IN MEMORIAM: PAUL A. SAMUELSON

On Sunday, December 13th, Paul A. Samuelson has died at the age of 94 (link).


He was on the economic giants of the 20th century. His ideas reshaped the economic science and revolutionized the mode of economic thinking around the world. With the mathematical rigour and analytical mastermind, his groundbreaking approach to economic analysis transfored the economic science into a dynamic problem-solving tool. In this short essay, I will present my reflections on the life and contributions of Paul A. Samuelson to the economic science.

I first came across Paul Samuelson in the year before I entered the university. In the first year of the undergraduate class, Samuelson and Nordhaus's Economics was the assigned reading for the Introductory Macroeconomics. I read the textbook back and forth and I liked it; not because of its simplicity in introducing the analytical framework of economics but rather because of the clarity, intuition and incentives to undertake a rigorous pursuit of analytical economics at the theoretical and empirical level. In addition, Samuelson penetrated the application of linear programming to economic problem-solving.

Together with Milton Friedman, Paul A. Samuelson is the economic giant of the 20th century. Hardly any economist could take the same place in the scope of influence as an economic thinker. He conducted the Neoclassical synthesis. As an interested reader can verify in his Nobel prize lecture (link), Samuelson's synthesis combined a Keynesian macroeconomics with a rigorous Marshallian microeconomics. In microeconomics, Samuelson extended the Marshallian analysis of partial equilibrium with strong mathematical articulation of demand and supply curves, cost curves and deadweight loss. On the abstract level, together with Abram Bergson, he constructed social welfare functions based on three marginal conditions and extracted from earlier work of Kaldor-Hicks-Scitovsky analysis (link). In macroeconomics, Samuelson further affirmed the dominance of Keynesian macroeconomics with a strong emphasis on the role of fiscal policy in stimulating full-employment output. In addition, he invented the term multiplier and the acceleration, the former relating to the effect of change in exogenous macro variables on endogenous variable (notably, output) and the latter referring to the partial adjustment of aggregate investment to the capital stock. Samuelson-Hansen multiplier-accelerator principles spurred the theoretical foundations of Keynesian economic policy. He also popularized Overlapping Generations Model which later became the corner stone of innovations in the modeling of aging population. In macroeconomics, Samuelson also proposed the so-called "Samuelson-Mishi condition for the efficient provision of public goods. When the condition is satisfied, it implies that further substitution of private goods provision for public goods will result in a diminishing social utility.

Assuming Pareto efficiency, Samuelson-Mishi condition satisfied the criteria for Lindahl equlibrium. The equilibrium states that when individuals are willing to pay for the provision of public goods according to marginal benefits, it will be Pareto efficient. However, such condition is not compatible with the incentive mechanism since it requires the complete knowledge of individual demand functions for particular public good which could result in the asymmetric distribution of benefits in response to relevation-principled taxation.

As a student of international economics, I came across the influential theoretical work of Paul Samuelson. Modern international economics is a combination of mathematical economics, advanced microeconomics, game theory and international finance. One of the most interesting and penetrating areas of international economics are theorems in international trade. Under particular assumptions theorem postulate axiomatic explanations based on previous statements. Back in 1941, he proposed Stolper-Samuelson theorem together with Wolfgang Stolper. The theorem quickly became a source of academic debate. In its simplest form, the theorem states the following: assuming constant returns to scale and perfect competition, a rise in the relative price of good will lead to higher return on the factor which is used more intensively in the production of the good and to the fall in the return to the other factor. Stolper and Samuelson wrote:

"Second only in political appeal to the argument that tariffs increase employment is the popular notion that the standard of living of the American worker must be protected against the ruinous competition of cheap foreign labor… In other words, whatever will happen to wages in wage good (labor intensive) industry will happen to labor as a whole. And this answer is independent of whether the wage good will be exported or imported."

The theorem showed that the international trade between two countries could lead to the opposition of international trade since the relative price of labor-abundant good in the high-wage country will be higher than the world price of that good, reflecting the relative abundance of capital or human capital. The theorem quickly became the main theoretical weapon of opponents to free trade. Even today, Stolper-Samuelson is the best explanation of why labor unions in high-wage countries oppose free trade agreements and further economic integration with low-wage countries.

Another important contribution of professor Samuelson is the so called Ballasa-Samuelson effect which states that higher growth productivity growth rate in tradable goods relative to non-tradables will lead to the real exchange rate appreciation. Balassa-Samuelson effect also went through numerous time-series regression. The effect has been tested 60 times in 98 countries. Cross-section regression studies of Ballasa-Samuelson effect were analyzed in 142 countries. In a vast majority, the empirical evidence of Ballasa-Samuelson hypothesis was supported. The main empirical findings emphasize that productivity differential between tradeable and non-tradable sector is positively correlated with differences in relative prices. The empirical evidence also supported Samuelson's initial proposition that productivity differentials translate into higher purchasing power parity through real exchange rate appreciation.

In finance, Paul Samuelson penetrated the analytical aspects of lifetime portfolio selection. In 1972 he published The Mathematics of a Speculative Price which later became the ground of option pricing. Based on discoveries of Bachelier's pioneering work, he laid the foundations of stohastic price movements and random forecasting matches. His pioneering work in financial theory of speculation and random walk (stohastic) movements in stock prices became the underlying theoretical foundation in the emerging financial industry. In an article entitled Probability, Utility and the Independence Axiom (Econometrica, 1952), he discussed the role of probability models in measuring the overall utility. In this sense, he relied on Keynesian defence of subjective theory of probability and argued that thesubjective perception of probability does not inhibit the proper functioning of financial markets. In 1965, he published A Proof that Properly Anticipated Prices Fluctuate Randomly where he provided the foundation of the efficient market hypothesis that has been further developed by Eugene Fama and other scholars. For a detailed discussion of Paul Samuelson's contribution to financial economics, see Merton Miller's contribution in Britannica (link).

In addition to his theoretical and empirical work, he is the founding member of the Econometric Society and its president in 1951. In 1961, he was the president of American Economic Association. In the political sense, Paul A. Samuelson influenced the economic policy of the Kennedy Administration. In 1960, the U.S headed for the recession. President Kennedy, following Samuelson's advice, enacted tax cuts and a balanced budget. In 1964, when Kennedy tax cuts were enacted, top marginal tax rate was reduced from 91 percent to 70 percent. The economic reasoning behind tax reductions was firmly laid in the Keynesian multiplier (1/(1+c)(1+t)). Paul Samuelson and Walter Heller (Chairman of Council of Economic Advisers during Kennedy Administration) argued that lower tax rate would stimulate consumption spending and boosted output and employment. Throughout the 1960s, the U.S economy experienced one of the longest periods of stable economic growth, favorable employment outlook and balanced federal budget. Here is how JFK, following Samuelson's advice, supported the tax reduction (link). Also, David Greenberg's article on Kennedy tax reduction is a worthy source of further information on that topic (link).

On Sunday, the economic titan passed away. He not only revolutionized the field of economic science but also spurred the interest for economics and popularized it in a manner that turned dismal science into a problem-solving science based on theoretical foundations and empirical verification of theoretical postulates. His approach to economic analysis combined Marshallian microeconomics and Keynesian macroeconomics which he joined together after the WW2 in a Neoclassical synthesis. Compared to other economic thinkers, he knew how to formulate theoretical postulates in a manner that stimulates the research interest for further investigation.

He will be missed and remembered as the giant of the economic thought and a titan of economic theory.

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.

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.

INTERVIEW WITH PAUL A. SAMUELSON

Conor Clarke has published a great interview with Paul A. Sameulson in two parts (here and here) discussing fiscal stimulus, Keynesian macroeconomics, behavioral economics and other issues as well.

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."

UNCERTAINTY IN ECONOMIC DECISION MAKING

Mr. Edmund Phelps, a Nobel laureate in economics, has written an opinion on economic uncertainty (link) published in Wall Street Journal. Mr. Phelps reviews the views on uncertainty suggested by different schools of macroeconomic thought and how uncertainty is considered in private and public decision-making in the light of current economic issues and perspectives.

KENNETH ARROW ON CARBON EMISSIONS AND CLIMATE CHANGE

Kenneth Arrow, a Nobel laureate in Economics, discusses the state and future implications of climate change (link).

The benefits are the avoided damages, including both market damages and non-market damages that account for health and ecological impacts. Following a “business as usual” policy, by 2200, the losses in GNP have an expected value of 13.8%, but with a degree of uncertainty that makes the expected loss equivalent to a certain loss of about 20%. Since the base rate of economic growth (before calculating the climate change effect) was taken to be 1.3% per year, a loss of 20% in the year 2200 amounts to reducing the annual growth rate to 1.2%. In other words, the benefit of mitigating greenhouse gas emissions can be represented as the increase in the annual growth rate from today to 2200 from 1.2% to 1.3%.

Source: Kenneth Arrow, The Case for Mitigating Greenhouse Gas Emissions, Project Syndicate, The Economists' Voice, 2007 (link)

INTERVIEW WITH JOHN NASH, THE 1994 NOBEL LAUREATE IN ECONOMICS

PBS has published an interview with dr. John Nash of Princeton University. John Nash received a Nobel prize in economics in 1994 for pioneering the equilibrium analysis of non-cooperative games. The interview can be read and seen as a video here.

On Discovering Math

"I was in grade school. I would be doing arithmetic, and I found myself working with larger numbers than other students would be using. I would have several digits, and they would have maybe two or three digits. I would do multiplication and basic operation, but with larger numbers. Later on in adolescence, I got some practice in using a calculator machine, where you could multiply and add, subtract and divide really large numbers like 10 digits."

John Nash