of a possible repetition of the Great Depression that it reached the necessary conclusions. By 1957, the share of personal consumption in GDP fell to 62 per cent, but government purchases rose to 22 per cent, fully compensating for the potential loss in aggregate demand, while gross investment remained practically unchanged at 15 per cent. The new structure of final demand reflected the increased role of government as a factor of economic stability and was consistent with higher taxes. Tax deductions from personal income rose to 11.5 per cent (on the average), taxes on corporate profits rose to 48.7 per cent. The personal tax increase by 8 percentage points ‘ate up’ part of consumer demand, but because the share of labour income rose by 7 percentage points – from 49 to 56 per cent of GDP – one compensated for the other. It is also noteworthy that a 3.5-fold increase in the corporate profit tax did not negatively affect the share of gross investment. In fact, business now spends nearly half of its gross profit on capital investment instead of a third in 1929. The rise in labour income reached its peak in 1981, that is, by the end of the welfare state reforms. After that, particularly as a result of Reaganomics and following the neo-liberal dogma of minimizing the role of government, the share of labour income started falling. This turnaround marked the end of government cooperation with trade unions and a more aggressive policy towards labour. Between 1929 and 1957 aggregate labour income rose at an average annual rate of 6 per cent, faster than growth of nominal GDP at 5.5 per cent. At that time the unions succeeded in imposing the rule under which growth in money wages should compensate for both the rise in labour productivity and consumer price inflation. This principle was recognized in collective agreements and while helping create a weak inflationary background, it also promoted growth in aggregate demand and helped make recessions weaker and shorter. In Russia, the role of trade unions is extremely low. What an alternative income policy needs is to guarantee by legislation labour’s more active role and the need for the faster growth of aggregate labour income compared to GDP for a substantially lengthy period. Russia could make use of the experience of indicative planning in France where the government together with trade unions and industrialist associations determined major macroeconomic proportions, including absolute and relative growth of labour income. Such a policy is likely to meet strong opposition from big business, which interprets any rise in the share of labour income as a reduction in profits. But this is not necessarily true. Given proportions that guarantee fast overall economic growth, profits tend to rise in absolute terms even though their share in GDP may be reduced. Another important point is to convince the business community that it has to separate the issue of reducing taxes from that of reducing government expenditure. Lower government expenditure will further reduce aggregate demand and slow economic growth. It will not necessarily free more resources for capital investment.


Policy recommendations To summarize, a minimum programme of proposed measures can be formulated in the following few points: 1. To establish effective control of the state, as proprietor of the nation’s mineral resources, over a sufficiently large share of the mineral rent and to re-channel it via the government budget and private capital markets into the chronically capital-deficient sectors of the economy. This implies the introduction of four special taxes: ● ● ●

●

tax on mineral rent; tax on market value of shareholdings; tax on capital gains shareholdings in privatized formerly governmentowned companies; tax on large dividends, particularly those transferred abroad.

2. One of the basic principles of business tax policy should be equalizing profitability in the various sectors of the economy. Sectors with higher profitability should pay higher taxes. 3. Government should retain its presence as owner and manager of business companies in those economic sectors where private capital is slow to invest in modernizing and expanding competitive productive activities. This should apply to key manufacturing industries as well as to lagging spheres of financial and other business infrastructure. 4. Government and mixed companies should be especially promoted in sectors with a particularly high potential for competition in foreign markets. 5. In general, the government sector should be used as a major means of promoting competition. By changing its basic business rule from maximizing profit margins to increasing output at reasonable prices, the government sector could act as a pioneer in breaking up monopoly behaviour in the Russian economy. 6. Government incomes policy should centre on joint determination with trade unions and business associations of major macroeconomic proportions that guarantee fast and stable growth of the economy. Particular attention should be given to a carefully coordinated programme of raising the share of labour income to about 60 per cent of GDP and drastically reducing the proportion of poverty and near-poverty income groups in the population. 7. Practical considerations, not ideologically-motivated models should be used as the basis for economic policy decisions and long-term strategies.

14

Escaping the Squeeze: Lessons from East Asia on how Middle-income Countries can Grow Faster Robert Hunter Wade

Middle-income countries continue to be under pressure to further open their economies to free trade and investment, to privatize state-owned assets, deregulate entry and exit to sectors, and give no preference to domestic firms over foreign firms. The pressure comes from the global economic multilaterals (especially the WTO, IMF and the World Bank), and from the US government and the EU;1 and beyond ‘pressure’, the appropriateness of such moves is ‘in the air’ of the ‘international development community’, and an operating premise of the leading English-language opinion-makers like the Financial Times and The Economist. The consensus is justified by the claim that these policy shifts will lead to faster rates of investment and economic growth, and thence to faster rises in average living standards and faster falls in the proportion of the population living below the national poverty line. In so far as they are adopted by many countries, the benefits will spread synergistically. The pressure for this direction of policy shift built up through the 1980s. John Williamson encoded them as the ‘Washington Consensus’ about desirable policies for developing countries in 1990. However, Williamson’s original list did not include open capital accounts and free capital movement – because he did not think, as of 1990, that there was a consensus among relevant people in Washington and in the ‘international development community’ that such a policy was desirable. Quite a few relevant people continued to accept the premise of the Bretton Woods agreements, that capital movement should be restricted in order to allow countries more room for manoeuvre in monetary and exchange rate policy. In the early 1990s, with the arrival of the Clinton administration, Washington Consensus Mark I gave way to Washington Consensus Mark II. Mark II included the items of Mark I, but also included opening the capital account and drawing on foreign savings – in other words, borrowing abroad in order to supplement domestic savings and thereby boost the rate of domestic investment.2 The strategy of increasing growth by drawing on foreign savings was taken to be self-evidently correct, its advantages too 196

Escaping the Squeeze: Lessons from East Asia 197

obvious to need evidence. The US Treasury under secretaries Rubin and Summers became especially keen, even adamant, about this strategy. Hence middle-income countries (and even very low-income countries, like Ethiopia) came under intense pressure from the global economic multilaterals to open their capital accounts, in addition to further liberalizing trade and foreign direct investment. How do we understand this shift? Policy preferences of international organizations do not come out of thin air, and they are generally underdetermined by empirical evidence – or empirical evidence that withstands independent scrutiny. It is clear beyond doubt that state attempts to alter the composition of economic activity within national borders can go disastrously wrong. It is clear not just from the communist cases based on central allocation and public property, but also from the cases of hard ‘import substitution’ in a market-based economy of the kind found in India from the 1950s to the 1970s and in New Zealand from the 1970s to 1984. But take away the extreme cases and the evidence in favour of unidirectional liberalization, privatization, deregulation and open capital accounts – Washington Consensus Mark II – becomes much less convincing. For example, several studies conclude that there is no evidence that countries without capital controls have grown faster, invested more, or experienced lower inflation, and some evidence, indeed, suggests that capital controls are associated with faster growth. Bresser-Pereira and Nakano find that the impact of a 1 per cent increase in foreign savings in relation to GDP on growth in GDP per capita, for 51 countries in the period 1979–98 is just 0.005, or almost zero.3 We can understand the ascendance of the Washington Consensus Mark II in terms of the ascendance within the United States and Britain, and a more contested ascendance within the European Union, of a rentier-oriented form of finance capitalism. This form subordinates the needs of industrial capitalism to the extraction of financial returns to the holders of financial assets, seeking the highest returns on money capital worldwide. It opens industrial capitalism’s ownership to takeover by financial groups through mergers and acquisitions. Once it dominates industrial capitalism, mergers and acquisitions, often hostile, become the central process of capitalist restructuring. Internationally, this form of capitalism expands its reach more through gaining access to ownership of assets abroad than through gaining access to product markets for exports. It seeks to reform pensions, housing finance, health systems, urban water and sanitation systems and the like so as to allow a bigger scope for private shareholders and for private flows of credit repayment and dividends especially to the owners of money capital in the home economy (the US and the EU). And it seeks to extend credit to private borrowers in middle-income countries in the expectation of generating debt-led consumption booms. American economists like to present the public rationale for this stance in terms of the rich countries’ exploding age-dependency ratios. Who is going to provide goods and services for all the retirees? They


ask. The answer is for rich countries to buy up assets in poorer countries today, which can later be drawn down as the baby-boomers stop working.4 Poorer countries have only to allow this asset buy-up to happen. Of course, this is not happening only in relations between the US and EU, on the one hand, and middle-income developing countries on the other; it is also playing out inside the EU. The tight macroeconomic policy followed by the European Central Bank can be understood as an attempt to force the policies of democratically-elected governments, including the German and the French, away from those expressing an alliance between (industrial) capital and labour and towards the pro-finance policies of the Washington Consensus Mark II. One expression is the consensus among those connected to financial interests in Europe that the reason for high and sustained unemployment in Europe is labour market rigidity. The key to lower unemployment, they say, is labour market flexibility (and not, for example, a more expansive macroeconomic policy, which is where a Keynesian economist would look). My premise in this chapter is that the governments of middle-income countries should be cautious about embracing anything close to the Washington Consensus Mark II. Even full-scale free trade should be viewed with caution. Trade liberalization exposes their manufacturers to direct competition with China and other East Asian producers in sectors with diminishing returns. Further, relying on large inflows of foreign direct investment (FDI) is not likely to be an effective means of catch-up. For one thing, almost all of the small share of total FDI that goes to developing countries goes to only a handful; and strikingly, the concentration has not decreased over the past two decades, contrary to the ‘evolutionist’ prediction that FDI would spread out to more and more developing countries. In these conditions trade and FDI liberalization may yield immiserizing growth, a ‘race to the bottom’ (working harder to stay in place). And we now have abundant evidence that countries that rely on foreign borrowing to accelerate their growth are quite likely to experience a serious crisis, especially if they are already carrying a high stock of debt. All three of the major Latin American countries adopted the ‘growth with foreign savings’ strategy through the 1990s and all experienced a serious crisis: Mexico in 1994, Brazil in 1998 and 2002, and Argentina in 1995 and 2001/02. The story of the East Asian crisis of 1997–98 was rather similar. On the other hand, while these crises were bad for growth and worse for the economic contentment of hundreds of millions of people, they did open the way to even more intense pressure from the US Treasury and the global economic multilaterals for the crisis-affected countries’ governments to go further than they had already done in the implementation of the Washington Consensus Marks I and II;5 and they opened the way for US and European firms to make large-scale purchases of productive and financial assets at fire-sale prices. Champions of the Washington Consensus Mark II often say that the solution is tighter prudential regulation in the developing countries, not restrictions


on foreign capital inflows. It is a disingenuous response, because we do not have good criteria for judging when a system of prudential regulation is ‘sound’ enough to safeguard domestic financial systems that are integrated with world capital markets. The World Bank listed those countries with sound enough financial systems to withstand full integration into world capital markets, in a publication of April 1997. ‘[M]ost of high-growth Asia (Korea, Malaysia, and Thailand, with Indonesia and the Philippines not far behind) and two markets in Latin America (Chile and Mexico, with Brazil also ranking well).’6 The East Asian crisis began a few months later, and then swept into Latin America. On the other hand, some sort of strategy of delinking from markets in the core economies, based on integration among groups of neighbouring countries, is not a promising alternative. Sooner or later these bad choices may induce policymakers and policy analysts in developing countries to reconsider the thrust towards free markets as the route to catch-up development, and then to engage in a more open-minded way with the East Asian experience of the developmental state. The start of wisdom is to recognize that central planning is not the same as central allocation. Communism used and discredited central allocation. But central planning in the broad sense – public authorities intervening to alter the composition of economic activity within their borders, in line with an economy-wide exercise in foresight about the economy’s future growth, in the context of a capitalist economy – has been alive and well in East Asia, and should – this is my subtext – be seen as an opportunity for governments elsewhere. I shall summarize my understanding of some of the roles of the state in economic development in capitalist East Asia (South Korea, Taiwan, Japan) first in the post-Second World War decades, then in the last decade or so. Fuller argument is given in the new edition of my book Governing the Market (2004). I wish to emphasise that (a) a lot of the sectoral industrial policies and programmes used in East Asia were of a rather modest kind, yet in aggregate probably very effective in accelerating the transformation of the economy into higher value-added activities; (b) they did not require sophisticated calculations and a highly skilled bureaucracy; and (c) other developing countries can and should adopt the same norms of industrial policy, even if with still more modest, blunter, instruments. This is to reject the view of an economist as sophisticated as Howard Pack, who concludes from his study of Japanese and Korean industrial policy from the 1960s onwards that the benefits to Japan and Korea were modest, even in the 1960s when the benefits were highest, and that: Countries attempting to extract the benefits from an industrial policy that Japan and Korea obtained [NB: this implies that they did obtain some benefits] have to possess not only an exceptionally capable bureaucracy but


also the political ability to withdraw benefits from non-performing firms … [Thus, developing] countries should be exceptionally cautious before embarking on such policies.7 If Pack is right, industrial policy should not be on the agenda. But he misses a whole swathe of East Asian industrial policy of a different kind to the largescale, picking-the-winners kind that he concentrates on.

Why the liberal explanation of East Asia’s catch-up is wrong But first I need to give some indication of why I think the conventional liberal explanation of East Asia’s catch-up growth is wrong – not entirely wrong but substantially wrong. The mainstream economics literature does present the catch-up as due in large part to steady liberalization of markets: first, liberalization of the trade regime, then, liberalization of capital movements in and out; both accompanied by a steady lightening of the hand of the state in the domestic economy, a steady deregulation and privatization of stateowned enterprises. All the attention is focused on the retreat of the state from the ‘import-substitution industrialization’ phase, when the state tried to change the composition of economic activity. In the conventional liberal explanation the liberalization of the trade regime receives central importance, as the key condition facilitating the rapid growth of exports. According to a major World Bank study, countries with ‘outward-oriented’ trade regimes have shown very much better performance on a range of indicators than countries with ‘inward-oriented’ trade regimes. The bank concludes that the causality is from trade regime to economic performance, and that the correlation between outward orientation and better performance holds not just across countries but for one country across time: the cross-sectional evidence strengthens our confidence that countries will experience improved economic performance as they liberalize their trade regimes. But the argument is full of holes. To give just a few illustrations. First, the World Bank study’s conclusion that outward-oriented trade regimes have better performance than inward-oriented ones obscures a contrary finding. The study took two time periods, 1963–73 and 1973–85, and for each period classified 41 developing countries in terms of four categories of trade orientation: strongly outward-oriented and moderately outward-oriented, and strongly inward-oriented and moderately inwardoriented. The moderately inward-oriented countries had better performance, by most measures, than the moderately outward-oriented cases. The result that the bank celebrates – outward-oriented trade regimes have better performance than inward – comes from aggregating the two sub-categories. The ‘strongly outward-oriented’ cases have such good performance indicators, and the ‘strongly inward-oriented’ ones such bad performance indicators, as to reverse the results for the ‘moderately-oriented’ cases.


Second, the sub-category of ‘strongly outward-oriented’ includes just three cases, Hong Kong, Singapore and South Korea. They are all East Asian, which raises the possibility that their outstanding performance has more to do with ‘East Asia’ than with ‘liberal trade’. Moreover, the performance of the subcategory is mostly Korea’s, which swamps the other two. Without the one case of Korea, the overall conclusion about outward-oriented regimes having better economic performance than inward-oriented ones would not hold. Third, to describe Korea’s trade regime in 1963–73 and in 1973–85 as ‘strongly outward-oriented’ is in any case a gross mis-characterization, given that the sub-category is defined as one where ‘trade controls are either nonexistent or very low … There is little or no use of direct controls and licensing arrangements.’ The study adds another criterion when defining the ‘moderately outward-oriented’ regime, namely, low variation of effective protection rates to different sectors of the economy; and we may presume that this criterion should also apply to the strongly outward-oriented cases. There is plenty of evidence that these criteria do not fit Korea’s trade regime in either period.8 One piece of evidence comes, ironically, from the locus classicus of the belief that Korea got rich by having a liberal trade regime, and it is worth citing in order to see how the liberal conclusion has been reached by selective inattention to data that would upset the liberal way of seeing things. The long-term World Bank consultant, Bela Balassa, coordinated an intensive study of the trade regimes of six developing countries based on data from around 1969. The study defined a liberal trade regime as one with two basic characteristics: (1) low average protection; (2) low variation (or dispersal) around the low average – that is, uniform protection across all sectors. The study found that for Korea and Taiwan, the average level of protection of manufactures in 1969 was relatively low. This was the key finding that supported the picture of a liberal trade regime. Strangely, the study did not draw attention to another finding that can be drawn from the same data. Dispersion of protection around the relatively low average was quite high. Korea and Taiwan did not have a uniform level of protection. Within manufacturing, different sectors had quite different levels of protection. The data in Table 14.1 illustrate this. Table 14.1: Trade regimes, incentives to sell on domestic market or to sell abroad, developing countries around 1969 (%)

Effective protection to manufacturing Intersectoral dispersion

Taiwan

Korea

Colombia

Argentina

14

13

35

112

23

47

56

35

Source: Wade, Governing the Market (table 3.2, p. 56), based on Balassa (1982).


It is likely that these differences were deliberate, the result of government intention reflecting the wider industrial development strategy (rather than accidental, or the result of cronyism). In contrast, where the level of average protection is high (Colombia, Argentina) it is more likely that a given degree of dispersion around the high average is not intentional but accidental. In short, even the study regarded as the locus classicus of the image of East Asian capitalist economies as having liberal trade regimes provides evidence that contradicts its own conclusions. Furthermore, the conventional neo-liberal explanation is wrong about timing, and therefore about the causality from trade liberalization to growth. Recall that it says that trade liberalization gave a strong propulsive boost to the growth of exports and thus to broader economic growth. Dani Rodrik has shown that this is not the observed sequence. One does not find a big improvement in incentives to export preceding the take-off in exports, but one does find a big improvement in investment incentives thanks in large part to government policy changes. First came a surge of investment (in the case of Taiwan, around 1958–60) while trade incentives remained largely unchanged, then rapid growth of exports, then faster growth, then accommodating liberalization of trade. ‘The lesson from East Asia is clear’, says Rodrik: [T]he three East Asian ‘dragons’ with low investment rates in the early 1960s – South Korea, Taiwan and Singpore – would not have been nearly as successful had their governments not given capital accumulation a big push by subsidizing, cajoling and otherwise stimulating private investors. The evidence from East Asia and elsewhere shows that investment booms produce economic growth as well as greater export orientation [and higher imports].9 The observed sequences in East Asia better fit the hypothesis that ‘as countries grow richer they liberalize trade’ than the hypothesis that ‘trade liberalization propels countries to become richer’. The priority to investment is not specific to East Asia: a step up in investment seems to be a nearly necessary condition of a step up in growth rates. Rodrik concludes, ‘Countries that are able to engineer increases in their investment efforts experience faster economic growth.’ (On the other hand, the cross-country correlation between decadeaverage investment rates and decade-average GDP growth rates (1950–1990) is not particularly strong.10) What about the World Bank’s East Asian Miracle study, published in 1993?11 It examined eight high-performing East Asian economies (not including China), and applied a range of tests to examine the impacts of industrial policy. About the impacts of sectoral industrial policy (targeted at specific sectors, such as chemicals or semiconductors) the study says, ‘industrial policies were largely ineffective’ and, ‘We conclude that promotion of specific


industries generally did not work and therefore holds little promise for other developing countries’ (pp. 312, 354). It also concluded that even had they been effective in East Asia, their administrative/political conditions are so demanding (for example, in terms of the sophistication of the calculations for identifying sectors for special promotion) that few other developing countries could achieve the same success. ‘[T]he prerequisites for success [such as it was] were so rigorous that policy makers seeking to follow similar paths in other developing countries have often [read, usually] met with failure’ (p. 6). If this sounds like Howard Pack, quoted above, it is no accident; for he was the consultant who wrote the chapter in the Miracle about the impact of industrial policies. I and others have shown why the Miracle’s evidence is not convincing.12 To give just one reason: the problem of capturing ‘externalities’, or spillovers from one sector to another. It turns out to be very difficult to track the effects of spillovers across sectors. Yet they are real. Some critics of industrial policy have pointed to the lack of correlation between the amount of subsidies and protection given to sector X and the growth of productivity in sector X, or even to a negative correlation, as evidence of industrial policy failure – or even of ‘picking losers’. But the test ignores the point that East Asian governments gave various kinds of resource help to ‘infrastructural’ sectors like steel and basic chemicals not mainly to promote productivity growth in those sectors but to have spillover benefits for the users of steel and basic chemicals. The World Bank has been a leading proponent of the idea that East Asia got rich because it liberalized markets and followed the policy mix later called the ‘Washington Consensus’. The East Asian Miracle was a bank research report; and the Balassa et al. study was sponsored by the bank, while Balassa worked as a de-facto bank staff member (de facto, because formally he was a long-term consultant). In appraising the evidence of these and other bank studies, it is important to bear in mind that the staff see themselves as – like it or not – speaking for the organization. The External Affairs Department instructs staff (including research staff) as follows: ‘Crucially, staff contemplating a speech, article, opinion/editorial, or letter to the editor must realize that a disclaimer that the speaker or writer is expressing personal views is unconvincing and usually ineffective. It also does not exempt the staff member from following procedures, or from recognizing that they speak for the institution.’13 To its credit, though, the Miracle study does recognize that its evidence is hardly conclusive. ‘We cannot offer a rigorous counterfactual scenario. Instead we have to be content with … analytical and empirical judgements’ (p. 6).

East Asian industrial policies: (I) the catch-up phase To think constructively about industrial policy, one has to distinguish at least three types. First, economy-wide ‘functional’ policies that include


exchange rate policies macroeconomic balance and competition policies (including average level of protection). Second, multi-sectoral ‘horizontal’ policies, that include incentives for R&D, incentives for ‘small and medium enterprises’, investment in port infrastructure and the like. Third, sectoral policies, to promote specific sectors or sub-sectors or firms (the Proton auto firm in Malaysia, for example).14 Most of the debate concerns the latter – did it matter in East Asia and could it work elsewhere? Immediately one can intuit how difficult it is to separate out the effects of the latter from the effects of the first two, because of the mutually-supporting relationships among them. No industrial policy champion would claim that the third type, sectoral policies, can work with inhospitable policies of the first and second types. Part of the problem of getting evidence specifically on the impact of sectoral policies is that the policies entered into the assessment tend to be of ‘The Ten Year Plan to Develop the Petrochemical Industry’ kind. What this misses is a great deal of activity ‘below the radar screen’, which may have rather small public expenditure costs but which in aggregate has probably had a powerful effect in raising the average level of technological and production capacity of East Asian firms. Taiwan, for example, had an Industrial Development Bureau (IDB) comprising, in the 1980s, some 200 engineers and allied professionals, and a sprinkling of economists. Much of the work was organized by input-output chains. The specialists in the chain that included, say, glass, monitored carefully the imports of glass, the buyers of imports, the production capacity of Taiwanese glass-makers. As part of their job they were required to spend several days a month, at least, visiting firms in their sector. (They were not allowed to have lunch with members of the firm they were visiting.) The aim of their monitoring and visits was to find opportunities to ‘nudge’ the process of import replacement and export promotion, by using various kinds of administrative methods to ‘encourage’ the big buyers of imports to switch from importing to local sourcing once they judged that domestic suppliers could meet the quality and price of imports, provided they had a long-term supply contract and some technical help. In the case of a transnational company, Philips, importing specialized glass for its televisions, the IDB officials informed Philips of the potential for switching and indicated that they would look favourably on other Philips’s requests if it saw its way to switching. Philips said no. Then Philips began to experience longer and longer delays in its applications to import the specialized glass, which had previously been granted immediately. Philips protested to the minister, who apologized profusely, said he would look into it. The delays continued. Eventually Philips got the message and switched. The domestic suppliers undertook the needed investment in quality, and later were in a position to start exporting.15 The point is that this sort of nudging of firms into higher value-added products – and jolting of transnational firms and domestic firms to establish


domestic supply relationships – has been going on across many sectors, case-by-case, for many decades in Taiwan. It has required an honest, competent cadre of public officials with skills in engineering and finance – though not a particularly large one; and an array of instruments on which to draw, which may include some capacity to manage trade (as in the Philips example) but may also include a wide range of non-trade measures for encouraging and discouraging. It has not required the sort of subtle strategic trade calculations that seem to be required – according to conventional strategic trade theory – in the case of cutting-edge high-tech industries in the advanced industrial economies. There is no question that it is difficult to pin down the quantitative effects of this sort of below-the-radar intervention by public officials – whether positive or negative. All we can be sure of is that a great deal of it was going on over decades, all the time, with a dedicated cadre of public officials to do it.

East Asian industrial policies: (II) forging ahead Today Taiwan has reached the technological level of middle-ranking OECD countries, which is an astonishing, almost unprecedented achievement given its starting point around 1950. But it remains well behind the world technology frontier in most sectors. For all its commitment to WTO principles the state continues to exercise economy-wide foresight, continues to shape the composition of activity within its borders, does not let ‘the market’ take its course. Linda Weiss and Elizabeth Thurbon remark that: the practice of governing the market is not just about policy – GTM [governing the market] is also, and perhaps more importantly so, about the normative environment that sustains the will to govern the market, and the legitimacy of governing the market as perceived by actors in the polity. This is a point often overlooked in the mainstream literature … which typically bases its claims on observed policy changes since the [financial] crisis [of 1997–98 – that is, claims that the Taiwan government has given up governing the market since the crisis]. The assumption is often that if a state has relinquished certain pre-crisis policies … it must also have abandoned a commitment to GTM and be acting in ways broadly consistent with the norms of competitive liberalism.16 They relate that the entrance to the Industrial Development Bureau is emblazoned with a quote from Goethe which captures the difference at the level of norms between a government role based on strategic economics and one based on liberal economics: ‘The most important thing in life is to have a goal, and the determination to achieve it.’


Taiwan continues with the organizational structure of the developmental state:17 ●

●

●

●

A pilot agency located in the very heartland of the state and chaired by the third ranking political leader in the state (the vice premier), called the Council for Economic Planning and Development. An operational agency that does the ‘nuts and bolts’ of industrial policy, the Industrial Development Bureau described earlier, located within the Ministry of Economic Affairs. Industry associations by sector, membership of which is obligatory, whose secretary is semi-appointed by the government and who is responsible for two-way interaction between the member firms and the government (and hence not likely to let the association become a centre of political resistance to government). Public R&D laboratories, notably the umbrella agency, the Industrial Technology Research Institute (ITRI), with a staff of some 10,000 scientists (by the mid-1980s) organized in sector-specific labs; and an even bigger military-oriented counterpart.

The essence of the political process of national development is intense dialogue between these organizational components of the developmental state. Earlier, the first two tended to call the tune and the others responded; since democratization in the late 1980s the balance of power has shifted towards the labs and the industry associations. In particular, much of the brainstorming takes place between ITRI labs and industry associations, which helps to build inter-firm networks with reliable collaboration between members. Commonly, an ITRI lab incubates a specific technology (for example, Radio Frequency Information Devices, a type of chip), gets it to pre-commercial stage, takes out patents, and then spins off a sort of private firm, to which it gives the patents in exchange for equity. Often the senior managers of the firm are ex-ITRI, or part-time ITRI. This technique has been used for many initiatives, including the import-replacement of bottleneck components whose recurrent delays in importing are impairing Taiwan’s entry into advanced sectors. In this and many other ways, the state helps to assume a large part of the risks of research and development of technologies to commercialization stage. Emphasis is given to promoting nationally-owned firms, with limits placed on the operation of foreign firms (for example, foreign service firms). All the time, the apparatus of the developmental state is looking for ways to maximize technology spillover from foreign firms (abroad or in Taiwan) into the heads and hands of local firms. Equally, however, the apparatus is actively involved in building up a large stock of Taiwan-owned firms operating abroad – building up outward FDI – so that Taiwan is more of a reciprocal


partner than if it were only playing the role of a periphery welcoming inward FDI from the centre. Taiwan’s outward FDI in China is well known; but it has also built up a large stock in other developing regions as well as in the core regions of the world economy ( Japan aside). The underlying competitive strategy for the nation is based on recognition that its firms, being some way off the world technology frontier, must seek to capture second-mover advantages. Its firms are mostly unable, yet, to capture the brand-name advantages of first movers. They must be able to chase hot products developed by first movers, push up production of specified items quickly, and exploit scale economies before profit margins become paper-thin. For this strategy, large firms, not networks of small and medium enterprises, are increasingly needed; large firms which are able to produce in large volumes and which are big enough to be of interest to first-mover firms as subcontractors.18 The government’s role is to push on with industrial policy of all three of the types distinguished earlier. In particular, to promote ‘industrial complexes’ or ‘urban economic commons’ or ‘growth poles’; and to promote moves in many industrial and service sectors – but often with sector-specific and even firm-specific instruments – into higher value-added parts of global value chains (such as into manufacturing-related service industries, MRSIs, as part of which the Radio Frequency Information Device mentioned earlier was developed).19 I have been talking about Taiwan. Singapore, Japan and China also retain major features of the developmental state. South Korea, on the other hand, has gone some way to dismantling what used to be a model of the type. The dismantling began in the late 1980s, with democratization and the discrediting of military rule – and by the same token, discrediting of bureaucratic rule. Like a swing in fashion, many Korean economists and public officials converted to neo-liberal economics of a fundamentalist kind, with UStrained Korean economists in the role of modern missionaries. Their ideas acquired power from their resonance with the interests of the large Korean conglomerates, like Samsung, which by the late 1980s had reached the point of organizational and technological sophistication where they saw the state as more of an obstacle than a help. And the G7 states particularly focused on Korea with demands that it open its markets, to avoid ‘another Japan’. By 1995 the Economic Planning Board – the pilot agency since the early 1960s – had in effect been abolished, and the capital market had been largely opened up for foreign borrowing and foreign financial service firms. Yet even in Korea things are not what they seem to be. Norms of ‘governing the market’ continue. That is, the government continues to have a legitimate role in steering and coordinating the strategies of the private sector – it coordinates a governance arrangement spanning government and autonomous but interdependent firms, though not (as before) as a commander of specific outcomes.


Take telecommunications liberalization as an example of gradual liberalization carried out in a way calibrated to retain a substantial presence of nationally-owned firms while facilitating their achievement of world frontier capabilities.20 Before the early 1990s telecommunication services in Korea were provided by two public enterprises (Korea Telecom and Korea Mobile Telecom), backed by a history of heavy government regulation in equipment and telecom services. Then in the late 1980s and early 1990s a new technology, digital mobile telecommunications, appeared on the world frontier. This promised a much higher demand for mobile services and accompanying infrastructure. The conglomerates wanted to diversify into telecoms. The US government pressed Korea to open its telecom market to US firms; as did the prospect of GATT/WTO membership. For all these reasons the Korean government had to privatize and liberalize the sector. But the government recognized that telecoms would be a ‘leading sector’ on a world scale in the coming decades, and that Korea had to maintain a strong presence of Korean-owned firms. The Ministry of Information and Communications (MIC) began to liberalize by privatizing the mobile carrier in 1993;21 a year later it licensed a second private carrier; two years later (1996) it licensed three more private carriers. It not only allowed foreign telecom firms to invest in the private Korea firms, but required their participation (to get their technology); but only up to a limit of 33 per cent of total equity. It also restricted the share of equity that could be owned by Korean manufacturing companies to less than 10 per cent. It limited new entrants in their choice of equipment, favouring Korean equipment makers, which constituted an entry barrier for foreign firms; it also limited their technology standards to government-approved ones. The whole process was aimed at developing a strong indigenous telecom capacity before full liberalization, quite contrary to what the US government had in mind. At the same time, a parallel project was under way to use a public–private partnership to do the R&D for CDMA (Code Division Multiple Access) digital transmission technology, especially because the leading foreign telecoms firms would not sell advanced technology to the Koreans. The ministry formed a technology development network with the government-sponsored Electronics and Telecommunications Research Institute (ETRI) linked to the former public telecom company and a number of private Korean manufacturers, each with an assigned task. Much of the funding for this network came from the sale of shares in the privatized public enterprise. The proceeds were also used to subsidize the uptake of demand for telecommunications services, including internet access, making a virtuous circle between supply and demand. And a further loop was created by requiring new entrants into the service market to use products and standards developed in this R&D consortium. As the new entrants proved themselves competitive, several of the measures used to incubate the Korean infants were eased; the limit on the share of equity


held by foreign firms and by Korean conglomerates was raised to 49 per cent in 1999, and the restrictions on the choice of equipment were also lifted. By this time Korea’s signing on to the WTO telecommunications agreement in 1997 was also pushing in the same direction. The overall results of this ‘phased liberalization’ have been spectacular. Korea jumped from being a nobody in world telecommunications in the early 1990s to being a major player in the early 2000s. It has the highest broadband penetration in the world. The Korean telecommunications case illustrates the virtues of gradual liberalization orchestrated by the state in line with national development objectives, where those objectives give weight to national ownership in important sectors. However, it has also to be said that the mass conversion of Korean policymakers and economists to fundamentalist free-market economics during the 1990s did result in the abandonment of the earlier emphasis on national ownership in many sectors of manufacturing and finance. With the Asian crisis expanding the opportunities, foreign investors came to acquire about 60 per cent of the shares of Korea’s top 20 conglomerates. Only recently has a serious push-back begun, amid increasing domestic fears that foreign interests are extending a baleful influence over Korean industry. Leaders of some of the conglomerates are even supporting a campaign to urge citizens to buy shares in their companies in order to thwart the threat of foreign takeovers.22

The theory of governing the market It is one thing to say that governments in East Asia remain committed to governing the market; but is there any theory which might suggest why such actions might be effective at promoting rapid economy-wide development? Conventional economic analysis stresses that any attempt by public agents to change the composition of economic activity away from that which results from well-functioning markets is bound to be ineffective, bound to thwart the expansion of comparative advantage along whose path sustainable development lies. Measures such as protection, or domestic content or export performance requirements, withdraw resources from more productive uses and reduce consumption. Export requirements, for example, may worsen the trade account by reducing the export potential of other industries. But once the underlying assumption of perfect competition is replaced with an assumption of oligopoly – a small number of firms and barriers to the entry of competitors – the argument changes. In particular, the argument changes when there are increasing returns to scale such that only some of many potential production sites can be established, and when there are learning-by-doing economies which give advantages to firms which establish production early. In these conditions there is scope for states, not to ‘create’ comparative advantage or ‘pick winners’ out of thin air, but to shape


and direct comparative advantage. These conditions occur frequently in the mid-tech industries of middle-income developing countries and the mid-tech and high-tech industries of East Asia. For example, states can intervene in order to accelerate the move of chunks of productive activity from existing high-cost sites abroad to host country sites, faster than the market would. Case studies of transnational corporations show clearly that corporations operating in conditions other than perfect competition – which is the normal case – are often slow to react to price signals at the margin, even when they are well-informed about profitable opportunities to shift locations. This is especially so when rearranging intra-firm operations – as in relocating production out of the core regions to a cheaper-labour site, or switching suppliers from a high-cost one at home to a cheaper one in a developing region – would incur substantial exit costs. The case of automobile production in Mexico provides an illustration. Ford and Volkswagen established assembly and engine plants in Mexico in the 1960s, with a large part of production intended for export. From this experience it became clear to them and to other auto firms that big cost advantages were to be reaped. Yet by the late 1970s their investments remained relatively small, far from world-scale capacity and far from being integrated into their global sourcing network; and other major auto makers had not followed them in establishing Mexican plants. So in 1978–79, Mexican industrial policy officials, aware that US car makers were under competitive pressure at home from Japanese imports, decided to enforce a 1977 decree that linked access to the domestic market to exports: ‘if you fail to meet an escalating export schedule your domestic sales will be cut’. The first to respond was General Motors, which in 1979 announced the biggest onetime investment in its history, to be placed in Mexico. Other auto makers soon followed GM’s lead in announcing plans for major expansion of exports from Mexican sites, in order not to lose share in the Mexican domestic market. But this was sixteen years after Ford and Volkswagen first began to show the cost advantages of Mexican sites! They and the other auto firms had resisted international comparative advantage for a long time, and it took the ‘jolting’ of Mexican officials to break their lock-in to exit costs and other intra-firm rigidities.23 The more recent case of auto production in South Africa provides another illustration. Here the government after 1995 introduced an export–import link system (similar to that in Mexico), such that an auto firm’s access to the domestic market (with current sales of around 350,000 light vehicle units a year and expected to grow) was made conditional on export performance, either of finished vehicles or components in the value chain. In addition, several complementary programmes – formulated and monitored by an auto industry development council, comprising representatives of assemblers, component makers, retailers, trade unions, government, plus a few academics, who met every six weeks – helped to improve business organization and labour


relations up and down the supply chain. The whole programme was designed to harness the rivalry between the big three German auto makers, but also Toyota and Ford, to the benefit of the South African economy. Justin Barnes et al. show that the selective policies targeted at the auto industry were almost certainly effective by several measures of effectiveness, and that they did not require large public expenditures or a sophisticated bureaucracy making sophisticated calculations.24

Conclusions The general point from all this is that there is a body of theory, or theoretical insights, at hand to support a strategy of governing the market in a developing country context, based on ideas of economies of scale, learning-bydoing, second-mover advantages, stickiness in location decisions of TNCs, and the arbitrariness of much of ‘comparative advantage’.25 And there is also some relevant empirical evidence, even if its conclusions about effectiveness are open to dispute – though no more so than the evidence which purports to show the fallacies of government efforts to change the composition of economic activity. The case studies show that the task for industrial policy strategists in identifying products or sub-sectors for targeting is not particularly difficult – it involves estimating costs of production, comparing with import prices and quality, estimating demand elasticity, and so on, the same sort of calculations as transnational corporations make every day; and it involves understanding the bargaining tactics of transnationals and how to turn them to national advantage. In the more advanced of the middle-income countries it is important for industrial policy strategists not to think only of inward FDI, but also of outward FDI as a strategy – using banks awash with funds to make mergers and acquisitions and perhaps green-field investments in core economies; this helps to shift thinking out of the centre–periphery mindset where the periphery thinks its salvation lies in obtaining resources from the centre. Again, Taiwan and other East Asian cases show how the government can help to orchestrate these outward investments in line with national interest. The more difficult task is not the policies themselves, but designing an industrial policy bureaucracy – even if not the larger developmental state, as above – which is motivated to achieve its intended objectives. But relatively meritocratic agencies like Taiwan’s Industrial Development Bureau should not be beyond the wit of many developing country states to create and empower to do the same sorts of tasks as Taiwan’s. In the end, the main obstacle to success lies – as Weiss and Thurbon suggest – at the level of the norms: the legitimacy of efforts by public agencies to change the composition of economic activity. Taiwan’s Industrial Development Bureau has the Goethe quote referred to earlier. The prevailing


norm in the ‘international development community’ and in the transnational community of economists, on the other hand, is captured in the remark of Sir Terence Burns, chief economic adviser during the Thatcher years, ‘If we can’t make money by manufacturing things, we’d better think of something else to do’, or the remark of Herbert Stein, Chairman of the Council of Economic Advisers during the Reagan years, ‘If the most efficient way for the U.S. to get steel is to produce tapes of “Dallas” and sell them to the Japanese, then producing tapes of “Dallas” is our basic industry.’26 Burns and Stein reflect the assumption that the competitive model is a reasonable approximation to the real world; the Goethe quote, as operationalized in Taiwan, reflects the assumption that the real world is better understood in terms of oligopolistic markets, where governing the market has potentially big payoffs. Developing country economists and policymakers believe Burns and Stein at peril to their economies’ catch-up with the West.

Notes 1. R.H. Wade, ‘What Strategies are Viable for Developing Countries Today? The WTO and the Shrinking of Development Space’, Review of International Political Economy, 10(4) (2003), 621–44. 2. See J. Williamson, ‘The Washington Consensus and Beyond’, Economic and Political Weekly (Bombay), 12 April 2003; and Luiz Carlos Bresser-Pereira and Yoshiaki Nakano, ‘Economic Growth with Foreign Savings?’, paper presented to the Seventh International Post Keynesian Workshop, ‘Fighting Recession in a Globalized World: Problems of Developed and Developing Countries’, Kansas City, Missouri, 28 June–5 July 2002, www.bresserpereira.org.br/. 3. Bresser-Pereira and Nakano, above. 4. Kenneth Rogoff, 2002, quoted in Bresser-Pereira and Nakano, above. 5. With the qualification that they backed off open pressure for further liberalization of the capital account. But as of the early 2000s and the George W. Bush administration, the US Treasury has been resuming the push for developing country governments to open the capital account, if less overtly than before. For example, all the free trade area agreements require the other side to open the capital account. 6. World Bank, Private Capital Flows to Developing Countries: the Road to Financial Integration (Washington DC: The World Bank, 1997), p. 59. 7. H. Pack, ‘Industrial Policy: Elixir or Poison?’, World Bank Research Observer, 15 (2000), p. 1, emphasis added. 8. See Wade, Governing the Market: Economic Theory and the Role of Government in East Asian Industrialization (Princeton, NJ: Princeton University Press, 2004 [1990]) chapters 1 and 11. 9. D. Rodrik, The Global Economy and Developing Countries: Making Openness Work, (Washington DC: Overseas Development Council, 1999) p. 63. The argument applies only to capitalist economies. 10. World Bank, World Development Report 1999/2000, Entering the 21st Century (Washington DC: The World Bank, 2000), figure 9. 11. World Bank, The East Asian Miracle (Washington DC: The World Bank, 1993). 12. A. Fishlow et al., Miracle or Design? Lessons from the East Asian Experience (Washington DC: Overseas Development Council, 1994).

Escaping the Squeeze: Lessons from East Asia 213 13. Quoted in D. Ellerman, Helping People Help Themselves (Ann Arbor: University of Michigan Press: 2004), p. 151. 14. I am indebted to an important paper by Justin Barnes, Raphael Kaplinsky and Mike Morris, ‘Industrial Policy in Developing Economies: Developing Dynamic Comparative Advantage in the South African Auto Sector’, Competition and Change, 8(2) (2004), 153–72. 15. Wade, Governing the Market, p. 285. 16. L. Weiss and E. Thurbon, ‘ “Where There’s a Will There’s a Way”: Governing the Market in Times of Uncertainty’, Issues and Studies, 40(1) (March 2004), 61–72, at p. 63. This same issue has several other papers by political scientists and economists about governing the market. 17. On the organizational structure of the developmental state (with specific reference to Korea) see Vivek Chibber, Locked in Place (Princeton, NJ: Princeton University Press, 2003). 18. A. Amsden and Wan-wen Chu, Beyond Late Development: Taiwan’s Upgrading Policies (Cambridge, MA: MIT Press, 2003). 19. Weiss and Thurbon (2004), above. 20. This account of Korea’s telecommunication strategy is based on information in Whasun Jho, ‘Liberalisation as a Development Strategy: New Governance in the Korean Mobile Telecom Market’, Working Paper, Institute of Social Science, Yonsei University, Seoul, 2004. 21. Also in 1993 the government began to privatize the other public telecom company, Korea Telecom, but slowly. By 2002 it had sold 57 per cent of shares of KT stock to the public, including foreigners. 22. A. Fifield, ‘S. Korea’s Business Giants Seek to Repel Invasion Force’, Financial Times, 24 November 2004. 23. T. Moran, ‘Strategic Trade Theory and the Use of Performance Requirements to Negotiate with Multinational Corporations in the Third World’, typescript, Georgetown University, October 1991. 24. Barnes et al. (2004), above. 25. P. Toner, Main Currents in Cumulative Causation (London: Palgrave, 1999). 26. Cited in R. Wade, ‘East Asia’s Economic Success: Conflicting Perspectives, Partial Insights, Shaky Evidence’, World Politics, 44 (January 1992), 270–320.

15

The Third World’s Debt Problem Kunibert Raffer

Introduction John Kenneth Galbraith discussed the Third World’s debt problem well before the ‘official start’ of the sovereign debt crisis in 1982. In a paper published by the German Federal Ministry of Cooperation in 1979 and reprinted in the annex of the German edition of his book The Nature of Mass Poverty (Galbraith, 1980, pp. 140ff.) he described Third World demands for debt relief and for a new framework to resolve debt issues with a great deal of sympathy. He emphasized in particular the strong Third World focus on reforms of debtor–creditor relations, such as an appropriate role in debt rescheduling or an international commission on debts. Galbraith recognized that a solution was necessary irrespective of the reasons for the debt burden. Very much a political mind, he put his finger on the main problem: reforms of debt management would be particularly difficult to accept for developed countries. Compromise on changing debtor–creditor relations should not be expected soon. Unfortunately this conclusion remains valid although some small movements in the right direction could be observed since then. This chapter fully shares Galbraith’s (1990) conclusions: meaningful debt reduction is inevitable, ‘lending those countries money with which to pay interest’ means only ‘postponing the day of reckoning’, and decent living standards and democratic government must be protected. It presents a fair and efficient procedure towards these goals, enabling sovereign debtors to participate appropriately in solving the debt problem which has stifled development and resulted in catastrophes in many developing countries. My proposal would alter creditor–debtor relations by finally introducing the rule of law, economic sense and the protection of fundamental human rights into the field of sovereign debts. Sketching the evolution of the debt problem since the 1950s and showing why ‘debt management’ has not worked it compares the proposals on the table at the moment. Finally, this chapter advocates the internationalization of the basic elements of US municipal insolvency. 214

The Third World’s Debt Problem

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Building up the debt fiasco The debt problem existed well before 1982. Structural disequilibria were identified as its root by the Pearson Report (Pearson et al., 1969), prepared at the request of the President of the International Bank for Reconstruction and Development (IBRD). They are the consequence of structural inequalities in the global economy that put the Third World at a disadvantage. The structural resource gaps to which the Prebisch–Singer thesis had drawn attention by showing evidence for secularly falling terms of trade are one important illustration. The debt problem may thus be seen as the result of temporarily covering up unequal and disadvantageous economic relations by sovereign borrowing. The Pearson Report considered the problem so urgent – even in 1969 – that it suggested debt reduction measures. It criticized debt management for emphasizing spending cuts and credit restrictions while neglecting the need to sustain sound development outlays, and warned of serious difficulties that could result from very large-scale lending. All this sounds like criticism of present debt management. Instead of remedies, large scale Euromarket lending took off at the very time that the Report was published. This new wave of private lending covered up the already recognized problem created by public creditors. Problematic facts such as the first adjustment measures during the mid-1970s or warning voices raised throughout the 1970s – including Galbraith’s – were simply ignored (compare, Raffer and Singer, 2001, pp. 163ff.). The crash of syndicated bank lending in the early 1980s triggered a shift towards multilateral lending. The Bretton Woods Institutions (BWIs) seized this opportunity to establish themselves as debt managers by pouring money into Southern debtors. Well before 1982 they had started ‘structural adjustment’. The IMF, established in 1944 to provide unconditional emergency resources, not to finance any programmes with conditions attached, was first. Obviously without economic raison d’être after the demise of the Bretton Woods system it tried to justify its further existence by carving out a new role. The IBRD increased programme lending in violation of its own Articles of Agreement (compare, Article III.4.vii.b). So did the International Development Association (IDA) (compare, Article V.1.b). International financial institutions (IFIs) were not meant to engage strongly in programme lending or to intervene in member’s economies – rightly so, as their record proves. Obeying their own constitutions, however, would not have allowed them to gain the importance they presently enjoy. In the early 1990s a new group of creditors was ushered in: private bondholders, who had been the main lenders to Southern sovereigns before 1940. Euphoric statements by multilateral institutions and the OECD and regulatory changes opened the door. Bringing in the public at large (including pension funds) has allowed ‘old’ creditors (including IFIs) to receive more


repayments than otherwise possible. Debts have kept growing but their structure has changed perceptibly. Argentina and Brazil are cases in point. ‘Debt management’ by public creditors under BWI leadership has been unable to solve this problem for decades. These waves of lending by different creditor groups are an international Ponzi scheme supported and driven by multilateral institutions and OECD governments (compare, Raffer, 2004a). Finally, no new group of creditors remains to whom substantial parts of debts can be shifted. The game of financial musical chairs is over – losses must finally be faced. Postponing the day of reckoning BWI debt management has prolonged suffering and increased the damage done to Southern economies. Official interventions also increased volatility. The risk weight given by the Basle Committee to short-run flows to banks outside the OECD region encouraged and fuelled short-term lending just before the Asian crisis. In spite of at least one official document warning of the high risks of quick capital account liberalization IFIs egged Asian countries on, right into the crisis of 1997 (Raffer and Singer, 2001, p. 151). Soon after 1982, internationalizing corporate insolvency procedures (Chapter 11, Title 11 of the US Code) was proposed as a means to solve the debt problem quickly and efficiently. At that time most creditors, especially the BWIs, defended the so-called illiquidity theory: debtors would ‘grow out of debts’. This view, called by Galbraith (1990) ‘financial flim-flam’, justified inactivity: nothing needed to be done. Reality was admitted much too slowly and still remains to be faced fully. After years, the ‘Toronto Terms’ and the Miyazawa-Brady Initiative eventually accepted the impossibility of full repayment. James Wolfensohn is to be commended for introducing the first Highly Indebted Poor Countries (HIPC) Initiative in 1996, which broke the last taboo, reducing multilateral debts, once the manifest need to do so could no longer be denied. Its second version, HIPC II (1999), remained as unsuccessful as the first. Because of absolute creditor domination this was to be expected: too little was given too late. The problem has been prolonged instead of solved. Calls were made for another improved HIPC Initiative (see, for example, Zedillo et al., 2001), HIPC III. By proposing its Sovereign Debt Restructuring Mechanism (SDRM) for middle-income countries (Krueger, 2001) the IMF admitted reality at last, immediately trying to profit institutionally from the debacle it had created through its own and other IFIs’ debt strategies. Suddenly turning around, the IMF advocated just what it had fiercely opposed over many years. After decades the fiction of total repayment is definitely gone. The only remaining question is how to distribute losses. Apparently, the SDRM is an attempt to protect the IMF’s own claims and to gain institutional advantages (compare, Raffer, 2002; forthcoming). A reform of debt renegotiation that J.K. Galbraith would be likely to approve remains to be supported by important creditors. ‘Debt management’ so far has been based on total control and


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domination by public creditors. Unlike in all other cases of insolvent debtors, developing countries are still denied any debtor protection or debtor rights. At present one law for the rich and another law for the poor have been established – very much as under France’s ancien régime where the legal standing of the privileged differed from that of the Third Estate. In contrast to Galbraith (1952, p. 175), who made a theoretical case for government intervention where ‘countervailing power is not fully operative’, OECD governments and the BWIs rigged the market further by precluding the evolution of any ‘countervailing power’ the enormous debt pressure might well have triggered. Financing bailouts they signalled that sovereign lending carried no risk, thus oiling the Ponzi scheme’s wheels and abolishing normal, healthy market risk. This in turn lead to a misallocation of resources: the South got more than it would have received under market incentives – with obvious, problematic results. The history of sovereign debts shows that market solutions usually prevailed before multilateral ‘debt management’. The lack of a proper mechanism proved a certain hindrance to quick and efficient solutions, but creditors and debtors eventually agreed on large debt reductions. More slowly and less efficiently than insolvency mechanisms would have done, insolvency solutions were de facto achieved. Knowing that not all loans will be repaid fully, private creditors have always accepted losses once they were sure of a debt overhang. This lending risk is routinely incorporated into spreads. In the case of insolvent debtors private creditors would have to finance any costs of further debt management themselves and à fonds perdus. Therefore they have a strong economic interest in a quick and acceptable solution unless someone bails them out. Sometimes – most notably in the case of Germany – insolvency mechanisms were emulated. Interestingly Germany, whose creditors, including developing countries, granted substantial debt relief in 1953, put up extremely fierce opposition to less generous debt relief for Third World debtors after 1982, arguing that creditor rights must be respected. Public interventions, most notably BWI debt management, tilted debt relations against the market and debtors. Unlike before WWII private creditors were offered bailouts after 1982. As any economic textbook would predict, they accepted. The whole debt conundrum might already be overcome if public creditors had not chosen to interfere with the market in an antiGalbraithian way. In the aggregate, losses necessary to achieve sustainability would have been lower for creditors. Unwilling to acknowledge insolvency and to grant early reductions, the BWIs boosted nominal debts to ever more unrealistic heights, increasing the share of phantom debts, uncollectible claims without any real economic base that exist only on paper. By including phantom debts in official estimates the BWIs boost the ‘costs’ of debt relief, providing economically erroneous arguments against meaningful reductions. This hides the fact that real costs – which means money that would be really lost as it could actually be collected from debtors totally at the mercy


of their creditors – are much lower. Economically, one cannot lose money one cannot get anyway. Changes in creditor structures, though, brought about quite noteworthy redistributional effects between creditor groups, exacerbated by the fact that IFIs were able to secure an unjustified privileged status.

Political and institutional interests vs economic efficiency While private creditors are in the end interested in profits not in political pay-offs, the interests of public creditors are more complex. Traditional debt management did not solve the debt problem, but it has changed North–South relations fundamentally. It provided long-term political leverage to the North, subjected debtors to strict control, and served to enforce neo-liberal policies and further globalization. The economic sense behind a solution ‘through concessional interest rates and a repayment period of 125 years, including 65 years of grace’ (IBRD, 2000, p. 171) or a ‘ “bullet” option’ with an interest rate of 0.0001 per cent (the IBRD does not dare write over how many years) remains unclear at best. Rodrik’s (1996) explanation of the debt crisis used as an opportunity to enforce policy changes seems more convincing. Although they should know better, all IFIs wrongly claim to be ‘preferred creditors’. Legally and pursuant to their own statutes they have no such status. The IMF could not deny that it enjoyed no legal or contractual status as a preferred creditor (Boughton, 2001, p. 820). Its own executive directors emphasized a need to treat the IMF ‘in practice’ preferentially – a legally irrelevant view to which they were, of course, entitled. The Interim Committee endorsed this view and ‘urged all members, within the limits of their laws, to treat the Fund as a preferred creditor’ (ibid., p. 821; emphasis added). Pressurized by external auditors, the IMF started to provide for nonpayment by building up loan loss provisions after its 1986 audit. Of course, the IMF prefers not to use this term, presumably because that might lead people to conclude that the IMF thinks losses unavoidable, preferring fancy wording such as SCA-1 (Special Contingent Account). The IMF’s surcharge in order to provide against loan losses was 0.1 per cent on average in fiscal year 2003 (IMF, 2003). Its ‘precautionary balances’ were about 8.5 per cent of credit outstanding, as of the end of October 2003 (IMF, 2004, p. 26). The IMF had decided to increase them further by two-thirds. All other IFIs have much higher precautionary balances, ranging from slightly more than 20 per cent (IBRD) to over 30 per cent (Asian Development Bank) of credit outstanding. While charging members the costs of defaults, all IFIs refuse to use this money for its intended purpose. This resembles insurance companies charging necessary fees but refusing to cover damages. Unlike IFIs, no insurance company would get away with such behaviour.


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The statutes of all multilateral development banks foresee procedures in the case of debt overhangs. All have built up loan loss provisions as demanded by their statutes, but refuse to use them as intended and needed. While the IMF has no statutory obligation to grant debt relief – but is not prohibited from doing so either – multilateral development banks violate their own constitutions by not giving members in distress relief as stipulated. Contrary to their founders’ intentions the IBRD has refused to use relief mechanisms, wrongly claiming that doing so would make development finance inoperational. This is clearly false. As the IBRD is only allowed to lend to governments or with government guarantees sovereign default was obviously considered a possible if not necessary way out by its founders. The European Bank for Reconstruction and Development writes off losses and submits to arbitration (also foreseen for the IBRD), which proves that multilateral development banks, if properly managed, can survive financial accountability and market risk. Economically, IFI behaviour can be explained easily. Obeying one’s own constitution by recognizing losses and using one’s loan loss reserves for the purpose for which they have been created would mean losing money and probably losing influence by defusing further crises one could again manage. Violating one’s statutes means further crisis management, additional income and importance, and new jobs. Creditor countries have repeatedly proved their eagerness to reward this behaviour, egging IFIs on. BWI debt management has always tried to establish and reinforce preferential treatment of IFIs. Both HIPC initiatives preserve IFI privileges by shifting the burden of losses as much as possible on to other creditors, expecting them to accept higher losses and asking bilateral creditors to fund most of the reductions ‘granted’ by IFIs. Nevertheless, HIPC I met fierce resistance both within Wolfensohn’s own institution and from the IMF. The economic results of HIPC are as one could expect from a creditor dominated process: Highly Insufficient Payment Cuts. Although both HIPC initiatives already contained trace elements of the idea of insolvency – anti-poverty measures under HIPC II in particular – they suffered from arbitrarily set definitions (compare, Raffer and Singer, 2001, pp. 192ff.). Targeting ‘emerging markets’ the IMF’s SDRM carries the logic of institutional self-interest further. It attempts to obtain de jure preferred status for IFIs in an extremely self-serving way. It would protect the IMF (and other IFIs) from losses by legally privileging multilateral claims at the expense of both private creditors and debtors. Characterized by strong institutional selfinterest the SDRM would firmly and officially install the IMF as the overlord of sovereign debt relief. The IMF’s Executive Board would determine the country’s policies and decree debt sustainability. Sustainability would automatically determine necessary debt reductions. This is not encouraging, as estimating debt sustainability highlights the inefficiency of IFI programmes with utmost clarity. For decades, overly


optimistic forecasts have inflicted damage on member countries, rendering strategies based on such forecasts, especially debt reductions, useless. The IMF and IDA (2004, p. 13) themselves admitted: past experience suggesting a systematic tendency toward excessive optimism … a common theme behind the historical rise in low-income countries’ debt ratios was that borrowing decisions were predicated on growth projections that never materialized … analysis of projections made by Fund staff over the period 1990–2001 suggests a bias toward over-optimism of about 1 percentage point a year in forecasts of lowincome country real GDP growth. The bias in projecting GDP growth in U.S. dollar terms, however, was considerably larger, at almost 5 percentage points a year. There is doubtlessly a ‘need for well-disciplined projections, including by laying bare the assumptions on which they are predicated and by subjecting them to rigorous stress tests that explicitly incorporate the impact of exogenous shocks’ (ibid.). For some three decades the BWIs have consistently made undisciplined projections whose assumptions were not explained and that failed to take a country’s vulnerability to exogenous shocks properly into account. Any normal client could successfully sue such consultants and get financial compensation. By contrast, those affected by IFI negligence, including many of the world’s poorest people, must shut up, pay up, and suffer. IFIs themsleves draw additional income from new programmes originating from the failure of previous programmes based on over-optimistic IFI estimates. Creating debacles is economically rewarded. Solving crises with the first programme results in less income and less influence. IFIs, especially the BWIs, established themselves as administrators of debtor countries. Although forcing decisions on countries they have been able to avoid any financial accountability for their actions. The normal market mechanism of connecting decisions and risks was abolished. This resulted in an economically perverted incentive system. A failed project may trigger a new loan to repair damages done by the first loan. Failed adjustment programmes call for new adjustment programmes. Lending more than if crises had been defused efficiently IFIs earn more income. Errors and negligently caused damage increase their importance: ‘IFI-flops create IFI-jobs’ (Raffer, 1993, p. 158; compare also 2004b). Minds more critical than mine might even argue that there exists an institutional interest in crises, which may explain the record of IFIs. Legally privileging IFI claims would enshrine present perverted incentive mechanisms with devastating economic effects. Market incentives must finally be brought to bear on the last surviving centrally planned economies. Under the SDRM the IMF, both a creditor in its own right and controlled by a creditor voting majority, would continue to call the shots. All this should


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be enshrined in the IMF’s Articles of Agreement. This statutory approach would further reinforce the IMF’s position. Its complicated nature is likely to prove a major hindrance for solutions and a big employment programme for the IMF. The SDRM proposal is a prime example of rent-seeking (Krueger, 1974) and the welfare costs it may cause: resources are devoted to competing for the position of head debt manager and the benefits, financial and others, that go with it. The BWIs admit that delaying sustainable solutions has created enormous damages in the South. In 1992, when the end of the debt crisis was proclaimed and one could argue that insolvency relief was no longer necessary, the IBRD (1992, pp. 10ff.; emphasis in original) itself lectured that insolvency was the problem: ‘In a solvency crisis, early recognition of solvency as the root cause and the need for a final settlement are important for minimizing the damage … protracted renegotiations and uncertainty damaged economic activity in debtor countries for several years.’ By simply refusing to acknowledge default, even when countries had not paid anything for six or seven years (Caufield, 1998, p. 319) the IBRD has inflicted damages in violation of its own statutes requesting debt relief when necessary. Speaking for the IMF, Krueger (2001) clearly acknowledged damage caused by countries ‘waiting too long’ to opt for insolvency procedures. It was conveniently forgotten that the BWIs themselves forced debtors to ‘wait’. They had ardently lobbied against debt reductions, arguing that countries would grow out of debts, repeatedly supporting this claim with highly optimistic forecasts of future export earnings. Some three decades of debt management by public creditors have not solved but prolonged the problem. Economically this is inefficient. However, institutional self-interest and political influence – which one hopes, of course, to have been irrelevant – offer a good explanation. Developing countries are the only debtors fully and absolutely at the mercy of their (public) creditors. Unlike in all other cases there exist no debtor protection mechanisms. Their people remain totally unprotected against austerity policies enforced to extract more repayment at severe cost to vulnerable groups. Over decades public creditors have forced Southern debtors to make sacrifices ‘which would not be acceptable in Canada and the United States’ (Galbraith, 1990). Even during the era of debt slavery creditors were not allowed simply to grab and enslave insolvent debtors. The decision of a court was needed. Sovereign debtors and their people do not even enjoy this flimsy legal protection nowadays. Creditors themselves decide how to proceed.

Internationalizing Chapter 9: a fair and efficient solution All domestic legal systems have introduced insolvency as the only economically efficient and fair solution to debt. Its record and the fact that no one wants to abolish it prove that it has increased market efficiency. This strongly


suggests emulating national insolvency procedures for sovereign debtors, a process that had already been advised as the best solution by Adam Smith. Soon after 1982 it was repeatedly proposed to use the principles of corporate insolvency in order to solve the debt overhang of sovereign states (compare Raffer, 2001). The self-evident fact that the issue of sovereignty is not dealt with by corporate insolvency was used as a powerful argument against this first generation of proposals, especially by employees of multinational financial institutions. Nevertheless Krueger’s (2001) ‘new approach’ proposed to adapt Chapter 11 – as corporate insolvency is called in the US – which should raise questions regarding the intention to deal with sovereigns appropriately. Once the IMF had presented the SDRM, many opponents of sovereign insolvency, especially IMF staff, forgot their earlier grave reservations. As though touched by Harry Potter’s wand, ‘arguments’ used to assert that the principles of insolvency could not be applied to sovereign debtors disappeared. The proposal to adapt Chapter 9, Title 11 (municipal insolvency) as the appropriate model was made in 1987 (Raffer, 1989) to counter the legalistically correct point that corporate bankruptcy (Chapter 11) cannot be applied to sovereign states. The special features of public/sovereign debtors need to be taken into account. Designed to solve the problems of governmental entities, Chapter 9 is easily adaptable to sovereign debtors. Naturally, only the fundamental principles of Chapter 9 should form the basis of arbitration proceedings; some important and necessary domestic details are unnecessary and inapplicable internationally. Eligibility and authorization to be a Chapter 9 debtor – fundamental and useful as they are within the US for constitutional reasons – are examples. My international Chapter 9 – also called Fair, Transparent Arbitration Process (FTAP) by some NGOs – is described in detail elsewhere (for example, Raffer, 1990). So are its fundamental differences to and few similarities with the SDRM (Raffer, 2002, 2003, forthcoming). This chapter presents its main elements, focusing on the important changes in debtor–creditor relations it would bring about. Respecting the rule of law It is the very foundation of the rule of law that one must not be judge in one’s own cause. Internationally, creditors have been judge, jury, expert, bailiff, even the debtor’s lawyer all in one, mocking the very concept of the rule of law. This concept must finally be respected in the case of developing countries and their peoples. Procedures must be chaired by neutral entities. While an institutionalized neutral entity would be technically feasible, ad hoc entities are preferable. Assuming that new cases will be rare once the present backlog of problems has been dealt with, any standing institution would be severely underemployed. Also, arbitration panels established by creditors and the debtor for each case might be more acceptable as they give parties more say. Following traditional practice in international law each


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side – creditors and the debtor – would nominate one or two persons, who in turn would elect a third or fifth person. My panel differs fundamentally from the IMF’s proposed ‘Forum’ (under HIPC there is not even any comparable entity). A perfectly neutral and disinterested entity, it would not be an IMF body without authority to challenge the IMF’s Executive Board’s decisions. Sustainability would not be determined by the IMF but would emerge from the transparent negotiation process between creditors, the debtor and representatives of the affected population. Arbitrators would have the task of mediating between debtors and creditors, chairing and supporting negotiations by advice, providing adequate opportunities to be heard for those affected by the plan, and – if necessary – taking decisions. As facts would be presented by both parties and the representatives of the population in a transparent procedure, decisions would be unlikely to involve substantial sums of money but would rather resolve deadlocks. Agreements between debtor and creditors would need the panel’s confirmation, in analogy to Section 943, Chapter 9. Panels would have to take particular care that fairness and a minimum of human dignity of the poor is safeguarded – in analogy to the protection enjoyed by a municipality’s inhabitants or, in fact, any debtor in civilized legal systems. The concept of human rights which demands debtor protection would finally be extended to the South. This panel could be established more quickly than by following the clumsy procedure proposed by the IMF. No institution would remain, looking for new tasks to justify its further existence once the debt problem has been solved. Unlike the SDRM or HIPC my Chapter 9 solution would be available to any insolvent country. It is based on objective criteria not on creditors’ perceptions. Filing for insolvency protection would trigger a stay. Immediately following its formation the panel must endorse or reject this stay. It has to reject the debtor’s demand if unfounded; denying the debtor any advantage from starting the procedure. It should verify claims, as is routine in any domestic case. This proposal (Raffer, 1990, p. 309) – initially classified as impracticable and utopian by IMF staff – has meanwhile become part of Krueger’s ‘new approach’ (IMF, 2002, p. 68). This gives hope that absolutely basic legal principles, such as checking whether someone signing a loan contract actually had the authority to do so on behalf of the debtor might soon be applied to Southern countries as well. Respecting sovereignty Chapter 9 is the only procedure protecting governmental authorities, thus making it applicable to sovereign entities. In the US the court’s jurisdiction depends on the municipality’s volition, beyond which it cannot be extended, in the same way as the jurisdiction of international arbitrators. Municipalities cannot go into receivership. Their ‘management’ – elected


officials – cannot be removed from office by courts or creditors (only, of course, by the electorate). The concept of sovereignty does not contain anything more than what Section 904 protects in the case of US municipalities. Furthermore, a public interest in keeping the debtor functioning exists. This makes Chapter 9 especially suited for sovereign cases. Protecting debtors and democracy Debtors – unless they are developing countries – cannot be forced to starve their children in order to be able to pay more. Human rights and human dignity enjoy unconditional priority, even though insolvency only deals with claims based on solid and proper legal foundations. A US municipality must be allowed to go on functioning and to provide essential services to its inhabitants. Resources necessary to assure this are exempt. This principle must also be applied to sovereign countries. Resources necessary to finance minimum standards of basic health, primary education and so on must be exempt. Private creditors have always been aware that some money simply could not be collected, for what they often call ‘political’ reasons, which is another way of describing this exemption. Anti-poverty measures under HIPC II have, finally, recognized this principle – at least verbally. The SDRM, by contrast, falls below this minimum standard, making no mention of any kind of debtor protection. Exempting resources necessary to finance minimum standards of basic health services, primary education and so on can only be justified if that money is demonstrably used for its declared purpose. Not without reason creditors, NGOs, and people from debtor countries are concerned that this might not always be assured. The solution is quite simple – a transparently managed fund financed by the debtor in domestic currency. The money going into that fund would not be phantom debts but money that could actually be recouped if no debtor protection existed, as is presently the case. The management of this fund could be monitored by an international board or advisory council consisting of members from the debtor country as well as from creditor countries. They could be nominated by NGOs and by governments (including the debtor government). As this fund is a legal entity of its own, checks and discussions of its projects would not concern the government’s budget, which is an important part of a country’s sovereignty. Aid could also be channelled through the fund, changing its character from money just set apart from the ordinary budget towards a normal fund for the poor. Participation of the municipality’s inhabitants is guaranteed in two ways: 1. The affected population has a right to be heard. 2. If electoral approval is necessary under non-bankruptcy law in order to carry out provisions of the plan it must be obtained before confirmation of the plan pursuant to §943(b)(6).


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The right of the affected population to be heard would have to be exercised by representation in the case of countries, as is part and parcel of international Chapter 9. Affected people would have the right to defend their interests, to present estimates and arguments, to show why or whether certain basic services are necessary. The openness and transparency usual within the US would become the norm of sovereign insolvency. In short, I propose to apply the same legal and economic standards to all debtors, to grant equal treatment of indebted people everywhere. Further participation by parliaments or the electorate could easily be integrated. The debtor government can choose to leave the task of nominating panel members either to the parliament or the people. Voters could, for example, elect arbitrators from a roster. Anyone reaching a minimum of supporting signatures by voters would have to be on this roster. One arbitrator might be chosen by parliament, the other by voters. The parliament might establish a special committee for this purpose including members of the cabinet, as proposed in a bill drafted on the initiative of Congressman Mario Cafiero by the Argentine opposition party ARI. This bill would establish a Comisión Representativa del Estado Nacional. Consisting of members from both houses and the executive power, it would nominate panel members and represent Argentina during the proceedings. In contrast to all initiatives so far, including the SDRM and HIPC, Chapter 9 would install open, transparent procedures befitting public entities and democratic states. Democratic values and governance would be duly protected. As in creditor countries themselves, legal and constitutional norms would not be overruled by creditor diktat. Fairness to everyone Precisely like the US insolvency laws which demand that solutions also be in the best interest of creditors my model is absolutely fair to creditors. The moral aspect of fairness apart, this is economically necessary. Only a fair procedure will be accepted by creditors and rightly so. A fair solution will allow former debtors new access to capital markets. Fair to the debtor and the debtor country’s population it would implement civilized debtor protection. Fairness to creditors demands equal treatment of all creditors as proposed above. All debts at the time of filing for Chapter 9 must be included, private, bilateral and multilateral. For obvious economic reasons there would be no cut-off date as practised over decades by the Paris Club. This cut-off date is when the debtor first asked the Paris Club for debt relief, which could be the early 1980s. With an early enough cut-off date 100 per cent ‘debt forgiveness’ may mean a reduction of less than 1 per cent of total debts. Eventually debt relief converges to zero, while percentages ‘forgiven’ converge to 100–100 per cent Paris Club ‘debt relief’ without a single cent actually granted. Another doubtful practice of the Paris Club would become obsolete. Non-Paris Club creditors are not allowed to participate in deciding debt


reductions but are expected to grant the same relief as Paris Club members. The weakest actor, the debtor country, is obliged to assure comparable treatment to creditors excluded from decision-making. Although Paris Club creditors demand that their debtors should not treat other creditors better – a basic tenet of insolvency, by the way – they refuse their debtors any legal protection against lawsuits by unwilling non-Paris Club creditors. Debtors have been taken to court in Paris Club member countries and been declared in breach of contract. Formally quite correctly so, because creditor governments have passed no law protecting bona fide debtors doing what the Paris Club forces them to do. This is hard to reconcile with the aim of solving the debt problem. As all creditors would have the right to participate in an international Chapter 9 this exclusion of some creditors could not happen. Furthermore, a slight change in sovereign immunity laws of the few relevant jurisdictions chosen by most loan contracts would suffice to solve the problem of disruptive litigation (Raffer, forthcoming). Debt reduction must be uniform, the same percentage must be deducted from all debts. So far, all approaches – especially HIPC and the SDRM – have made important distinctions between the private sector, bilateral loans and IFIs. While private creditors granting debt reductions have felt the sting of the market mechanism, IFIs increase their exposure, knowing that their claims are politically protected. This raises the question of whether an objective reason exists for their preferential treatment. Considering all arguments the answer is no. The understandable self-interest of any creditor apart, there is no reason why they should get a better deal. Multilateral lenders argue that they charge interest below the debtor’s market rate. Even for normal IFI lending, which is too tough to qualify as Official Development Assistance, this is generally (but not always) an objective difference between IFIs and the private sector. There is, however, another objective difference: commercial banks did lend aggressively but have usually not interfered with their clients’ economic policy, while multilaterals have strongly influenced the use of loans and exerted massive influence on debtor economies. IFIs take economic decisions but refuse to participate in the risks involved. They insist on full repayment, even if damages negligently caused by their staffs occur, which have to be paid by the borrower, as discussed above. To increase IFI efficiency and to improve their role in capital markets, market incentives must be brought to bear. The international public sector must become financially accountable for its own errors in the same way that consultants are liable to pay compensation for damages caused by negligence on their part, or OECD governments are liable for damages by negligence or the violation of laws. By contrast, the IMF has been allowed and encouraged to violate its own statutes with impunity (compare Raffer, 2004b). Finally, the present privileged position of international public creditors discriminates unfairly against private creditors suffering avoidable losses because of IFI privileges when countries are unable to service


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their debts. This urgently calls for mechanisms to correct present inefficiencies. Considering the trend towards unfair discrimination against private creditors an international Chapter 9 would also be very much in the economic interest of the private sector. As it is practically impossible to determine the fair share of one or more IFIs in failed programmes, Chapter 9 provides a clear and simple solution, finally ‘bailing-in’ the public sector, making IFIs pay for avoidable errors and shortcomings. Symmetrical treatment in an insolvency could be the way that the BWIs are held financially accountable. While the importance of decisions by official creditors may vary, their impacts have always been particularly strong in the poorest countries. Lack of local expertise in participating appropriately in decision-making and high dependence on aid are the reasons. This is fundamentally different to private creditors who usually limit themselves to lending without any additional consulting activities. The present practice of letting ‘recipients’ pay for failures, errors or negligence by their creditors-cum-consultants is particularly unjustified for countries with high IFI involvement, which have been forced to orient their policies according to IFI ‘advice’ for quite some time. As the shares of multilateral debts are relatively higher in the poorest countries, protecting IFIs from losses is done at the expense of particularly poor clients, often highly dependent on solutions elaborated by IFI staff, as well as at the expense of other creditors. Although an improvement, symmetrical treatment is not yet a satisfactory solution because the perverted incentive system of rewarding negligence would largely continue to function, in particular with regard to projects. Therefore financial accountability must go further. The right of the victims of development finance to compensation for damages must be established. ‘Advising’ IFIs must become liable to pay damage compensation for negligent or irresponsible behaviour as private consultants have always been under tort and liability laws. This important issue is treated elsewhere (Raffer, 1993, 2004b). The effect of financial accountability on Third World debts would be remarkably lower multilateral debt burdens.

Conclusion After decades the need for debt reduction is finally accepted. But creditors – especially public creditors – remain unwilling to apply what they have been teaching to their debtors over many years: respect for the rule of law and human rights. They prefer to continue using Third World debts as a mechanism to preserve political leverage and – in the case of IFIs – to establish themselves as administrators of the Third World although this has had substantial negative effects on vulnerable groups as well as debtor economies. To some extent laudable moves in the right direction, both the HIPC and the SDRM also increase the dependence of debtors and enhance the importance of IFIs as official receivers. Nationally no longer acceptable, this debt-prison


model must be abolished internationally. Another model of treating a debt overhang is needed to level the playing field between debtors and creditors, as Galbraithian government interventions would do. It must assure equal treatment of all debtors irrespective of passport or colour. A sovereign Chapter 9 would also stabilize the international financial architecture because the perception that creditors or speculators would always be bailed out in the Third World would be gone. This market imperfection in international credit markets would be repaired. Technically, my proposal can be implemented at once. It uses existing concepts and mechanisms, such as arbitration or domestic US Chapter 9. Politically much remains to be done. Differing sharply from present creditordominated procedures, this fair and transparent process, which would give sovereign debtors the rights all other debtors have, is not yet acceptable to OECD countries. Until this changes it is better to live on the right – and mostly white – side of the North–South divide.

References J.M. Boughton, Silent Revolution: the International Monetary Fund 1979–1989 (Washington DC: IMF, 2001), http://www.imf.org/external/pubs/ft/history/2001/ ch16.pdf. C. Caufield, Masters of Illusion: the World Bank and the Poverty of Nations (London: Pan, 1998). J.K. Galbraith, American Capitalism. The Concept of Countervailing Power (London: Hamish Hamilton, 1952). J.K. Galbraith, Die Arroganz der Satten (Bern & München: Scherz, 1980). J.K. Galbraith, ‘Interview by John Newark’, Aurora, http://aurora.icaap.org/talks/ galbraith.htm (1990). IBRD, World Debt Tables 1992–93, vol. 1 (Washington DC: IBRD, 1992). IBRD, Global Development Finance 2000, vol. 1 (Washington DC: IBRD, 2000). IMF, ‘The Design of the Sovereign Debt Restructuring Mechanism – Further Considerations’, 27 November 2002. IMF, ‘Executive Board Reviews IMF’s Income Position’, Public Information Notice no. 03/64, 22 May 2003, http://www.imf.org/external/np/sec/pn/2003/pn0364.htm. IMF, ‘Financial Risk in the Fund and the Level of Precautionary Balances’, 3 February 2004, http://www.imf.org/external/np/tre/risk/2004/020304.pdf. IMF and IDA, ‘Debt Sustainability in Low-Income Countries – Proposal for an Operational Framework and Policy Implications’, 3 February 2004, http://www. imf.org/external/np/pdr/sustain/2004/020304.pdf. A. Krueger, ‘The Political Economy of the Rent-seeking Society’, American Economic Review, 64(3) (1974), 291–303. A. Krueger, ‘International Financial Architecture for 2002: a New Approach to Sovereign Debt Restructuring’, 26 November 2001, http://www.imf.org/external/ np/speeches/2001/112601.htm. L.B. Pearson et al., Partners in Development: Report of the Commission on International Development (New York: Praeger, 1969). Raúl Prebisch, ‘El desarrollo económico de la América latina y algunos de sus principales problemas’, El Trimestre Económico, XVI(3) (1949), 447ff. (Engl. version published by UN-ECLA in 1950.)


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K. Raffer, ‘International Debts: a Crisis for Whom?’, in H.W. Singer and S. Sharma (eds), Economic Development and World Debt (Selected papers of a Conference at Zagreb University in 1987) (Basingstoke and London: Macmillan, 1989). K. Raffer, ‘Applying Chapter 9 Insolvency to International Debts: an Economically Efficient Solution with a Human Face’, World Development, 18(2) (1990), 301–13. K. Raffer, ‘International Financial Institutions and Accountability: the Need for Drastic Change’, in S. M. Murshed and Kunibert Raffer (eds), Trade, Transfers and Development, Problems and Prospects for the Twenty-First Century (Aldershot, UK and Brookfield, VT: Edward Elgar, 1993), http://homepage.univie.ac.at/Kunibert.Raffer. Kunibert Raffer, ‘Solving Sovereign Debt Overhang by Internationalising Chapter 9 Procedures’, Working paper 35 (Österreichisches Institut für Internationale Politik (ÖIIP), Vienna, 2001), http://homepage.univie.ac.at/Kunibert.Raffer/net.html. K. Raffer, ‘The Final Demise of Unfair Debtor Discrimination? Comments on Ms Krueger’s Speeches’, paper prepared for the G-24 Liaison Office to be distributed to the IMF’s Executive Directors representing Developing Countries, 31 January 2002, http://homepage.univie.ac.at/Kunibert.Raffer. K. Raffer, ‘The Present State of the Discussion on Restructuring Sovereign Debts: Which Specific Sovereign Insolvency Procedure?’, paper presented at the Fourth Interregional Debt Management Conference, DMFAS, UNCTAD, Geneva, 11 November 2003, http://r0.unctad.org/dmfas/pdfs/raffer.pdf. K. Raffer, ‘The Debt Crisis and the South in an Era of Globalisation’, in Max Spoor (ed.), Globalisation, Poverty and Conflict, a Critical ‘Development’ Reader (Conference proceedings, 50 Years Institute of Social Studies, October 2002, The Hague) (Dordrecht, Boston and London: Kluwer Academic Publishers, 2004a), pp. 97–115. K. Raffer, ‘International Financial Institutions and Financial Accountability’, Ethics & International Affairs, 18(2) (2004b), 61–78. K. Raffer, ‘The IMF’s SDRM. Another Form of Simply Disastrous Rescheduling Management?’, in Ch. Jochnick and F. Preston (eds), Sovereign Debt at the Crossroads (Oxford: Oxford University Press, forthcoming). K. Raffer and H.W. Singer, The Economic North-South Divide, Six Decades of Unequal Development (Cheltenham and Northampton, MA: Edward Elgar, 2001). D. Rodrik, ‘Understanding Policy Reform’, Journal of Economic Literature, XXXIV(1) (1996), 9–42. Hans W. Singer, ‘The Distribution of Gains between Investing and Borrowing Countries’, American Economic Review, Papers and Proceedings, 40 (1950), 478ff. Zedillo, Ernesto et al., ‘Recommendations of the High-level Panel on Financing for Development’, UN, General Assembly, 26 June 2001 (A/55/1000).

16

Global Organization and Developing Countries: Current Aspects of Neo-mercantilism and the Global Framework of Accumulation Dimitri Uzunidis

Introduction The world economy consists of a set of relations between economic centres of interest and power (commercial, technological and financial), both political and military, of unequal strengths. The structures of domestic and international markets are determined by antagonistic relations (confrontations and pacts) between such national centres (states and firms). The institutions and big firms of industrialized countries shape world markets through competition while the weakest economies suffer violent fluctuations in prices as well as fluctuations in financial markets or raw material prices. The word ‘globalization’ indicates a strong integration of national economies into the international flows of capital and goods as well as the implementation of a set of rules aimed at ensuring firms and financial institutions full freedom of action through the Bretton Woods international institutions (IMF, World Bank, WTO). The neo-liberal framework of globalization was proposed by the World Bank economist, John Williamson in 1989, who coined the term ‘Washington Consensus’ (see P. Davidson’s contribution, Chapter 11). A transnational legal framework of accumulation generated by the political tensions and compromises between states is being implemented. This global legal framework of accumulation is based on the hard and fast principle in capitalism that capital must be used at all times by all financial, commercial and regulatory channels with a view to making the most durable profit possible. The current attempts to form a global legal framework of accumulation are justified by the economic crisis and the necessity to make new investments. This changes the norms and nature of the global expansion of capitalist production: the old norm would associate 230

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market expansion with generalized mass consumption, and the new one renews the markets through ‘permanent innovation’. The rules thus applied to capital management and transnational accumulation illustrate the priority objective of the top countries whose positions guide the international institutions’ interventions: to preserve and reinforce the economic power of big industrial and financial groups by giving them better and easier access to new production resources and by improving their profitmaking potential.

Neo-mercantilism and the global legal framework The purpose of a global legal framework is to ensure the success of neomercantilistic policies1 in which the ‘rest of the world’ is an unlimited market for national products. For Joan Robinson, mercantilism is the natural trend of capitalism because an economy of market and private enterprise is most of the time an economy of buyers. Such an economy comes up against the insufficiency of effective demand. The excess situation (defined by the excess in the supply capacity in terms of capital, money and goods with respect to the solvent demand), as Marx and Schumpeter cleverly demonstrated, means that firms have to continuously renew their production processes: renovate supply, reduce costs and open new markets. They must therefore export. Joan Robinson shows without difficulty that the capitalist world is always, in a way, a market of buyers, in the sense that production capacity exceeds what can be sold for a profit. A situation in which demand exceeds what firms can physically produce and sell is often a precarious one. The resulting investment and recruitment increase production capacities to the point where they achieve excess production. The evolution of capitalist society is conditioned by the forecasts made by the entrepreneurs. Profitable areas are rapidly saturated by new investors entering them in large numbers. Competition and the short-sightedness of entrepreneurs together with opaque markets and the retention of any type of information lead as much to excess production as to monopoly. As soon as a buyers’ economy is in place, the closing down of borders worldwide is both reprehensible and, above all, untenable. Such a policy is bad, not only from the point of view of the assumed superiority of free trade, but because gaining market share in the export of goods and capital is as beneficial to the capitalists as to the workers. In order to understand the difference between free trade and new mercantilism, Joan Robinson notes that, as full employment is not guaranteed, profit and employment levels could be higher at all times in a capitalist country if exports increased more rapidly than imports. ‘The trading nations have always been mercantilist at heart’ (p. 227). To champion the adoption of free-trade policies, one must mention that the advantage of abolishing foreign trade barriers is, for the national exporters, greater than the disadvantage of lifting their own national trade barriers.


New mercantilism is a system which impoverishes debtors. At all times the most powerful economies (those recording a surplus in their foreign accounts and/or having a common currency in their international transactions) have discharged their surplus (goods and capital) into the other countries while carefully selecting their purchases from those countries. They are concerned with the maintenance of their own national activity and impose international rules (terms of trade, ‘free trade’, bills of exchange) that ensure the flow of surplus savings while taking no further interest in the future solvency of their debtors. The latter, representing most of the developing countries, are thus pushed into the spiral of debt, and then into the degearing and reorganization crisis. The sadistic deflationary policies (as John Maynard Keynes called them just after the Second World War) which were implemented in the 1980s were combined with policies of reduction in customs tariffs, in foreign exchange restrictions, and with policies of increased foreign trade. Such public policies of liberalization and rationalization of the markets of capital, goods and services have also supported big firms thus making it possible for them to implement financial, production and commercial strategies worldwide.2 As a matter of fact, such firms can now manage their financial, industrial, technological and, often, human assets globally as they can adjust to national economic and political rules which, for their part, tend to become simpler and meet the institutional investors’ expectations. A global profit strategy is characterized by (a) transborder expansion of the activities of the firm and further centralization of its core functions in terms of organization and management of its investment, sales and finance; (b) growth based on the integration and increase of the firm’s property through multiple acquisitions, takeovers and alliances involving other firms as well as institutions; and (c) integration and unification of the big firm’s industrial, financial and commercial activities to the detriment of the cohesion of national economies. Any interpretation of globalization should be based on an in-depth analysis of the changes that have occurred in the legal and institutional framework of competition and accumulation. Globalization and corporate global strategy make sense only if their aim is to remove the obstacles to profitmaking. Hence the importance of a legal framework for the promotion and protection of ‘free enterprise’ worldwide. By ‘global legal framework of accumulation’ we mean the coherent set of coercive rules, forms, procedures, competitive and cooperative means shared by economic players whose aim is to organize public and private economic activities on a global scale without any visible discrimination and without any preferential treatment. Such rules may be new (for example, compliance of all countries with the rules of free circulation of capital or protection of capital ownership) or old, but they must be respected by all signatories without any discrimination in a context of multilateral agreements (for example, compliance with the most favoured nation clause for foreign investors whatever their origin). This legal framework


is a global one as it confers an inalienable legal status on the economic players whose activity goes beyond the borders of a national economy. The organization of transborder economic activities is possible only if the international firm acquires a legal status, that is a status that ensures it full recognition, giving it rights and obligations in any country as long as such rights and obligations are similar from one country to the other. In this context of implementation of supranational rules, it is clear that all countries must review their laws and constitutions to ensure full compatibility of their legal systems with the oncoming international law. The liberal legal framework of accumulation is a framework that shows how ‘economic liberalism’, as it becomes reality, is useful to the new mercantilism of the most powerful economies. The economic stabilization programme (see ‘Washington Consensus’) included in the legal framework of accumulation employs the major liberal principles: ●

●

●

●

●

●

●

●

Budget discipline. As public deficit is a source of inflation and balance of payments deficit, budget austerity should help the state out of debt, but also maintain and improve purchasing power mainly for the poorest categories of population. Redefinition of government expenditure priorities. Subsidies in favour of the economy, employment and firms should take the place of direct assistance to health, education and the construction of infrastructures. Fiscal reform. In order to fight tax avoidance and the increase of parallel economies, and also to improve the finances of the state and boost the economy, the government should aim at two objectives: increase the tax base and reduce marginal rates of taxation. Liberalization of interest rates. The market should determine interest rates, but the state should see to it that they be positive and moderate so that they can be attractive to international investors. The latter may thus contribute to financing development. Competitive rates of exchange. The objective is to facilitate exports. Controlled currency depreciation should be implemented to this effect while avoiding the inflationary spiral due to excessively low rates. Liberalization of trade. The promotion of exports is not possible if not concurrent with the liberalization of trade: both tariff and non-tariff barriers must be lifted. Liberalization of foreign direct investment. To begin with, foreign investment should be free from obstacles, and then international financial institutions impose the liberalization of movements of capital of all sorts (which paved the way for major financial crises throughout the 1990s). Privatization. Lower public deficit, contained state interventionism, and also more competitive firms (in liberalized markets) through more appropriate management – such are the main objectives of privatization most recognized by the experts of the ‘Washington Consensus’.

234 John Kenneth Galbraith and the Future of Economics ●

●

Deregulation. Market contestability should be implemented on a large scale. All governments should be inspired by the alleged success of this type of policy (the Reagan years): lift barriers within and outside the markets, and facilitate free enterprise. Property rights. The reinforcement of property rights facilitates private initiative and enables the informal sector to acquire property rights at acceptable costs.

World organization and national economies in trouble As regards international relations, the catchword of governments (and primarily the United States government) is ‘Trade, not aid’. According to the standard economic theory, the international division of labour and specialization of national economies in the products for which they have abundant capital or labour are not only beneficial to particular countries but to the whole world. Through the action of the relative prices of goods and agents, costs will decrease and the standard of living of populations will improve. The free circulation of goods and, in their absence, of capital, is the prerequisite for global well-being, even if in the short term some economic adjustments would make more than one nation suffer (Krugman, 1997). But history shows that some specializations are impoverishing and discriminating. The poorest countries suffer more from deteriorating terms of exchange than they suffer indirectly from subsidies to rich farmers. The prices of agricultural raw materials are very volatile: between 1997 and 1999 prices have decreased by 48 per cent for cocoa, 36 per cent for tea and 46 per cent for cotton. The recovery over the last three years should not hide that since 1995, the terms of exchange for all the primary goods exported by the South have deteriorated by 42 per cent in constant dollars.3 Such countries must then borrow to pay for their imports of food and industrial products, aggravating their trade deficits and, consequently, their external debts. The generalizing legal framework of accumulation, with its aim of imposing and maintaining free circulation of goods and capital, contributes to the decreasing role of the state in the economic development process. Without any real instruments of economic policy (money being subjected to international rules and fluctuations, and the regulatory framework being designed externally), most developing countries have lost control of their own economies (many of them, in fact, have never been in control). Their negotiating power with big international firms in terms of technology transfer, employment, ploughback or protection of young industries is reduced. As the national measures implemented to control investment or goods flows no longer apply, national governments lose control of the economy. The problem is then an economic one. The launching of large accumulation processes in most developing countries is due to the measures implemented for foreign


investment control in the sectors of primary resources, energy, transport, communications, defence and security, banking and finance and so on. After the multilateral liberalization of flows, the host country has lost its capacity to focus foreign investment on the sectors likely to promote or reinforce its national industries and/or to control its own market. The absence of any efficient control over the activities of international firms reduces the spin-off effects on local activities, curbs investment, weakens the local structures of production and makes the economy more dependent on external resources and more vulnerable to global market fluctuations. In addition, the global implementation of the legal framework of accumulation does not mean a better allocation of production resources worldwide. The countries which are further advanced towards development and have implemented adequate attraction policies will always be the ones receiving the highest volumes of foreign investment and retaining a leading position in international trade. The countries with good transport, telecommunication and energy infrastructures, those with the richest scientific and technical potentials, those with large financially solvent markets will be the first to be served by global firms. The more developed the production forces on a national basis, the easier it is for the relevant economy to integrate the global logic of big firms. The liberalization of capital markets, the presence of positive interest rates as well as the easy terms and the ‘national treatment’ granted to internationalized firms should, for their part, offer new prospects for the financing of development. But, according to UNCTAD (2002), in the 1990s and at the beginning of this century, 90 per cent of foreign direct investment only concerned a small group of ‘emerging economies’, against about 50 per cent before the start of the debt crisis. The ‘least advanced countries’ have to make do with 1 per cent of international investment. Not only are they unattractive to investors, but they are also increasingly dependent on public aid for development, which is far from the objective of 0.7 per cent of the GDP of rich countries as determined at the Rio summit in 1992. One of the main causes of the failure of development under the rules laid down by the global legal framework of accumulation is the ‘all market’ attitude applied under the pressure of international financial institutions encouraged by the Bretton Woods institutions. Internally, the reduction in the social bill relative to non-profitable expenditure, wage austerity, lay-offs, and streamlining policies following nationalizations lead to deeper social inequalities in the countries adhering to budgetary and fiscal orthodoxy. On the other hand, fiscal policies follow the implacable liberal logic by the terms of which if the income of the privileged sections of the population increases, the latter will finally invest, hire employees, distribute wages, and solve the poverty issue. But, due to the liberalization of capital markets, those privileged sections of the population invest their savings in foreign countries and thus contribute to financing growth in the countries of the northern hemisphere.


More serious still, the failure of the ‘consensus’ can also be attributed to the unorthodox but fundamentally neo-mercantilistic policies implemented by industrialized countries. As pointed out by the World Bank,4 the US government advocates free trade, but its agricultural, steel and ‘sensitive sectors’ policies (advanced technologies, armament) are far from complying with the principles of ‘free enterprise’. Will the recent WTO agreements cancelling subsidies make it possible to reverse the situation in aid of Southern producers? Each year, US producers receive $10.7 billion in subsidies, while the whole country devotes only $3.1 billion to public aid for the development of Sub-Saharan Africa. At the same time, in 1994 the provisions relative to public markets in the Marrakech Agreement, which eventually led to the formation of the World Trade Organization, stipulated that the armament markets and the markets proving ‘necessary for national security’ (art. 23) could be excluded from the negotiation over the lifting of protectionist barriers in international trade and financial relations. The WTO subsequently issued the multilateral agreement on investment which excludes international investment and public orders relative to defence and advanced technologies from the scope of free trade. But is it possible to exclude such products without trespassing on the wider domain of ‘traditional industries’? The countries (North Korea, Taiwan, post-Pinochet Chile) that have not entirely observed the above programme, or that have not observed it at all (China, India) and that, instead of adopting full liberalization and privatization policies, have privileged a strong public sector to absorb the financial crisis and continue to develop their industries, have obtained better macroeconomic results than other comparable countries (Brazil, Argentina, the Philippines, and so on). Such countries adopted anti-cyclic policies, even during periods of financial crisis: increases in education, health and infrastructure expenses, progressive taxation, control over short-term capital inflows and so on. The countries that have not conformed to adjustment programmes have obtained better results in terms of the fight against poverty than those that have implemented the IMF and World Bank programme.5 The virtuous cycle of accumulation and growth is closely related to deep economic changes and especially to industrial development and diversification. Even during the debt crisis, the economies of South-East Asia continued to rely on high added-value, technology-intensive industries and services. On the other hand, most Latin-American and African economies are experiencing ‘premature de-industrialization’6 (Table 16.1). As Joseph Stiglitz points out, ‘Developing countries keep asking why the United States, when facing an economic crisis, is in favour of expansionist budgetary and monetary policies, whereas when they are themselves in a similar situation, they are asked to do exactly the opposite.’7 Of course, the Bretton Woods institutions and the international financial institutions will not allow developing countries to act this way in times of crisis. But, further to the setbacks suffered by neo-liberal economies in the 1990s, as well as the

Global Organization and Developing Countries 237 Table 16.1: Share of manufacturing production in GDP per region, 1960–2000 (%) Region

1960

1970

1980

1990

2000

Sub-Saharan Africa Western Asia and North Africa Latin America Southern Asia Eastern Asia (excl. China) China Developing countries Developed countries

15.3

17.8

17.4

14.9

14.9

10.9

12.2

10.1

15.6

14.2

28.1 13.8 14.6

26.8 14.5 20.6

28.2 17.4 25.4

25.0 18.0 26.8

17.8 15.7 27.0

23.7 21.5

30.1 22.3

40.6 24.7

33.0 24.4

34.5 22.7

28.9

28.3

24.5

22.1

18.9

Source: R. Kozul-Wright and P. Rayment, Globalization Reloaded: an UNCTAD Perspective, Discussion Paper no. 167, United Nations Conference on Trade and Development, January 2004.

financial crises, a measured revival of regulation and institutionalism seems to be taking place internationally. The World Bank recommends the implementation of good governance (development of education and infrastructures, environmental protection, fairer distribution of resources) as a necessary condition for smoothly operating markets. A legal system is required to regulate the liberalization of the markets of products, capital and labour and thus to prevent such problems as capital evasion and the rise of illegal and informal activities. Institutional reform is indispensable to a better supervision of the economy, involving all the economic players (politicians, firms, trade unions) in decision-making processes. Finally, the taxation system should see to the fair distribution of income. However, it will also be necessary to ensure that the poor may ‘have access to assets’: education, property, micro-credit, land reform and so on. This does not mean a return to a sprawling state, both corrupt and extravagant, but to a ‘clever state’. The global legal framework of accumulation formalizes the neomercantilistic policies of the major industrial countries while promising developing countries the acceleration of their industrialization through free trade. It is a matter of applying an economic model to societies ‘without taking account of the concept of historical process’.8 Throughout his works on development, J.K. Galbraith has always supported the need to make allowances for the historical specificities of economies to which the superpowers apply ready-made development programmes. Such programmes reflect the condition of the economy of those powers and leave little room for the social and political conditions which could make up a basis for capital


formation. Learning the lesson from the experience of old industrial countries, in Galbraith’s opinion the prerequisite to economic development is political development, itself conditioned by the democratization of education. The political system should be stable and predictable, honest and efficient; citizens, both educated and informed, should be players in this system. But for this purpose, citizens should be educated. Education is the keystone of the political organization from which the development process arises. ‘Free and compulsory education of a good standard breaks off the accommodation to the culture of poverty. But it is also closely associated with the democratic regime.’9 Then, a good general education paves the way for more specific education in the technical, scientific or administrative fields, making it possible to train the ‘human capital’ required for selecting, designing and/or using and improving the technologies which are necessary and compatible with the economic development project. General and specific education are also vital to the formation of a stable political system which can give a sense of purpose to development and provide the economy with the tangible, financial, cognitive and institutional resources it requires to this effect.

Development and institutional revival In an open economy, how can development be oriented? What are the conditions, and what types of institutional tools can an economy use to stabilize the economy, control flows and master stocks? International institutions have realized that without the state, in the absence of a representative political system, economies sink and firms get weaker. Table 16.2 shows the damage caused by the implementation of a liberal legal framework of accumulation to the most fragile economies, and, on the other hand, some institutional agreements which are necessary to get out of the accommodation to underdevelopment. J.K. Galbraith militates in favour of greater determination by the IMF in its ‘cleansing action’ relative to ‘incompetent bankers and business people’ and a kinder attitude to ‘the innocent and suffering peoples whose general demand is necessary to the economy’.10 International dialogue is required. It is thus necessary to accept, as Joseph E. Stiglitz said, a progressive and differentiated international opening according to the national objectives of the developing countries, as has been done by the neo-mercantilistic superpowers which have built their economies while protecting their key industrial sectors and their marketing forces. But the WTO prevents developing countries from protecting their industries by replacing their imports by local production or by applying higher ‘local content’ standards in case of foreign direct investment (Agreement on Trade-Related Investment Measures – TRIMS). It also forces those countries to enforce very strict legislation for the protection of intellectual property rights (Agreement on Trade-Related Aspects of Intellectual Property Rights – TRIPS), which annihilates every effort aimed at absorbing and developing new technologies. Even if the new official

Global Organization and Developing Countries 239 Table 16.2: Patterns of development Liberalism, globalization and development crisis ● ●

● ●

● ●

●

Instability and political crises Unemployment, pauperization, deeper social inequalities Defective markets, informal practices Unstable financial institutions and regulations Neglected collective infrastructures Economy subject to the uncertainties of the international environment Fragile national economy due to the unpredictable movements of capital

Institutional revival and market control ●

●

●

●

●

●

Promotion of a predictable political system and rehabilitation of the role of the state Priority to education and collective social infrastructures Coordinating system for market players, and decision-making power of the state Procedures for the control of national production resources (formation of capital, income, currency) Domestic savings centralization system International opening differentiated according to national objectives

thinking about the relationship between development and international relations is focused more on the state and institutions, it is far from opening new forms of organization of the world economy.

Conclusion The outlook is even darker, due to the return of bilateralism in the processing of economic issues. While the IMF, since the crisis in South-East Asia, has re-examined its position on the uncontrolled liberalization of movements of capital, the US administration, outside the framework of the WTO, has started bilateral negotiations with countries such as Chile or Singapore intended to make them lift all regulatory barriers to capital inflow. The US administration describes as ‘a coalition of liberators’ the group of countries which link to the US via bilateral or regional ‘free-trade’ agreements. Brazil and Argentina would like better cooperation between Latin-American countries, and they would also like better access to the United States’ market for their beef, orange juice, cotton and tobacco. The US government response is to sign free-trade agreements and begin negotiations with other Latin-American countries, but also with Asian countries (ASEAN), and countries in the Middle East, in Africa (customs union with South Africa, Morocco and so on) and Oceania (Australia). According to forecasts, at the end of 2004, in addition to Canada, Chile and Mexico, twelve other Latin-American countries (Colombia, Ecuador, Peru and so on) will join the free-trade area initiated and organized by the United States. This policy, which is also called ‘competitive liberalization policy’,11 is a response to the relative changes in the WTO’s opinion faced with the uncontrolled liberalization of the flows of goods and capital and further to


a number of protests by citizens and some governments of the Southern countries. For the United States, this neo-mercantilistic policy is vital to safeguard its military and monetary power as well as for the benefit of its big firms. For the governments and privileged classes of the allied countries ‘competitive liberalization’ entails two major risks: their low negotiating capacity facing such a huge economic power could lead them into the same deadlock as the implementation of the measures of the ‘Washington Consensus’ revised by international financial institutions and it will be difficult for those developing countries to make up their own groups of negotiators at international conferences. By adopting the ‘my way or the highway’ approach, the US government impedes the anticipated reform of the international institutions and of the global legal framework of accumulation. But the attitude of the governments of many developing or industrialized countries in accepting the unilateral US position also deserves blame for the entropy and the turbulence which could mark the world economy in the coming years.

Notes 1. ‘New mercantilism’ (otherwise neo-mercantilism) is a term borrowed from Joan Robinson. See J. Robinson, An Introduction to Modern Economics (London: McGraw-Hill, 1973); D. Uzunidis and B. Laperche, ‘Power of the Firm and New Mercantilism: an Analysis Based on Joan Robinson’s Thought’, in L.R. Wray and M. Forstater (eds), Contemporary Post Keynesian Analysis (Cheltenham, UK and Northampton, MA: Edward Elgar, 2004), pp. 333–47. 2. D. Uzunidis, ‘Nature financière et économique des transnationales et cadre légal mondial’, Alternatives Sud, vol. IX (2002). 3. World Bank, Global Development Finance 2004 (Washington DC: World Bank, 2004). 4. Ibid. 5. W. Easterly, ‘The Lost Decades: Explaining Developing Countries’ Stagnation in Spite of Policy Reform 1980–1998’, Journal of Economic Growth, 6(2) (2001), 135–57. 6. R. Kozul-Wright and P. Rayment, Globalization Reloaded: an UNCTAD Perspective, Discussion Paper no. 167, United Nations Conference on Trade and Development, January 2004, Geneva. 7. J.E. Stiglitz, La grande désillusion (Paris: Fayard, 2002), p. 308. 8. J.K. Galbraith, La voix des pauvres, ou, ce qu’ils ont à nous dire sur l’économie (Paris: Gallimard, 1984), p. 21. 9. Ibid., p. 36. 10. J.K. Galbraith, Pour une société meilleure: Un programme pour l’humanité (Paris: Seuil, 1997). 11. T. Barry, ‘Coalition Forces Advance’, ‘America’s Program’, Interhemispheric Resource Center, Silver City, July 2004, www.americaspolicy.org.

References P. Krugman, Pop Internationalism (Chicago: MIT Press, 1997). UNCTAD, Annual Report (Geneva, 2002).

Index Abramovich, Roman 191–2 accumulation, global legal framework of 230–1 and concentration of resources 235 and developing countries 237 and failure of development 235 and meaning of 232–3 and neo-mercantilism 231–4, 237 and purpose of 231 and state’s decreased role 234–5 and Washington Consensus 233–4 Acemoglu, D. 145 Adelman, Irma 165 Agénor, P.-R. 118 aggregate demand and demand for and supply of 92–4 and institutions as determinant of 5, 93–4 and party control theory of economic policy 93 and political economy theory of 92–4: and formal model 95–9; and test results 99–101 and power as determinant of 5, 92–3 Agricultural Adjustment Administration 31 Akerlof, G. A. 75 Alesina, A. 117 Alfa group (Russia) 185 Amendola, M. 152, 153, 157 American Agricultural Economics Association 15 American Economic Association 15, 30, 37 Arestis, P. 105, 112, 130, 135 Argentina 198, 202, 216 Aron, Raymond 57 Arrow, Kenneth 40 Asian Development Bank, and loan loss provisions 218 Association for Evolutionary Economics 15

Balassa, Bela 201, 203 Baldwin, R. 159 Bank of England 132, 149 Bank of Japan 153 banks, and Russia 183–4, 192 Baran, Paul 45, 60 Barnes, Justin 211 Barro, R.J. 112, 113, 114, 136 Bay of Pigs 54 Beard, Charles 55 behavioural economics 83–4 Bellone, F. 158 Bentolila, S. 155 Berle, A. A. 18 Biefang-Frisancho Mariscal, I. 112 bilateralism 239 Black, Bill 20 Black, John D. 3, 31 Blinder, Alan 67, 68, 116 Blundell, R. 117 Bobbio, Norberto 57 Boeri, T. 155 Böhm, B. 147, 148, 149, 150 Boskin, Michael 72 Boskin Commission 72 Boughton, J.M. 218 BP-TNK 183 Brainard, William 69 Brazil 198, 216 Bretton Woods agreements 56, 167 Bretton Woods Institutions, and Third World debt 215, 217 Brooks, David 83 Bryce, Robert 36 budget deficits and eurozone 126–7 and Stability and Growth Pact 128, 136–8 Burns, Arthur F. 38, 67 Burns, Terence 212 Bush, George W. 19, 54, 82 Cafiero, Mario 225 Cambridge University 35–6 241

242 Index Canada, and First World War 27 capital, and nature of 79 capital controls 197 capitalism and the common good 78, 80 and democracy 59 and equilibrium 81 and global legal framework of accumulation 230–1 and government’s role 81–2 and hoarding 81, 85n8 and nature of capital 79 and non-productive behaviours 78–9 and oversight of global corporate 82 and pseudo-capitalists 78–80 and relative capitalism 79, 80–1 and self-interest 78, 82 and unregulated nature of 57 see also neo-liberalism catch-up development, and developing countries 199 Caufield, C. 221 Central Banks and exchange rates 133–4 and fashionable role of 130–1 central planning 199 Chandler, Alfred 73 China 58–9, 207 Chirinko, R.S. 109 Churchill, Randolph 21 civic participation 56, 61 Clark, John Bates 80 clearing union, international, and proposals for 170–6 Clinton, Bill 169 cognitive science 84 Colander, D.C. 36 Cold War 54–5 and military establishment 42–3 Colombia 202 common good, and self-interest 78, 80 Commons, John R. 32 competition policy 156–9 and European Commission 143, 156 conservatism, and psychological bases of 84 consumer choice, and The Affluent Society 2, 17–18 consumption, and dependence on production 18

control fraud 20–1 conventional wisdom, concept of 17 and Central Banks 130–1 as metacultural frame 78 convergence, and concept of 180 coordination failures 7 and European Union 144, 148, 150–1, 160–1 corporate global strategy 232 corporate governance, and George W. Bush administration 19 ‘Corporate Republic’ 19 Council for Economic Planning and Development (Taiwan) 206 Council on Economic and Financial Affairs (ECOFIN) 126 countervailing power 18 credit controls 134 Crosland, Anthony 57 crowding-out, and fiscal policy 109–12 Cunningham, S.R. 109, 110, 136 currency crises, and international financial system 166–7 Currie, S. 141 Czech Academy of Sciences 57 Dahrendorf, Ralf 57 debt see Third World debt deficit bias and fiscal policy 117 and governance 118 DeLong, Brad 69, 111 Delors, Jacques 57 democracy and capitalism 59 and economic development 48 Democratic Party, and presidential election (2004) 82 Dennison, Henry 34–5 developed countries, and fiscal policy 118, 119–20 developing countries and catch-up development 199 and economic development 9–10, 236 and finance capitalism 197–8 and fiscal policy 118, 119 and global legal framework of accumulation 234–5 and good governance 237

Index developing countries – continued and governing the market 209–12 and industrial policy 10 and militarism 48–9 and restrictions on 238 and state’s decreased role 234–5 and supranational rules 10–11 and trade regimes and economic performance 200–2 and Washington Consensus 198–9 see also Third World debt development, and institutional revival 238–9 developmental state, and industrial policy 206 Dickens, W.T. 75 disarmament 4, 40, 48 and implications of 46–7 division of labour, international 234 Dolado, J. 155 Dorfman, Joseph 29 Drury, E.C. 28 East Asia and crisis (1997–98) 198 and East Asian Miracle study (1993) 202–3 and economic development 9–10, 199 and industrial policy 199–200, 202–3: and low-level intervention 204–5; and role of state 205–9 and liberal explanation of catch-up growth 200–3 and trade regimes and economic performance 201–2 Easterly, William 73 Economics, Peace and Security (EPS) 40 economic development and democracy 48 and East Asia 9–10 and education 238 and militarism 48–9 and the state 199 economic growth and European Union 142–3 and growth regimes 147–8 and institutional change 6–7 economic organization, and The New Industrial State 2, 18–19

243

economic policy, and party control theory of 93 economics and biases within 4–5, 65, 74–5, 83: and efficient market theory 74; and free trade 70–1; and growth theory 73; and inflation measurement 71–2; and monetarism 66–9; and natural rate theory 69–70; and public investment 72–3; and rational expectations 70; and shock therapy in Russia 73–4 as conformist Salon 65–6 and contradictory approaches to 1 and future of 2–3 and research programme for 20: and control fraud 20–1; and inequality 20; and monetary policy 21; and principle of 21–3 Economists Allied for Arms Reduction (ECAAR) 40, 45 education, and economic development 238 efficient markets theory, and management of firms 74 Ehmke, Horst 57 Eichengreen, Barry 165 Eisenhower, Dwight D. 49 Eisner, Robert 40, 73 elites, and social control of 4 Ely, Richard 29–30 embezzlement 17 employment and definition of full 88 and free trade 71 employment protection 154–5 English, John 27 Enron 78, 84n6 equilibrium, and capitalism 81 Erler, Fritz 57 Eschenburg, Theodor 57 European Bank for Reconstruction and Development 219 European Central Bank (ECB) 6, 127 and changes required in 134–5 and commenting outside its remit 131–2 and exchange rates 133–4

244 Index European Central Bank (ECB) – continued and finance capitalism 198 and justification for 129–30 and lack of accountability 132 and monetary policy 128, 129–35 and neo-liberal agenda of 131–2 and one-size-fits-all problem 132–3 and responsibilities of 128, 143 European Commission, and competition policy 143, 156 European Constitution 127 European Convention 127 European Monetary System 100, 101 European Monetary Union (EMU) 6 European Union 60 and budget of 128, 140–1 and competition policy 156–9 and coordination failures 144, 148, 150–1, 160–1 and economic performance of 142–4 and economic transformation 151–2 and growth regimes 147–8 and impact of country size 160 and improving job creation 145–6 and inappropriate economic policy 148 and institutional failures 145 and labour market 146–7, 154–5 and monetary policy 148, 152–3 and need for coordination 144 and post-war economic development 144–5 and structural instability 148 and structural reforms 146–7 eurozone and budget deficits 126–7 and coordination of fiscal policy 136–7, 139–40 and economic performance of 126–7 and exchange rate volatility 133 and fiscal policy 127 and ‘new consensus’ in macroeconomics 128–9 and policy framework for 128–9

firm management, and economic bias 74 First World War 27 fiscal policy and crowding-out 109–12 and ‘deficit bias’ 117 and economic development level 118 and eurozone 127, 136–7, 139–40 and institutional aspects of 115–18 and model uncertainty 115–16 and need for reinstatement of 6, 105, 120 and ‘new consensus’ in macroeconomics 106–9 and pro-cyclical nature of 116 and quantitative effects of 118–20 and Ricardian equivalence theorem 112–15 and Stability and Growth Pact 128 and supply-side inefficiencies 117–18 Fischer, Stanley 165 Fisher, Irving 30, 111 Fitoussi, J.-P. 148, 149 foreign direct investment 198 and concentration of 235 and outward FDI 206–7, 211 foreign policy 43, 53, 54 Frankfurter, Felix 35 fraud and control fraud 20–1 and financial panics 2, 17 and innocent 78, 81 free trade and bias in favour of 70–1 and exclusions from 236 and new mercantilism 231 Fridman, Mickhail 185 Friedman, Milton 37, 38, 66–7, 69, 74, 115 Friedmann, Georges 57 Fukayama, Francis 32, 40 full employment, and definition of 88 Furner, Mary 30

Fama, Eugene 74 Fazzari, S.M. 109, 110, 120 finance capitalism, and ascendancy of 9, 197–8 financial panics 2, 16–17

Gaffard, J.-L. 148, 149, 150, 152, 153, 161 Galbraith, Archie 27–9 Galbraith, John Kenneth and approach to economics 1, 52–3

Index Galbraith, John Kenneth – continued and disarmament 40, 48 and economic development 237–8 and education 238 and financial panics 16–17 and foreign policy 43, 53, 54 and honesty of 35 and industrial society 52, 56–7 and influences on 1, 3, 32: and agricultural policy 30–1; and early years 26–9, 53–4; and Howard Tolley 30–1; and John D. Black 31–2; and Keynesianism 26, 32; and Leo Rogin 29; and pre-Keynesian academic economics 29–30 and intellectual courage of 65 and Journal of Post Keynesian Economics 38 and Keynesianism 3, 34–6 and militarism 41–4, 45–6, 48–9 and military expenditure 44–5, 47–8, 54 and Post Keynesianism 3, 38–9 and Third World debt 214, 216, 221 as transforming figure 16 and writings of: The Affluent Society (1958) 2, 17–18, 32–3, 56; American Capitalism (1952) 18, 56; Capitalism, Communism and Coexistence (1988) 8, 180; The Culture of Contentment (1993) 41–2, 43, 44; Economics and the Public Purpose (1973) 36, 41, 43, 44; The Great Crash (1955) 2, 16–17; A Life in our Times (1981) 34; Modern Competition and Business Policy (1938) 35; The Nature of Mass Poverty (1980) 214; The New Industrial State (1967) 2, 18–19, 41, 56 Galbraith, Kate 27, 28 Galbraith, Kitty 35, 37 Gazprom 185 Germany and sovereign debt 217 and United States 56 globalization and corporate global strategy 232 and neo-liberalism 230

245

see also accumulation, global legal framework of Goldfield, S. 67 Goldwater, Barry 83 Goodhart, C.A.E. 141 Gorbachev, Mikhail 57, 58, 180 Gordon, D. 110 governance, and World Bank 237 governing the market, and industrial policy 205, 209–12 government, and relative capitalism 81–2 Gramsci, Antonio 77, 83 Great Society 59 Grether, Ewald 29, 30 growth theory, and economic bias 73 Hansen, Alvin 32, 36 Hemming, R. 106, 110, 115, 117, 118, 119 Hicks, John 168 Highly Indebted Poor Countries (HIPC) initiatives 216, 219 hoarding 85n8 and pseudo-capitalists 81 Hochfeld, Julian 57 Hong Kong 201 imperialism, and United States 53, 54, 55–6 India, and Galbraith 54, 60 industrial capitalism, and subordination to financial capitalism 9 Industrial Development Bureau (Taiwan) 204, 206, 211 industrial policy and East Asia 199–200, 202–3: and low-level intervention 204–5 and governing the market 205, 209–12 and role of state 205–9 and sectoral policies 204 and spillovers 203 and types of 203–4 industrial society 4, 52, 56–7 and state socialism 57–9 and Third World 60 and western social democracy 59–60 Industrial Technology Research Institute (Taiwan) 206

246 Index inequality and research programme for economics 20 and Russia 188 and unemployment 20 inflation and aggregate demand policies 91 and labour power 90 and measurement of 71–2 and monetarism 67–9 innocent fraud 78, 81 innovation 6–7, 142 and labour market flexibility 154, 155–6 and requirements for 145–6 insider operations 2, 17 institutionalism, and international revival of 237 institutionalists 3, 29 institutions and definition of 102n3 as determinant of aggregate demand 5, 93–4 and development 238–9 and economic outcomes 95, 97–9, 100–1 and economic performance 5, 87, 101–2 intellectual property rights 238 International Bank for Reconstruction and Development (IBRD) 215 and failure to grant debt relief 219 and insolvency 221 and loan loss provisions 218 international clearing union, and proposals for 170–6 International Development Association (IDA), and Third World debt 215 international development community, and Washington Consensus 196–7 international financial institutions (IFIs) and failure to grant debt relief 219 and inefficiency of programmes 219–20 and institutional self-interest 219, 220, 221 and interference by 226

and loan loss provisions 218–19 and ‘preferred creditor’ claims 218 and rewarded for failure 220 and Third World debt 215–17 international financial system and fundamental flaws of 166–8 and global reserve system 168–9 and IMF loans 169 and international clearing union proposal 170–6 and Keynes on 170 and need for new architecture of 169–70 and problems with 8, 165 and reform proposals 165 and special drawing rights 169 and Washington Consensus 165–6 International Monetary Fund 8, 9, 60, 165 and institutional self-interest 219 and loan loss provisions 218 and ‘preferred creditor’ claim 218 and Sovereign Debt Restructuring Mechanism 216, 219, 220–1 and Third World debt 215 and Washington Consensus 169 international relations, and ‘trade, not aid’ 234 Intriligator, Michael 40 investment, and economic performance 202 Japan 144, 148, 207 and economic performance of 150 and monetary policy 153 Jensen, Michael 74 Johnson, Lyndon Baines 53, 59 Jost, John T. 84 Journal of Post Keynesian Economics 37–8 Kahn, Richard 35, 36 Kahneman, Daniel 83 Kalecki, Michael 35 Kasyanov 185 Kennedy, John F. 52, 54, 55, 57 Kerry, John F. 82 Keynes, Maynard 21, 35, 61, 78, 232 and international financial system 170

Index Keynesianism and Galbraith 3, 26, 32, 34–6 and Golden Age of capitalist development 90 Khodorkovsky, Mikhail 191 King, Mervyn 130 Kirkland, Lane 55 Klein, Lawrence 40 Klein, Michael W. 71 Korea (South) 201 and role of state 207–9 and telecommunications liberalization 208–9 Korea Mobile Telecom 208 Korea Telecom 208 Krueger, A. 221, 222, 223 Krueger, Ivar 17 Krugman, P. 159, 234 Kuhn, Thomas 77 labour market and European Union 146–7 and flexibility 154–6 Lafollette, Robert 30 Lakoff, George 84 Landreth, H. 36 Lane, T. D. 118 Lasch, Christopher 57 Laurier, Sir Wilfred 27 least cost rule 79–80 Lebedev, Platon 191 Lewin, Leonard C. 46 liberalization and competitive 239–40 and economic performance 200, 202 see also neo-liberalism lifestyles 79 Lindert, Peter 73 Lisbon process 142 LUKOIL 183 MacDougall Report (1977) 139–40 macroeconomics and Keynesianism 90 and ‘new consensus’ in 106–7, 128–9: and fiscal policy 107–9 and New Keynesianism 91–2 and party control theory of economic policy 93

247

and political economy theory of aggregate demand 92–4: and formal model 95–9; and test results 99–101 and radical shift in 90–2 and unemployment 88–90 MaCurdy, T. 117 Madrick, Jeff 83 Magee, Stephen 71 Marcuse, Herbert 60 market size, and growth theory 73 Marrakech Agreement (1994) 236 Marshall, Alfred 29, 79 and definition of economics 1 Marshall, T.H. 57 Martin, P. 159 Marx, Karl 21, 231 Mayer, M. 172 Mazzucato, M. 157 MDM Bank 183 Means, G.C. 18 Meany, George 55 media, and cretinization by 61 Meltzer, Alan 67 Menshikov, S. 8 mercantilism see neo-mercantilism Merriman, Robert 30 meso-economics 20 metacultural frames and conventional wisdom 78 and neo-liberalism 77, 83 Mexico 198 and automobile production 210 Mezhprombank group (Russia) 185 middle-income countries and finance capitalism 197–8 and Washington Consensus 198 militarism 3–4, 41–2 and Cold War 42–3 and economic development 48–9 and lack of democratic control 43–4 military expenditure 54 and call for reduction in 40 and impact of 3–4 and Marxist theory of 45 and stabilizing effect of 44–5 and wastefulness of 47–8 Miller, Alexey 185 Miller, William 67 Minsky, H.P. 111

248 Index Mirowski, Philip 18 Miyazawa-Brady Initiative 216 model uncertainty, and fiscal policy 115–16 Modigliani, Franco 40, 74 monetarism 66–7 and inflation 67–8 and money supply 67 and recession 68–9 monetary policy 21 and credit controls 134 and European Central Bank 128, 129–35 and European Union 148, 152–3 and impact on real economy 130 and interest rate volatility 117 and model uncertainty 115–16 and one-size-fits-all problem 132–3 and prominence of 5–6, 105 and Russia 187 moral politics 84 motivated social cognition 84 Mussa, Michael 67 Muth, John 74 Myrdal, Alva 57 Myrdal, Gunnar 57 Nadiri, Ishaq 72–3 nationalism, and Russia 58 Nelson, Richard 73 neo-liberalism and challenges to 77, 83–4 and deconstruction of 5, 78 and decreasing relevancy of 78 and equilibrium 81 and globalization 230 and metacultural frame 77, 83 and US presidential election (2004) 82–3 and pseudo-capitalists 78–9 and self-interest 82 neo-mercantilism and debtor impoverishment 232 and free trade 231 and global legal framework of accumulation 231–4, 237 Netherlands, and economic performance of 148–9 New Deal 59 New Keynesianism 91–2

Nishimura, K. 158 Nordhaus, William 73 Norilsk Nickel 183 North, Douglas 40 objectivity, and illusion of 53 organizations, and power 2, 18 Orwell, George 60 Ottaviano, G. 159 Pack, Howard 199–200, 203 Paris Club 225–6 Parker, Richard 23 Pearl Harbor 25 Pearson Report 215 Perotti, R. 117 Perry, George 69, 75 Philips 204 Pizzorno, Alessandro 57 Poland 58 Popper, Karl 77 Porter, Michael 77 Post Autistic Economics movement 19–20 Post Keynesianism 36 and Galbraith 3, 38–9 power and definition of 102n3 as determinant of aggregate demand 5, 92–3 and economic outcomes 95, 97–9, 100–1 and economic performance 5, 87, 101–2 and organizations 2, 18 Prebisch-Singer thesis 215 production, and consumption’s dependence on 18 productivity 7 and labour market flexibility 154 pseudo-capitalists 78 and hoarding 81 and non-productive behaviours 78–9 and roots of 79–80 public interest groups 4 public investment, and economic bias 72–3 Punzo, L.F. 147, 148, 149, 150, 161 Putin, Vladimir 184, 185, 190

Index Raffer, K. 220, 222 rational expectations 70 and Washington Consensus 168 Reagan, Ronald 18, 168 recession, and monetarism 68–9 regulation policy 158–9 and international revival of 237 Rein, Martin 77, 83 Republican Party and neo-liberalism 83 and US presidential election (2004) 82 Ricardian equivalence theorem (RET) 6, 112–15 Ricardo, David 79 Rice, Condoleeza 55 Richta, Radovan 57 Robertson, D. H. 35 Robinson, Austin 36 Robinson, Joan 35, 231 Rocard, Michel 57 Rodrik, Dani 75, 202, 218 Rogin, Leo 3, 29, 30 Rogoff, K. 130 Romer, C. D. 149 Rosneft 191 Ross, Dorothy 30 Rostow, Walt 20 Rusal 183 Rusk, Dean 37 Russia and absence of product innovation 182 and banking industry 183–4, 192 and business/government relationship 184–5 and capital gains tax 191, 192 and capital market 192 and dividend taxation 191–2 and economic development, future of 189 and economic policy, weakness of 187 and economic reform 9 and features of economy 181 and gross profit/labour income imbalance 187–9, 193 and impact of devaluation 181–2 and incomes policy 194 and industrial policy 187

249

and inequality 188 and inertial economic system 181–9 and manufacturing 186–7, 192 and maximalist approach to reform 189–90 and minimalist approach to reform 190 and monetary policy, absence of 187 and nationalism 58 and neo-liberalism 8, 185 and oil and raw materials imbalance 185–6, 190–1 and oil/mineral rent 186, 191, 192 and oligarchic capitalism 8–9, 58 and oligarchic groups 182–4, 186, 187, 190 and profit maximization by price 181 and property tax 192 and reform proposals 195 and reluctance to invest 182 and shock therapy 73–4 Sachs, Jeffrey 40 Sakharov, Andrei 57 Samsung 207 Samuelson, Paul 3, 23, 36 sanctions, and questionable effectiveness of 49 Sapir, A. 145 Sargent, T.J. 70 Sawyer, M. 105, 130, 135 Say’s tautology, and capitalism 81 Schelsky, Helmut 57 Schön, Donald 77, 83 Schuh, Scott 71 Schultze, Charles 67, 70, 72 Schumpeter, Joseph 18, 21, 231 Schwartz, A. 67 self-interest and capitalism 78, 82 and the common good 78, 80 and pseudo-capitalists 78, 80 Sen, Amartya 32–3, 75 Sharpe, William 74 Shiller, R.J. 75 Sibneft 183, 191 Silvermaster, Gregory 30 Silvos-Labini, Paolo 57 Simon, Herbert A. 18

250 Index Singapore 201, 207 Single Market Programme 142 Slavneft 185 Slemrod, Joel 73 Smith, Adam 17, 21, 61, 222 social bargains 94 and economic performance 101 social democracy, western 4, 59–60 social-historical school 3, 29 socialism, and social control of elites 4 socio-linguistics 84 solidarity, and systematic decomposition of 59 Solidarnosc 58 Solow, R. 116 South Africa, and automobile production 210–11 sovereign debt and insolvency 222–3 and international Chapter 9 proposal 222: and debtor protection 224; and democratic representation 224–5; and fairness 225–7; and human rights 223; and neutral arbitration 222–3; and sovereignty 223–4 and market solutions 217 Soviet Academy of Sciences 57 Soviet Union 57–8 and collapse of 47, 180 see also Russia special drawing rights (SDR) 169 spillovers, and industrial policy 203 Sraffa, Piero 35 Stability and Growth Pact (SGP) 6, 126, 135–40, 143 and argument for 135–6 and budget deficits 128, 136–8 and coordination of fiscal policy 136–7, 139–40 and criticism of 137 and fiscal policy 128 and operational difficulties 127, 128 stagflation 69, 91, 92, 148 state, the and economic development 199 and governing the market 205, 209–12 and industrial policy 205–9 and reduced role of 234–5

and relationship with business 184 and role of 1–2, 56 state intervention 4 state socialism 57–9 Stein, Herbert 70, 212 Stiglitz, J.E. 75, 165, 236, 238 and international financial system 166–7, 168–9 and special drawing rights 169 stock options 74 Strachey, John 57 structural adjustment, and Third World debt 215 SUAL 183 Summers, L. 111 Sun Yat-Sen 58 supranational rules, and developing countries 10–11 Surgutneftegaz 183 Sweeney, John 55 Sweezy, Paul 29, 45, 60 Szecpanski, Jan 57 Taiwan 201, 202 and achievement of 205 as developmental state 206–7 and industrial policy 204–5 and outward FDI 206–7 Taylor, J.B. 105, 116 Taylor, Lance 75 Taylor, Paul 30 technostructure 18 and industrial society 56 and military sector 3, 40, 41 and state socialism 57–9 and Third World 60 and western social democracy 59–60 terrorism, and war on 26, 55 Thatcher, Margaret 192 Third International 57 Third World debt 10, 214, 227–8 and absence of debtor protection 217, 221 and changing structure of 215–16 and debt management 216–17, 221 and enforcement of policy changes 218 and failure to grant debt relief 219 and Highly Indebted Poor Countries initiatives 216, 219

Index Third World debt – continued and institutional self-interest 219, 220, 221 and international Chapter 9 proposal 222: and debtor protection 224; and democratic representation 224–5; and fairness 225–7; and human rights 223; and neutral arbitration 222–3; and sovereignty 223–4 and international financial institutions 215–17, 219–21, 226 and loan loss provisions 218–19 and structural disequilibria 215 Thurbon, Elizabeth 205, 211 Tinbergen, Jan 180 Tobin, James 69, 111, 165 Tobin tax 82, 165 Tolley, Howard 3, 29, 30–1 Touraine, Alain 57 trade regimes, and economic performance 200–3 trade unions 4, 55, 194 Treaty establishing a Constitution for Europe 127 Triest, Robert K. 71 Turner, Frederick Jackson 55 unemployment and causes of 34–5 and definition of full employment 88 and inequality 20 and Keynesianism 90 and market power strategy 93–4 and natural rate of 66, 69, 91 and New Keynesianism 91 and non-accelerating inflation rate of 69–70, 91 and party control theory of economic policy 93 and political economy theory of aggregate demand 92–4: and formal model 95–9; and test results 99–101 and rational expectationists 70 and social bargains 94 and trends in 88–90 United Farmers of Ontario 27–8

251

United Kingdom and economic performance of 149 and United States 56 United States and bilateralism 239 and competition policy 156 and competitive liberalization 239–40 and economic performance of 142–3, 149–50 and growth regimes 148 and imperialism 53, 54, 55–6 and monetary policy 153 and post-war economic policy 193–4 and presidential election (2004) 82–3 and social democracy 59 and subsidies 236 as superpower 25–6 US Treasury 8, 165, 197 Veblen, Thorstein 16, 19, 21, 42 Vekselberg, Viktor 185 Venables, A.J. 159 Viakhirev, Rem 185 Vietnam War 37, 43, 53, 54 Vilasuso, J. 109, 110, 136 Volcker, Paul 68 voting patterns, and economic outcomes 97–8, 100 wages, and unemployment 91 war 3 and functions of 46 warfare-welfare state 55 Washington Consensus 8, 165–6, 196–7, 230 and currency crises 167 and developing countries 198–9 and features of 233–4 and finance capitalism 9, 197–8 and IMF loans 169 and lack of credible evidence for 197 and rational expectations 168 Wassenaar agreement (Netherlands, 1982) 149 Waugh, Evelyn 21 Weber, Max 18 Weintraub, Sidney 36, 37, 38 Weiss, Linda 205, 211 Wicksteed, P.H. 80

252 Index Williams, William Appleman 55 Williamson, John 165–6, 167, 196, 230 Wisconsin School of economics 30 Wojnilower, Albert 68 Wolfensohn, James 216 World Bank 8, 9, 165, 199, 236 and East Asian Miracle study (1993) 202–3 and good governance 237 and trade regimes and economic performance 200–2

World Development 165 world economy, and character of 230 World Trade Organization 9, 236, 238 WorldCom 78 Wright, Gavin 73 Wright Mills, C. 60 Wyplosz, C. 136 Yeltsin, Boris 58, 184 YUKOS 183, 185, 186, 191, 192

John Kenneth Galbraith and the Future of Economics

The Economics of John Kenneth Galbraith: Introduction, Persuasion, and Rehabilitation

The Economics of John Kenneth Galbraith: Introduction, Persuasion, and Rehabilitation

Economist With a Public Purpose: Essays in Honour of John Kenneth Galbraith (Routledge Frontiers of Politicaleconomy)

The Essential Galbraith

The Essential Galbraith

The Future of Philanthropy: Economics, Ethics, and Management

The Future of Life and the Future of our Civilization

The economics of nature and the nature of economics

Frontiers of development economics: the future in perspective

Economics and Finance of Risk and of the Future (The Wiley Finance Series)

Crisis Economics: A Crash Course in the Future of Finance

Economics of John Rae (Routledge Studies in the History of Economics, 20)

Future Directions for Heterodox Economics (Advances in Heterodox Economics)

John Maynard Keynes (Great Thinkers in Economics)

Robeson, Kenneth - The Vanisher

Robeson, Kenneth - The Secret of the Su

Robeson, Kenneth - The Pirate of the Pacific

The future of life

The Future of Coal

Hieroglyphs of the Future

The Future of Faith

Vision Of The Future

Vision of the Future

The Future of Career

The Future of Citizenship

Physics of the Future

The Future Of Sustainability

Vision of the future

Fantasies and the Future

John Kenneth Galbraith and the Future of Economics

The Economics of John Kenneth Galbraith: Introduction, Persuasion, and Rehabilitation

The Economics of John Kenneth Galbraith: Introduction, Persuasion, and Rehabilitation

Economist With a Public Purpose: Essays in Honour of John Kenneth Galbraith (Routledge Frontiers of Politicaleconomy)

The Essential Galbraith

The Essential Galbraith

The Future of Philanthropy: Economics, Ethics, and Management

The Future of Life and the Future of our Civilization

The economics of nature and the nature of economics

Frontiers of development economics: the future in perspective

Economics and Finance of Risk and of the Future (The Wiley Finance Series)

Crisis Economics: A Crash Course in the Future of Finance

Economics of John Rae (Routledge Studies in the History of Economics, 20)

Future Directions for Heterodox Economics (Advances in Heterodox Economics)

John Maynard Keynes (Great Thinkers in Economics)

Robeson, Kenneth - The Vanisher

Robeson, Kenneth - The Secret of the Su

Robeson, Kenneth - The Pirate of the Pacific

The future of life

The Future of Coal

Hieroglyphs of the Future

The Future of Faith

Vision Of The Future

Vision of the Future

The Future of Career

The Future of Citizenship

Physics of the Future

The Future Of Sustainability

Vision of the future

Fantasies and the Future

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