What went wrong with supply-side economics?

The economic crisis of 2008/2009 had confronted the mainstream economic theory with an unpalatable task of revisiting the notions and perils of the ideas which dominated the course of economic theory in the last few decades. In 2003, delivering a speech to the American Economic Association, Robert Lucas famously noted that the central problem of depression prevention had been solved by mainstream macroeconomic theory which was built by combining the rational expectation hypothesis with New Keynesian macroeconomics. Although one should not obscure the achivements of new classical macroeconomics and new Keynesian macroeconomics, the criticism of contemporary macroeconomic theory is not uniform. It stems from the unrecognized role of systemic shocks in the financial sector and the spillovers from Wall Street to the Main Street. In contemplating the the linkages of over-leveraging and biased financial deregulation, it should not come as a surprise that early warnings of the financial crisis, mainly leveraged borrowing in the U.S subprime mortgage market, were earmarked in the mainstream economic theory.

In fact, in 1970, George Akerlof's influential paper on the issue of adverse selection in the market for lemons, was a landmark achievment in the economic theory since it demonstrated the falacies of perfectly competitive market mechanism when the information on quality of various commodities is distributed unevenly. In addition, a series of papers in 1970s by Joseph Stiglitz on screening theory and asymetric information, has dealt exactly with the central origins of the 2008/2009 financial crisis. Subprime loans and highly-complex derivate schemes which enabled the exponential growth of overleveraging of the banking sector were most likely to be used by the least sophisticated and accordingly the most risky borrowers. The only difference is that in normal circumstance, banks would recognize adverse selection by rationing credit to risky borrowers but the continuous obsession with home-ownership and the reluctance of the Federal Reserve to "remove the bowl of punch when the party started" - to use the analogy of Preston Martin, former Vice President of the FED - added to the turbulence of overleverage that turned into the most disastrous financial meltdown after the Great Depression.

The fact is that contemporary macroeconomics had little to offer to predict the subsequent financial meltdown although Robert Shiller of Yale University has repeatedly warned against unstable stock market fundamentals, particular notorious price-earnings ratios after the dot-com bubble came to burst. However, the central element of the critic of mainstream economic theory should revisit the notorious paradigm of supply-side economics whose intelectual melange of fervent belief in tax cuts and a dangerous preoccupation with deregulation as the cure of the malaise which led to stagflation in early 1970s, have proved how dangerous the conclusions could become.

First, the rise of the supply-side economics in the political economy began in early 1980s. But the intelectual influence of the supply-side economics should not be confined to the theoretical paradigm itself. The field of the political economy of taxation manifested itself as the intelectual triumph of supply-side economics. The original idea of the Laffer curve, the relationship between tax rate and tax revenues, was not disputable after all. In fact, if tax rates reached predatory levels, decreases in total tax burden would yield considerable gains, not only in total tax revenue but also in terms of higher level of productivity. However, when average and marginal tax rates were at moderate levels, it would be foolish to believe immense revenue gains would ensue by reducing the rates of taxation to bottom-levels, arguing for significant gains in terms of employment growth, productivity boost and total tax revenues. Even though cross-country empirical evidence does suggest an increase in tax revenues amid the decline in average tax rate, the pattern is confined to the episodes where average and marginal tax rates were very high, exceeding 70 percent threshold. Once tax rates were reduced, there is no evidence of higher revenue gains.

The major peril of supply-side economics is the claim that tax reduction would boost the aggregate supply and stimulate productivity growth. On the other hand, the valuable contribution of supply-side economics is the notion that additional tax increases do not generate much higher revenue. One should not feel reluctant to recall the 1964 Kennedy-Johnson tax cut which decreased marginal tax rates substantially. Although supply-side economics has repeatedly blasted the intelectual heritage of Keynesian macroeconomics, the 1964 tax reform was itself a Keynesian prescription for the U.S recession in the years prior to Vietnam war. Back in early 1960s, Paul Samuelson wrote that "Congress could legislate, for example, a cut of three or four percentage points in the tax applicable to every income class, to take effect immediately under our withholding system in March or April, and to continue to the end of the year." (link). Therefore, Samuelson's mindful observation that additional spending would not automatically counteract the recession unless complemented by tax reductions, probably would not come due in the framework of supply-side economics. Moreover, what distinguished the supply-side economics from the framework of sound economic analysis taught in microeconomic and macroeconomic textbooks, was adverse propensity to enforce tax cuts for the rich while leaving the middle class and low-income households no pie from tax reductions. The striking features of income inequality in the U.S. suggest that from 1970s, median household income stagnated (link) while top 5 percent of households have received disproportionately windfall gains from tax reductions up the point where more than 85 percent of total income was earned by top 5 percent of households (link). Moreover, one should distinguish between patterns of good and bad inequality as Gary Becker recently suggested (link). It is envitable that income inequality has some great value in the society when market outcomes lead to better overall health, less stress and higher standard of living and the evidence is yet inconclusive whether the narrowing of income inequality would return health improvements for the poor - since poor health outcomes of low-income households are mainly attributed to deteriorating dietary habits and dangerous lifestyle.

While bad inequality, especially rents from non-market outcomes, have precipitated the decline in good inequality in the last two decades, there is an overwhelming evidence that stagnation of median household income (despite moderate productivity improvements) caused a somehow lower quality of the U.S. labor force and a widening gap in educational achievments of American children. The drawbacks of widening inequality were largely ignored by supply-side economics or justified on the hands-off approach to the issues of the poor. It should not be forgotten that negative income tax, which favored low-income families, was suggested by Milton Friedman, whom supply-siders have taken for the intelectual father without a detailed knowledge of his precious contribution to economics.

Second, supply-side economics has been perhaps known for favoring the deregulation as the cure for social ills and staggering income growth. Despite substantial euphoria caused by the pioneers of deregulation of banking and financial sector, the regulatory framework eventually jeopardized sound regulation that could prevent hazardous outcomes as shown in the seminal work of George Akerlof and Joseph Stiglitz. In fact, deregulation of the banking sector, hailed by supply-side economics as the triumph of its own ideology, laid the basis for rigorous financial innovation by special investment vehicles (SIV) and shadow banking institutions.

In fact, deregulation of the banking and financial sector was not the central issue per se. The main systemic flaw was rather the adoption of unsound regulation that did not predict the perils of over-leveraged banking sector and especially the system-wide spillovers during the financial crisis. Moreover, the loosening of the monetary policy and the series of fiscal stimulus have notified two main drawbacks in the macroeconomic outlook. The first is the invariant postponement of taxation fuelled by the mountain of government debt. And the second is the hidden explosive potential for inflation following the flood of money supply in the balance sheet of the banking sector.

Generally speaking, the intelectual adventure of supply-side economics has overlooked the possibility of pitfalls brought up by rigorous tax cuts to the wealthy and deregulation of banking and financial sector. It would not come due to label mainstream economic theory as a cataclysm which the financial crisis proved accordingly. It would be either insensible to tarnish the useful contribution of supply-side economics. In fact, tax cuts do generate systemic incentives, particularly in the response of the labor supply to tax reductions. However, the elusive quest for higher growth and job creation after reducing tax rates for the wealthy, is an important lesson we should learned from the unfortunate turn of supply-side economics in favoring deregulation without acknowledging the possibility of systemic banking collapse and the consequences carried over by society at large.

AUTHORITARIAN POLITICS AND ECONOMIC GROWTH

Dani Rodrik argues (link) that political dictatorship is damaging to economic growth since democracies not only outperformed countries with flawed political regimes in the dynamics of economic growth but also in terms of greater civil, economic and political liberties and investment in education that help enforce better public policies and yield better prospects of economic development.

"Democracies not only out-perform dictatorships when it comes to long-term economic growth, but also outdo them in several other important respects. They provide much greater economic stability, measured by the ups and downs of the business cycle. They are better at adjusting to external economic shocks (such as terms-of-trade declines or sudden stops in capital inflows). They generate more investment in human capital – health and education. And they produce more equitable societies."

ECONOMICS AND THE RETURN OF HISTORY?

In Friday's edition of NY Times, David Brooks wrote a very interesting column (link) discussing the state of economics. Although subtle and rigorous in its assertions I doubt that the field of economics needs a fundamental change in the philosophical origins of economic methodology. I agree with the author that economists often ignore the notion of moral philosophy and history in economic analysis but that doesn't mean that old textbooks on classical microeconomics need to be disposed. The author points out the role of economic forecasters who often appear on the TV, essentially trying to forecast economy's future path. Econometrics, which constitutes time-series forecasts on which most economic projections are based, is a real discipline to which numerous new scientific articles are devoted, published mostly in The Econometrics Journal and Econometrica. In his famous 1983 article (link) Let's take the con out of econometrics, Ed Leamer wrote how econometric modelling can be misused if a researchers ditch the true role and significance of assumptions. A prominent example is the study of death penalty on crime deterrence. As you can read in more detail in Leamer's article, one study found out that each capital punishment deters more than 9 murders while another one found out that each additional capital punishment causes more murders.

The contradicting evidence doesn't imply the falsification of the scientific method in economics. It merely reveals the hidden difference in how economists set assumptions regarding the behavior of individuals, firms and countries. David Brooks pointed out that economists failed to predict the recent financial crisis. However, many economists (myself included) pointed out the true dangers of an over-leveraged economy and monetary easing which led to subprime mortgage crisis and the consequential aftermath.

Many of us have had clear evidence, models and studies that showed how an over-leveraged financial sector can induce a significant economic downturn. However, many policymakers ignored the evidence of the behavior of the financial system which could be easily compared with chaos theory in mathematics. In my recent paper on Iceland's financial crisis I showed that the depository banks' overall leverage and indebtedness in the small country was growing exponentially, beyond the limit of capital adequacy.

As Paul Krugman recently noted, lessons from the Great Depression were not learned because people forgot it too quickly. Although mainstream economics, as every field within economic science, needs some major cures, I disagree with author's assertion that economics is not a real science but a moral philosophy. True, economics is not exact science because human behavior is not as experimental as particle analysis in physics but economics tries to resemble the scientific methodology through models, data, statistical inference and evidence. In fact, new interdisciplinary fields within economics are emerging such as behavioral economics, neuroeconomics and transport economics in which economic analysis is combined with other disciplines such as law, psychology, sociology and neuroscience.

The limits of mathematical recourse in economics were already discussed by economic thinkers such as John Maynard Keynes. And agreeably, mathematical reasoning is bounded by economic reasoning. However, from the real point of view, we need models to address human behavior mostly because, as F.A Hayek noted, it's too complex to capture its essence in a scientific entirety. If the neccesity of assumptions, models and evidence were not the case, hardly any lessons would be learned from the episodes of crises, booms, busts and periods of economic advancement in human history.

INTERVIEW WITH JOSE PINERA

POVERTY, INCENTIVES AND DEVELOPMENT

Daron Acemoglu wrote a marvelous article discussing the supportive role of incentives and institutions in global poverty reduction and economic development (link):

"If we know why nations are poor, the resulting question is what can we do to help them. Our ability to impose institutions from the outside is limited, as the recent U. S. experiences in Afghanistan and Iraq demonstrate. But we are not helpless, and in many instances, there is a lot to be done. Even the most repressed citizens of the world will stand up to tyrants when given the opportunity. We saw this recently in Iran and a few years ago in Ukraine during the Orange Revolution."

WHAT EASTERN EUROPEAN TIGERS CAN TEACH WESTERN EUROPE

In yesterday's edition of WSJ, Johnny Munkhammar and Nima Sanandaji wrote a well-argued dissussion (link) on how Eastern Europe's advantage in terms of competitive tax rates, low tax burden and sizeable reform efforts in emerging from the crisis offer a great lesson for economic recovery of the Western counterparts.

NOBEL PRIZE IN ECONOMICS 2009

This year's Nobel prize in economics goes to Elinor Ostrom and Oliver E. Williamson (link). Elinor Ostrom received the prize for her analysis of economic governance, especially the commons while Oliver E. Williamson received the prize for his contributions to the economic governance, emphasizing the boundaries of the firm and its role in conflict resolution and case bargaining.

Michael Spence, the 2001 Nobel prize winner, briefly summarized (link) the main contributions of Elinor Ostrom and Oliver E. Williamson to the economic theory.

THE ECONOMICS OF UNIONS

Gary Becker (link) and Richard Posner (link) opened a discussion on how unions influence policymaking decision. Recently, president Obama imposed punitive 35 percent tariff rate on imported Chinese tire (link) risking the coming trade war. Indeed, China may file a case against the U.S at the WTO, and the WTO may rule against the U.S for imposing illegal and discriminatory trade practices.

Many believe that president Obama enforced trade protection to win the support of the unions in health care reform. In fact, the bailout of GM and Chrysler was one of the major efforts to help unions, particularly the United Auto Workers, in paying the health-care and pension benefits that GM and Chrysler couldn't actually afford to pay.

Recently, the Congress has been split up on Employee Free Choice Act which suggests giving mandate to unions representing employee in arbitrating union-management contracts. I believe the Congresional Budget Office will yield a meaningful research on the economic effects of the act.

The empirical evidence on union activity is, in fact, quite clear. In OECD comparison panel (link), there is a strong, negative and significant relationship between the density of union membership and labor market rigidity. Sweden, for example, hasn't enforced a general level of minimum wages. Yet in 2007, over 7o percent of the working population was unionized. High union density further contributed to inflexible labor market structure which led to low employment growth, low productivity growth and exerted a strong upward pressure on real labor cost.

Yet, there is a distinctive character of trade unions within Europe. Traditionally, unions in Europe possessed a stronger influence on political decision in areas such as taxation, income redistribution and government size. However, there are significant disparities in union activity throughout Europe. In 1990s, Denmark enforced a series of reforms that deregulated labor market structure towards greater flexibility. Today, Denmark's labor market is cited as the most competitive in the world (link). From 1990 to 2007, union density decreased from 75.3 percent to 69.1 percent. On the other side, labor market structures in Continental and Mediterranean Europe are known for inflexible features, regulation and rigidity. Meanwhile, Anglo-Saxon countries, Britain and Ireland, are known for flexible labor markets and few barriers impeding labor market performance. Dismissing and employee costs 10 weekly salaries in Ireland compared to 56 weekly salaries in Spain.

Although variation in trade union density over time explains a relatively large part of variation in productivity, union activity and influence in political decision-making could be the decisive factor in explaining cross-country variation in labor market outcome. That would requiring the design of principal indicator that could measure union influence on the quantitive basis. The influence of trade unions has, in my opinion, a strong common connection to cultural patterns and informal institutions.

For instance, countries with weak rule of law, persistent corruption, high tax burden and barriers to trade and investment, tend to have larger underground economies. Empirical estimates on the size of underground economies suggest that, in Europe (link), Mediterranean countries (Italy, Spain, Greece, Portugal) have the largest share of shadow economies. There is a significant cross-country variation. The estimates of shadow economies for 28 transition countries is 40.1 percent and 16.3 percent for the OECD. So, could union activity affect the size of shadow economies

If unions, as an interest group, exert a strong influence in politics, their political philosophy will probably lean left. Thus, if unions influence decisions on taxation issues, welfare benefits, pension schemes and government size, the outcome will probably induce more complexity, more regulation and more barriers to trade, entrepreneurship and investment. The combination of those factors can strongly influence labor and business incentives and, hence, also determine and productivity growth.

HAPPY BIRTHDAY, MILTON

Milton Friedman died on November 16th 2006. July 31st remarks his birthday and an opportunity to reflect his profound legacy of economic thinking and ideas promoting individual liberty.

I first came across Friedman's ideas through one of his first research papers, Income from Independent Professional Service (link), coauthored with Simon Kuznets, wherein Friedman and Kuznets showed how shortage of physicians emerges from restrained labor supply and upward wage pressures. Together with Kuznets, Friedman applied statistical models to the analysis of income from professional services. The empirical results indicated that the regulation of professional services raises general income level for existing practitioners while, at the same time, reduces incentives for market entrants by raising fixed entry costs and compliance cost.

The paper was written in 1945 when orthodox Keynesian economic policies took a full-fledged march. Friedman's strong analytical rigour successfully challenged Keynesian economic establishment of that time. In Theory of the Consumption Function, Friedman showed how Keynesian theory of consumption fails to capture long-run behavior of households. In General Theory, Keynes postulated that household's consumption is determined by autonomous consumption and consumption induced by income. Since Keynes assumed that consumption is a linear function of income, higher income is ought to result in higher savings. Later on, Simon Kuznets showed that Keynesian consumption function suffers from empirical incosistencies. Even though it had been seemingly accurate in short-run cross-section data, it failed to predict household income pattern in time-series data over the long run. If Keynesian assumption was held true, the savings-to-income ratio would grow over time. On the contrary, the ratio remained constant over time in spite of relatively large income changes. Keynesian theory of consumption was further shook by new theories of consumption. Franco Modigliani, Nobel Laureate in Economics from 1985, challanged Keynesian consumption theory by introducing life-cycle hypothesis, showing how savings-to-income ratio changes over the entire lifetime, depending on household's life stage. Franco Modigliani and Richard Brumberg proposed the life-cycle income hypothesis with a more realistic assumption. He tested the following equation: C = aW + cY where a is marginal propensity to consume wealth (W), and c is marginal propensity to consume income (Y). The empirical results for the United States estimated the marginal propensity to consume from disposable income (c) at 0.7 and marginal prospensity to consume from wealth (a) at 0.06. The estimates were used to examine household consumption patterns. Thus, over the lifespan, as household's income went up by 1 percent, consumption expenditures wemt up by about 0.7 percent on average. Meanwhile, as household's wealth increased by 1 percent, the consumption expenditures grew by 0.6 percent on average.

The research by Modigliani and Brumberg in 1957 and Kuznets paved way for Friedman's Permanent Income Hypothesis. In a proposed hypothesis, Friedman argued againist Keynesian consumption theory. Its major inability is the weakness of prediction and the inconsistency in consumption patterns between short-run and long-run results. Contrary to Keynes, Friedman argued that disposable income arises from permanent and transitory income. Permanent income held by household was defined as household's preference for a stable consumption over the long run. Friedman showed that consumer's choices are made not by transitory income but by permanent income expectations. Thus, transitory changes in income have little effect on consumption behavior. The empirical assessment of permanent income hypothesis showed that households with lower income tend to have higher marginal propensity to consume. Friedman concluded that consumer's spending is not affected by static expectations but rather by real wealth such as physical assets and human capital assets. These determine consumer's earning ability and enable consumers to forecast their lifetime income.

When Friedman received a Nobel prize in economics back in 1976, the Nobel Commission entitled the award for "...his achievements in the fields of consumption analysis, monetary history and theory and for his demonstration of complexity of stabilization policies..." Back in 1963, Friedman and Schwarz wrote the Monetary History of the United States 1867-1960 where they examined the monetary trends in the United States since the end of the civil war.

Through an extensive empirical observation of money supply, monetary policy and business cycles they showed that monetary intervention by the Federal Reserve System, which was established in 1913, in an attempt to stabilize the short-term cyclical shock in the financial market resulted in the worst economic depression in world history. Fed's intervention reduced the broad money supply, destroying the depository base. The intervention led to the banking panic. Lending operations were disabled and the banking system suddenly went insolvent. When Federal Reserve cut the money supply by one-third in 1929, the ordinary recession turned into the depression in the light of deflationary shock. As the leading voice of the monetarist school, Friedman showed that inflation is a monetary phenomena resulting excessive growth of money supply relative to output growth.

Friedman's empirical research on monetary trends over time led to important conclusions. The most notable conclusions were that (1) short-run changes in money supply affect output while (2) long-run changes in money supply affect price level. Friedman's empirical work on monetary economics dropped the Keynesian myth of inflation caused by oil price increases or upward wage pressures. Friedman suggested that Fed should increase the quantity of money by a rate, ranging from 3 to 5 percent, determined in advanced. In a debate with Walter Heller, the chairman of Council of Economic Advisers to President Kennedy, Friedman argued that fiscal policy is an inefficient demand management tool in stabilizing economic fluctuations.

Milton Friedman was also a leading and indispensable libertarian voice throughout the world. Back in 1962, he published Capitalism and Freedom. The book spread the ideas of economic and individual liberty around the world. Friedman wrote that economic freedom is a neccesary condition for individual and political freedom. The ideas of ending all currency controls, removing barriers to trade, drastically cutting government spending, privatizing social security, introducing school vouchers and ending progressive income tax structure, spurred the creation of liberal freedom movements around the world.

As one of the rarest voices around the world, Friedman proposed the negative income tax as an alternative to progressive income taxes. As the wealthy take advantage of various loopholes, exemptions and tax breaks, progressive income tax does not achieve its purpose but, contrary to expectations, it further increases the income inequality. The basic idea behind the negative income tax is that general allowance would be raised to guarantee the minimum income level while the income above basic exemption would be taxed at the flat rate. The books written by Milton Friedman truly revolutionized the world. Free to Choose, coauthored with Rose Friedman, introduced free-market ideas to the general public by popularizing cases for limited government, the rule of law, and various way to end government monopolies.

Friedman's ideas reached the arena of public policy in many countries. Although heavily criticized by the left-wing intellectuals, Friedman visited Chile and delivered a lecture in Santiago on economic freedom. He advocated deregulation, privatization and the case for floating exchange rate. Due to the decision of Chilean Ministry of Finance, the exchange rate was fixed to the U.S dollar as a cure to heel rampant inflation. Since the Central Bank of Chile hadn't reduce the money supply, dollar-denominated foreign loans deteriorated Chilean trade balance. The decision to fix the exchange rate in the absence of accomodative monetary policy, imports were inflated. Because exchange rate was not floating, the elimination of fixed exchange rate and a disinflationary policy of the central bank unavoidably resulted in a two-year recession.

However, nothing could be further from the truth than then assertion that free-market reforms destabilized Chilean economy. Output contraction is a natural consequence of disinflationary policy, following the reduction of money supply. After exchange rate controls were eliminated, and after the launch of the privatization of state-owned companies and the social security, deregulation and free trade, starting in 1985, Chilean economy grew at the robust rate. Industrial production increased and the unemployment went down. In the long run, Chile's GDP per capita has been the highest in the region with a vibrant economy facing stable institutions and an enviable Friedman's ideas influenced many leaders around the world.

His ideas inspired Margaret Thatcher to undertake the course of free-market reforms. Prior to the launch of fiscal and monetary policy reforms, the British economy was recognized as the sick man of Western Europe, facing high annual rates of inflation and unsuccessful Keynesian economic policy attempt to cure the ailing economy by boosting aggregate demand through government deficits. After Lady Thatcher slashed marginal tax rates, introduced deregulation, liberalized labor market and proposed the privatization of state-owned industries, the British economy thrived with economic growth rates reaching historic highs.

Milton Friedman left a wealthy legacy of free-market thinking and efforts to promote individual liberty, free economy and political freedom. The financial crisis of 2008/2009 that spurred the economic recession intiated the beginning of heavy government intervention. The pursuit of ideas in favor of individual liberty and economic freedom is the best weapon againist the growth of government and the welfare state. With an iron will of the classical liberal, he successfully battled the failures of the welfare state and government intervention. He surely is one of the greatest economists and thinkers of the time.

WHY INTELLECTUALS LOVE SOCIALISM

Back in 2005, Vaclav Klaus delivered a great speech (link) on why there is a huge and remarkable inclination of intellectuals towards the ideas of socialism.

"As we see both in Europe and in America, the intellectuals love such a system. It gives them money and an easy life. It gives them an opportunity to be influential and to be heard. The Western world is still affluent enough to be able to support and finance many of their unpractical and directly unpurposeful activities. It can afford the luxury of employing herds of intellectuals to use “poetry” for praising the existing system, for selling the concept of positive rights, for advocating constructivist human designs (instead of spontaneous human action), for promoting other values than freedom and liberty."

HARVARD ECONOMISTS ON FINANCIAL CRISIS

Here (link) is Harvard's Department of Economics web, listing articles and opinion by Harvard economists on current financial crisis.

Top suggesstions: here, here and here.

NOBEL PRIZE IN ECONOMICS 2008

The Nobel laureate in economics in 2008 is Paul Krugman (here):

"IT WAS widely expected that Paul Krugman, who won the the 2008 Nobel prize for economics on Monday October 13th, would claim the award one day. In 1991 he had received the John Bates Clark medal for the best young economist, which is widely seen as a stepping stone to a Nobel award. What is more of a surprise is that he was honoured rather sooner in his life than many other winners. Like most Nobel laureates in economics, Mr Krugman was recognised for research undertaken early in his career—in this case for his pioneering work on modelling trade between countries whose firms grow more profitable the bigger they become. At 55, he is only four years older than the youngest ever winner, Kenneth Arrow, who was 51 when he won in 1972. But he is a fresh-faced youngster in comparison with Leonid Hurwicz, one of last year’s winners, who was 90 when he shared the prize."

DON BOUDREAUX ON THE ECONOMICS OF PROSPERITY

Donald Boudreaux recently published an article where he discusses the emergence of prosperity (here)

THE POTENTIAL OUTCOME OF OBAMANOMICS

Tom Wilson, a British speechwriter, wrote an opinion (link) in Wall Street Journal, showing incredibly similar parallels between Obama's economic agenda and the economic agenda of Britain's Labour party in Pre-Thatcher years, that turned British economy into the sick man of European economy.

CLASSICAL LIBERALISM, PUBLIC CHOICE AND ECONOMIC DEVELOPMENT: THE CASE OF SLOVENIA

I recently listened the serie called "Intelekta" (link) on Radio Slovenia. The topics of the talk was classical liberalism and its direct and indirect effects on economic growth and development. Nobel laureate fromm 1973 and an imminent philosophical and economic thinker, Friedrich August von Hayek once famoulsy noted that society's course will be changed only by the change in ideas. Once ideas meet the minds of the individual initiative, the politico-economic measures will follow. Slovenia, still the wealthiest post-communist economy, enjoys moderately high standard of living while the future prospects of economic development are hampering the growth of output and productivity. My research (link) has shown an alarming evidence of Slovenia's score on economic growth and development: back in 1991, the relative gap in terms of standard of living between Slovenia and Estonia stood at 35-41 years, taking purchasing power parity and current prices into account. In 2007, the gap between Slovenia and Estonia reduced to 13 years. In simple terms, this implies that in 13 years, the level of living standard in Estonia will surpass the standard of living in Slovenia. In this briefing paper, I intend to draw a perspective on Slovenia's economic development and empirically alternatives to statist economic policy and Bismarckian welfare state.


The Empirical Side of Economic Policy

Back in early 1970s, David Nolan of the MIT, composed a chart, showing how each political ideology is derived from the mathematical treatment of marginal changes in two variables - personal and economic freedom. Today, this matrix is called Nolan chart (link). The usefulness of this matrix is of the high purpose since it can show revealed preferences of political parties as vote-maximizing agents in an oligopolistic political market. Kenneth Arrow, a Nobel-winning economist, devised an impossibility theorem, the assertion of which is that it is impossible to devise a constitution or voting system which offers more than two reasonable choices to the individual, or that will guarantee to produce a constant set of preferences for a group which correspond to the preferences of the individuals making up that group. Hence, the paradox of voting is that it is impossible to have rational and at the same time egalitarian choice. Assume a two-agent utility-maximizing model in the political market where both agents strive to maximize election output. Because both groups face a monotonic utility function, which means practically the same preferences under different set of policy measures, the empirical intuition is under what rules the agents will react. In Social Choice and Individual Values, Kenneth Arrow, proposed the rules of social choice (link). Unless clear rules are given in the game of economic policy, limiting the scope of government action, the use of discretion would always arise and be made permanent. This simple theorem referes to Arrow's general impossibility theorem and to the rules determining social choice. The behavior of utility-maximizing political agents is shown in the graph. The utility function y = u(x) is downward sloping. This movement reflects the fact that the first choice done by a political agent will inherently reduce the utility his competitor. It means that the support for one measure, say tax reform, will not be strong enough to pass it through. Each utility-maximizer in the political market will inevitably seek to maximize the utility sum of each square by reducing the utility of the competing agent per se. What determines the voting outcome is the rule of the margin - meaning that higher majority rule of one group will entail greater feasibility of social choice. From an empirical point of view, that could be the reason why political system with smaller number of utility-maximizing political agents tend to score higher on the scale of political freedom and quality of governance. In theoretical terms, the paradox of voting is that higher majority rule implies the full-scale fluidity of individual preferences transmitted into the machine of collective choice. Notably because individual preferences of choice can be fully processed only by the market mechanism, the collective choice always entails a contradiction in terms. Instead, it should be noted that transitivity and non-coercion are the main determinants of the welfare choice, not the aggregation of preferences.

Picture No.1: Political Competition and the Public Choice

Economic Theory and Policy: The Failure of Statism in Slovenia

After 17 years of transition from state-controlled to market-oriented economy, Slovenia is still the strongest economy in Central and Eastern Europe. A detailed view on the scoreboard of economic growth shows that throughtout 1990s, the overall growth of real productivity per head stagged compared to other countries in Central and Eastern Europe. The real reason for rachitic growth of factor productivity is not the insufficient amount of working hours in the market but the size of tax burden. Until the latest minor change in tax rate structure, top marginal income tax rate was 50 percent. Even now, when the top rate on earned income is 41 percent, the rate structure is not inclined towards the growth of productive behavior such as investment, entrepreneurship and labor supply. Additional tax burden levied on workers and entrepreneurs, such as employee social security contribution and mandatory employer social security contribuion, has downsized the potential growth of overall productivity - which is, in all empirical and theoretical aspects, the main determinant of wage level. The unparalelled growth of the corporate state triangle of government, employer associations and trade unions - initiated a collective bargaining which still attempts to determine wages via central-planning mechanism that is not based upon market-clearing price system. The overall consequence of collective determination of wages is that the relative price of labor services is mis-allocated, causing labor shortages and surpluses. At the same time, that is the reason why real private-sector economy in Slovenia is facing labor shortages of skilled labor supply. True, brain-drain is another consequence of labor shortages because of high tax rates that hinder productivity growth and human capital utilization in the real sector. The lack of privatization is reflected in the fact that state control in the Slovenian economy is at the same share as Soviet Union under Lenin when the latter launched New Economic Policy (link). Considering the data, the share of private sector activities in the GDP is, in Slovenia, the smallest in the region. When the last comparison was published, public sector activities composed 35 percent of the GDP compared to the regional average of 20 percent. The most alarming threat to Slovenia's macroeconomic stability is the expected increase in net financial liabilities and transfers into inter-generational accounts through pension and health-care system. From a rational and sustainable perspective, capital market is the best guarantee of savings utilization for the old-age as the long-run sustainability of the rate of return on portfolio investments determines the level of old-age income, not transfers such as "pay-as-you-go" or income distribution that skews the productivity of the labor supply. When all aspects of statism are taken into the empirical and methodological account, it does not seem surprising why Slovenia's comparative economic performance stalled while other economies in the region, such as Slovakia and Estonia, faced significant rates of output growth. If Slovenia's long run output growth rate increased from 3,0 percent to 4 percent in the long run, the gap in the standard of living between Austria and Slovenia would shrink from 58 years to 22 years, ceteris paribus. Perhaps that is the best possible evidence that stable and free institutions, pro-growth economic and tax policy, limited government spending, free world trade, the absence of government intervention is superior to cradle-to-grave welfare state and economic policy based on government intervention. Adam Smith once wrote that "...the highest level of prosperity occurs when there is a free-market economy and a minimum of government regulation." So true.

Rok SPRUK is an economist.

ANOTHER EVIDENCE WHY EU FARM SUBSIDIES ARE DEADLY HARMFUL

EU Observer has recently quoted (link) the study conducted by a team of British scientists showing that, each year, farm subsidies on behalf of EU's common agricultural policy cause strong heart diseases and stroke-related deaths as a consequence of too high nutrition values per se, given the amount of fat that farm producers can use to produce food. This is an additional sign why EU's common agricultural policy is a roadmap in the wrong direction. Taking some basics of the microeconomic theory into account, we can see that EU farm subsidies lead to massive overproduction of milk and diary products simply because producers do not meet a sufficient amount of market information as a consequence of subsidy distortions. Again, subsidies can be attributed only if there is more negative neighborhood effects that the amount of positive ones while agricultural sector is a case study that would suffice the criteria for subsidy giving as there is a market-clearing price mechanism. World Health Organization revealed that EU's annual milk production subsidies amount 16 billion EUR, including a 500 million EUR butter consumption stimulus.

The EU Observer noted (link):

"Looking at the 15 EU states before the 2004 round of enlargement, the annual "mortality contribution attributable to CAP was approximately 9,800 additional CHD deaths and 3,000 additional stroke deaths within the EU," the study says, with France, Germany, Italy, Spain and the UK seeing the highest numbers of excess deaths."

Market liberalization and an immediate end of subsidizing agricultural production would certainly boost the shift towards consumer choice and demands. In turn, that would also bring positive neighborhood effects since producers' prices would be closer to marginal cost level which means that the severity of heart diseases and stroke-related deaths and consequences would disappear faster and easier. Frankly, it's about time to end the tyranny of EU's agricultural subsidies and CAP. The effect of farm subsidies revealed by British scientists are another strong argument and evidence of the mischief of subsidy-giving.

LESSONS FROM ARGENTINA

ECONOMIC REFORMS AND THE POLITICAL CYCLE

Johnny Munkhammar (link) recently explained the willingness and to implement market-based reforms as a political incentive of re-election. He explains how economic policies based on product market deregulation, pro-growth tax cuts, market liberalization and the reduction in public spending can quickly bring re-election and thus offset the incentive to pursue further reforms and policy innovation The podcast can be launched here.

THE AGE OF MILTON FRIEDMAN

While reading prof. Mankiw's blog, I came across Andrei Schleifer's new working paper entitled The Age of Milton Friedman has drawn a linking line between an unparalelled progress of the last twenty years and free market economic policies.

The acceptance of free-market policies has been initiated by Ronald Reagan and Margaret Thatcher. The policies of both contained tax cuts, deregulation of the product markets, privatization of the industries and free trade. In the last quarter of the century, millions of lives have been lifted out of poverty. Normative economic analysis might explain this phenomena in a distinct feature. Some might possibly claim that greater government intervention through social security accounts and welfare state in some countries is the reason why poverty has largely been avoided. Despite a misleading utopia that populist politicians and social demagogues are using it, the truth is that a large disappearence of poverty has largely been a result of free-market policies that emphasized tax reform and deregulation.

Milton Friedman's intellectual mind has indeed inspired many leaders around the world to pursue free-market reform agenda. Margaret Thatcher succinctly fought the status quo set by the unions which resisted the deregulation of the labor market.

Ronald Reagan endorsed the most extensive tax reform in the U.S. history. Milton Friedman's intellectual radius also reached China that, despite being a communist country, implemented several pro-growth economic reforms that emphasized openness to the world. Surprise, surprise - China is today the fastest and most rapidly growing economy in the world. This achievment hasn't been an outcome of an enhenced government intervention but largely an outcome of economic reforms that communist China embraced under Deng Xiaoping. Those reforms lifted millions of poverty by allowing them to trade, invest and do business.

The age of free-market reforms brought an unimaginable improvement in the standard of living. Market liberalization brought competition into every walk of economic life. And competition, by no surprise, has brought welfare and value to consumer in terms of lower prices and improved product and service quality. Competitive mechanisms slashed top marginal tax rates, therefore bringing job growth and incentives to work, save and invest. The liberalization of the global trade slashed tariff rates and reduced both, transaction cost and the difficulty of a resource allocation in a productive use.

Territorial competition improved the quality of business locations around the world. The number of procedures to start a business has fallen down dramatically. And most importantly, fiscal competition has made spending fever much more restrictive, putting notable limits on government spending and consumption. The economic progress in transition economies such as Estonia, Slovakia and Czech Republic, has been made possible because of a commitment to reform, responsible leadership and an ambitious growth agenda. Indeed, Friedman's Free to Choose, Capitalism and Freedom and numerous intellectual debates contributed to the understanding that today's welfare and progress is an outcome of yesterday's reform and ideas.

ECONOMIC FREEDOM IN 2008

In a mutual cooperation, Heritage Foundation and Wall Street Journal issued a new 2008 Index of Economic Freedom (link). The index measures the level of economic freedom in the world, emphasizing the degree of economic liberty in each country. Some countries, such as Montenegro, Serbia and Iraq, remained unranked subject to incomplete information about the areas reflecting the level of economic freedom. By a methodological definition (link), the economic freedom is a material autonomy in relation to the state and organized groups. An individual is free who can secure and protect his human resources, labor and private property. Economic freedom involves several sub-levels such as freedom to invest, freedom to start a business, freedom to choose, freedom to trade, freedom from corruption, freedom from government, fiscal freedom and the protection of private property rights nevertheless. Higher the value of each component, higher the level of economic freedom.

The Meaning of Economic Freedom

Innumerable empirical investigation has confirmed a positive correlation between economic freedom and sustainable economic performance. Gwartney, Lawson and Holcombe (1999) have explored the relationship between economic and economic growth (link). They concluded that an environment with a high degree of economic freedom is essential to sustainable growth performance. As an ingredient of general prosperity, high level of economic freedom is impossible without a firm role of institutions whose aim is to protect private property from expropriation and to enforce the rule of law. Institutions are defined as the rules of the game and interaction between individuals. Institutions are a set of formal and informal rules that define the scope and shape of behavioral limit in private contracts. Inevitably, the aim of institutions is to minimize the transaction cost through codified arrangements and the respect for individual liberty and a limited role of government. The pursuit of institutions to minimize the transaction cost is, of course, essential to sustainable economic performance. Douglass North, the father of new institutional economics once wrote:

"The inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the third world."

Source: Douglass North; Institutions, Institutional Change and Economic Performance, Cambridge University Press, 1990 (link)

The quality of the business environment regarding creativity, innovation, financial markets and free exchange, is a set of components that determine the rank of economic freedom in a particular country. By the logic of the common sense, economic freedom is a necessity for both human and political freedom. Economic control is not only the control of economic transactions. It is the control of the means for all individual ends. And whoever has the control over the means must also determine which values will rate higher and which ends shall be served. The following relationship has been succinctly explained by Friedrich August von Hayek who once wrote:

"Even striving for equality by means of a direct economy can result only in an officially enforced inequality - an authoritarian determination of the status of each individual in the new hierarchical order"
-- Friedrich August von Hayek

Top 10 - The Champions of Economic Liberty

In this year's index, economic freedom in only seven nations was distributed as free. The distribution of economic freedom is officially shaped in six different categories. Again, Hong Kong remained the freest economy in the world, scoring very high on each component of economic liberty. In the group of free economies there are also Singapore, Ireland, Australia, United States, New Zealand and Canada. Those countries scored very high in monetary freedom, business freedom, private property rights, labor freedom and financial freedom. Among top 10 there are three countries left: Chile, Switzerland and United Kingdom. Sound regulatory environment, efficient judicial system, deregulated product markets, liberalized financial sector and low exchange costs reflect the ranking of countries among top 10. Among them, only Chile is a middle-income country but economic reforms in the past decade such as the privatization of the pension system boosted growth performance of the Chilean economy and contributed to Chile's high score in economic freedom. In 2008, the overall economic freedom of the world has not increased, but some countries progressed dramatically well while some other countries diverged. For example, Mauritius and Denmark performed a continued improvement from previous ranking while Russia's ranking decreased substantially.

Economic freedom in Nordic countries

The proponents of the so-called Nordic model argue that it is possible to combine sound economic performance and an unlimited welfare state. At this stage, they cite the example of Nordic countries. It is somewhat of a paradox to speak of the Nordic countries as they notably differ in several aspects. Therefore, it is actually impossible to speak about the Nordic model in general. Nordic countries score very well in the area of the quality of the business environment, having created one of the freest business areas in the world. Nordic countries also score very well on freedom to trade internationally, open investment environment, non-existent corruption, flexible financial environment, and independent judiciary. But Nordic tigers score quite badly in the areas of fiscal burden and government size. However, each Nordic countries has its own features. Iceland has been very successful in tax reform, entrepreneurship and competitiveness, Denmark has reformed its labor market towards far greater flexibility, Finland is known for the highly rated elementary and secondary education system, Sweden pioneered voucher system and the privatization of health-care and pension funds. Norway, the least free Nordic country, is known for rich natural resources, enabling both generous welfare system and impeding structural environment.

Slovenia - Subalpine Jail

This year's rank of Slovenia in terms of economic freedom has not improved substantially. Officially, economic freedom in Slovenia improved by 0,4 percentage point reflecting a cautous approach to pro-growth economic reforms. However, Slovenia is ranked as 75th freest economy in the world. A growing number of former communist countries has overtaken Slovenia such as Albania, Macedonia, Romania, Bulgaria. Even Lebanon has surpassed Slovenia. The country scored well on trade freedom and monetary freedom. Poor quality of the business environment reflects the overburden and failure of the regulatory environment. Slovenia lacks the privatization of banking and insurance sector. Also, the judicial system lacks the independence from political influence and it is known for substantial court delays, inefficient staff and slow procedures. Halted privatization programs have been a wish of political aim to control particular sectors of the economy. In addition, minor tax reform slightly cut tax rates on productive behavior. However, tax rates remained steeply progressive and high. Public spending has not increased substantially but the level of public spending is still very high accounting for 47,2 percent of the GDP in recent year.

Trade Unions as Means of Coercion

The most significant obstacle to higher level of economic freedom is Slovenia's highly regulated and rigid labor market that hinders productivity growth and job opportunities. Without a radical deregulation of the labor market, productivity growth could slow substantially. Flexibility is a key feature of the labor market, brining generous effect on labor supply. In fact, the power of labor unions is the greatest obstacle to the strength of economic freedom in Slovenia.


Rok SPRUK is an economist.

Copyright 2008 by Rok SPRUK