Lionel Robbins Memorial Lectures Economics after the crisis: Objectives and means Lecture III - Economic Freedom, Public Policy and the Discipline ...
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Lionel Robbins Memorial Lectures
Economics after the crisis: Objectives and means
Lecture III
Economic Freedom, Public Policy and the Discipline of
Economics
Adair Turner
London School of Economics
13 October 2010
0Starting Point: The Instrumental Conventional Wisdom
Free Allocative Human
Growth
markets efficiency happiness
Free
markets Inequality: Justified because it helps deliver growth
1Happiness and income per capita in the USA
Source: Bruno Frey & Alois Stutzer, Happiness and Economics, Princeton University Press, 2002
2Income and Human Contentment:
Possible stylised pattern over time
Pre-industrial societies The Great Transformation
Income / Contentment
Income
Developed
economies
Human wellbeing
contentment / happiness
China
Africa
Economic and technological
progress
3Three distinct reasons why relative income matters
1. Rising
expenditure on Concern for relative
fashion and status in itself
branded goods Higher
relative
income
increases
Happiness
2. Increased competition Relative income happiness
a function
for inherently limited influences absolute of others’
supply positional goods living standard income as
well as
own
Rising average incomes
3. Congestion externalities degrade quality of some
forms of consumption
4“Distributive” versus “creative” activities
“Creative” Increasing the net real
income available for
consumption
“Distributive” Winning increasing
income at expense of
others
Source: See Roger Bootle, The Trouble with Markets, chapters 4 and 5
5Health and social problems
Income Inequality
Source: Wilkinson & Pickett, The Spirit Level , Penguin 2009
6USA debt as a % of GDP by borrower type
300%
250% Corporate
200%
Household
150%
100%
Financial
50%
10%
1971
1977
1996
1959
1965
1983
1990
2002
1929
1935
1941
2007
1947
1953
Source: Oliver Wyman
7Global issuance of Collateralised Debt Obligations:
Cash and synthetic
300
Synthetic
250 Cash
200
$bn
150
100
50
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Source: IMF Global Financial Stability Report, 2006
8Complete markets as a route to…
… efficiency … and stability
Credit derivatives “enhance the “There is a growing recognition
transparency of the markets’ that the dispersion of credit risk
collective view of credit risks.. by banks to a broader and more
[and thus]… provide valuable diverse group of investors has
information about broad credit helped make the banking and
conditions and increasingly set overall financial system more
the marginal rice of credit. resilient …
Therefore, such activity improves The improved resilience may be
market discipline” seen in fewer bank failures and
more consistent credit provision”.
IMF, Global Financial Stability Review, April 2006
9Share of the financial industry in US GDP
%
9
8
7
6
5
4
3
2
1
0
1850 1910
1850
50 70 90 1910
10 30 50 70 90
Source: Philippon, T (2008), The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence. (As referenced
by Andrew Haldane in The Future of Finance, LSE Report, 2010)
10Historical 'excess' wage in the US financial sector
'Excess' wage
0.5
0.4
0.3
0.2
0.1
+
0.0 -
1910 2000
0.1
1910 2000
Source: Philippon,10
11
T12
13
15
16
and17
18
20
21
22
23
25
Reshef 26
A27
28
30
31
32
33
35
36
(2009). 37
38
40
41
42
Wages43
45
46
47
and48
50
51
52
53
55
Humal 56
57
58
60
61
6263
Capital6566
in6768
70
the71
72
73
US75
76
77
78
80
81
8283
85
Financial 86
87
88
90
91
9293
95
Industry: 96
97
98
00
01
02
03
05 NBER Working Paper
1909-2006,
No 14644.A. Resh (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)
11 Growth not the objective but by-product of other
desirable objectives
Policy implications
Implications for the discipline of economics
12The case for growth
Growth in low and middle income countries
The poor in rich countries
Economic regression in absence of markets
The journey, not the destination
Economic freedom as an end per se
+
Avoidance of involuntary unemployment
13The internally contradicted argument
Economic growth in rich countries still matters because it
matters to poorer citizens
Economic growth is maximised by significant inequalities /
incentives
Therefore don’t worry if economic growth is combined with
increasing inequality
14The case for growth
Growth in low and middle income countries
The poor in rich countries
Economic regression in absence of markets
The journey, not the destination
Economic freedom as an end per se and avoidance of
involuntary unemployment
15Keynes, The General Theory
“There is social and psychological justification for
significant inequalities of incomes and wealth…
… dangerous human proclivities can be canalised into
comparatively harmless channels by the existence of
opportunities for money-making and private wealth
which, if they cannot be satisfied in this way, may find
their outlet in cruelty, the reckless pursuit of personal
power and authority, and other forms of self-
aggrandisement. It is better that a man should tyrannise
over his bank balance than over his fellow citizens.”
(Chapter 24)
16The case for growth
Growth in low and middle income countries
The poor in rich countries
Economic regression in absence of markets
The journey, not the destination
Economic freedom as an end per se and avoidance of
involuntary unemployment
17Happiness, income and changing aspirations
Aspiration 1
Aspiration 2
Happiness
2 3 Aspiration 3
1
Flat line of long-term happiness
Income
18The case for growth
Growth in low and middle income countries
The poor in rich countries
Economic regression in absence of markets
The journey, not the destination
Economic freedom as an end per se and avoidance of
involuntary unemployment
19Amartya Sen, “Freedom as Development”
“… the freedom of people to act as they choose in
deciding where to work, what to produce, what to
consume…”
“The merit of the market system does not lie only in
its capacity to generate more efficient culmination
outcomes but also in the processes by which those
outcomes are achieved”
(Chapter 1, The Perspective of Freedom)
20 Growth not the objective but by-product of other
desirable objectives
Policy implications
Implications for the discipline of economics
21Four clear policy implications
Maximise stability and minimise downsides
• Financial regulation and macro-economic management
• Climate change mitigation
Maximise public choice: especially at local level
Minimise positional goods competition
• Welcome population stabilisation
22Happiness, already achieved income, and changing
aspirations
Plus:
Happiness
Happiness as
1 2 3 4
function of
relative as well as
absolute income
Income
23Do we “need to grow” to afford public expenditure?
Health In general no, if main cost is
salaries which rise proportionally
with average GDP per capita
Education
Debt servicing Yes, if macro-instability or fiscal
profligacy generate high stock of
debt relative to GDP
24Costs and benefits of higher capital and liquidity standards
Possible costs to GDP growth
• Long-term? Vs Benefits of reduced probability
• Transitional of negative setbacks
Standard evaluation techniques
• Compare costs & benefits using a discount rate which accords
equal weight (in any given year) to costs and benefits
Consequence: will undervalue stability and over-value minor
increments to growth, if people highly value already achieved
wealth/income and avoided unemployment, and deeply dislike
setbacks
25Estimating GDP
Measured value of
Long-term trends and
financial services?
cross-country
comparisons between
Distributive rent rich countries have
extracting versus
Lionel Robbins:
uncertain meaning
“creative” activities “both the concept of
world money income
and of national
Increasing % of money income have
income devoted to Annual or quarterly strict significance
housing house changes are crucial only for monetary
prices increase: guide to inflation theory”
inflation or real targeting and
income? economic stabilisation
26Four clear policy implications
Maximise stability and minimise downsides
• Financial regulation and macro-economic management
• Climate change mitigation
Maximise public choice: especially at local level
Minimise positional goods competition
• Welcome population stabilisation
27Growth in UK living standards: with 80% emissions cut
GDP per capita 2006=100
300
338
225 1.0 – 2.0%
lower
150
100
75
0
2006 2020 2030 2040 2050
Business as usual
80% emissions cut
28Costs of climate change
Conceptually clear – but difficult to quantify, e.g.
changes in agricultural yields
Inherently uncertain
• Contingent social and political responses
Small probability catastrophic losses
29The impact of discount rates
Assuming 2% per
£1000 in 2150 annum growth: 100 %
Discounted is worth of GDP in 2150 is worth
at 4% real £3.67 today 6% of GDP today
at 2% real £59 today 100% of GDP today
30Discount rate and declining marginal utility
r = η (g) + δ
η = the elasticity of the marginal
utility of consumption
Utility
g = growth rate
δ = the rate of pure time Consumption
preference
Stern’s base case η = 1 g = 1.9 δ = 0.1 r = 2.0%
The flatter the curve becomes, the higher η, and the higher the discount rate
31Happiness already Achieved Income and Changing
Aspirations
Plus:
Happiness
Happiness as
1 2 3 4
function of
relative as well as
absolute income
Income
32Three problems with the standard discount rate approach
Losers in future may be Discount rate should be
poorer than rich big negative
emitters today
Small probability of Discount rate applied to
catastrophic losses those losses should be
negative
Losses of
environmental goods – Gains of economic income
species, beauty, cannot offset environmental
diversity – valued in losses
themselves
33Four clear policy implications
Maximise stability and minimise downsides
• Financial regulation and macro-economic management
• Climate change mitigation
Maximise public choice: especially at local level
Minimise positional goods competition
• Welcome population stabilisation
34Four clear policy implications
Maximise stability and minimise downsides
• Financial regulation and macro-economic management
• Climate change mitigation
Maximise public choice: especially at local level
Minimise positional goods competition
• Welcome population stabilisation
35Population growth and stabilisation: UN medium projections
World population (bn) EU 27 and UK population (m)
9.5 9.2
9.0 8.8 600
8.5 8.3 500
8.0
495 513 519 520 515
7.7
400
7.5
7.0 300
6.5 200
6.5
6.0
100 60 65 68 70 72
5.5
5.0 -
2005 2020 2030 2040 2050 2005
2005 2020
2020 2030
2030 2040
2040 2050
2050
Source: UN Medium Projections
36Four clear policy implications
Maximise stability and minimise downsides
• Financial regulation and macro-economic management
• Climate change mitigation
Maximise public choice: especially at local level
Minimise positional goods competition
• Welcome population stabilisation
Overall Objective: Creating a stable environment in which freedom to choose
can be allowed expression while minimising downside consequences and
setbacks
37Two unclear issues
1. Are some goods / services more important to human
wellbeing / happiness than others – even when counted
equally in GDP?
2. How much inequality is fair / optimal / unavoidable?
38Different marginal utility of different “goods”
Utility / Happiness
Utility / Happiness
Utility / Happiness
Income Income Income
Congestion and
Branded environmental
Good health? fashion goods? damage?
3940
Sub-optimal consumption choices
Goods consumed as a result of public choice
Social mores, herd-like fashion, and advertising
Congestion and environmental externalities
41Two unclear issues
1. Are some goods / services more important to human
wellbeing / happiness than others – even when counted
equally in GDP?
2. How much inequality is fair / optimal / unavoidable?
42How much inequality?
The instrumental Inequality is justified because and to the extent that it
justification delivers growth which delivers wellbeing; low taxation
rates incentivise effort and entrepreneurship
The reality
Relative income matters
Standard responses inadequate
– Growth
– Skills
– Opportunity
Relative status competition invalidates standard incentive theory
Economic freedom, and even perceived fairness, imply significant
inequality
43 Growth not the objective but by-product of other
desirable objectives
Policy implications
Implications for the discipline of economics
44Economics in the dock
Prosecution Defence
Assumption of rationality Always recognised
imperfections
Mathematicisation: “physics
envy” Never monolithic
Focus on market completion • Mirrlees, Stiglitz, Akerlof
and equilibrium • Kahneman
Lack of enquiry about end • Sen
objectives Never said growth (rather
than welfare) was objective
Prosecutors:
Robert Skidelski Keynes: “The Return of the Master”
John Cassidy: “How Markets Fail”
45From Arrow-Debreu to the Washington Consensus:
Three simplifications
Downplay of severity of market imperfections
From Pareto equilibrium to good outcome – even
without redistribution
From equilibrium to growth as the objective
46Economics for the real world, not for ease of modelling
Objectives
Is happiness the objective? Or welfare? Or freedom?
How are they related to each other, and to income?
Can we measure happiness or welfare?
Means
Inherent failures of complex markets
Consequences of human mental processes – part
rational, part instinctive
Inherent irreducible uncertainty, not mathematically
modellable probability distributions
47Keynes on economics
“economics is a moral and not a natural science”
***
“no part of man’s nature or his institutions must be
entirely outside [the economist’s] regard”
***
The economist should be “mathematician,
historian, statesman and philosopher in some
degree”
48“Economics deals with ascertainable facts: ethics with
valuations and obligations. The two field of enquiring are not on
the same plane of discourse”
(Lionel Robbins, On the Nature and Significance of
Economic Science, 1932, P.132)
“As against Robbins, Economics is essentially a moral science.
That is to say, it employs introspection and judgement of value”
(John Maynard Keynes, Letter to Roy Harrod)
49Lionel Robbins: Essay on the Nature and Significance of
Economic Science
“Both the concept of world money income and of national income
money have strict significance only for monetary theory”
***
“There is no penumbra of approbation around the theory of
equilibrium. Equilibrium is just equilibrium”
***
“It is highly desirable that the economist who wishes that the
application of his science should be fruitful should be fully
qualified in cognate disciplines and should be prepared to
invoke their assistance”
***
“There is nothing in economics which absolves us of the obligation to choose”
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