The Responsible Economy

Jefferson Frank

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317594147
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

After the 'financial crisis' and 'Great Recession', some have called for replacing standard economic theory by heterodox models based upon behavioural approaches. The Responsible Economy argues that there is nothing wrong with economic theory. Instead, the problem has been a 'devil's pact' of simplistic pro-market economics combined with simplistic Keynesian monetary policy.

This book revisits the fundamental theorems in economics that state the conditions for markets to achieve efficiency. It has long been known that there are limitations of markets in dealing with externalities, increasing returns to scale and monopoly. The role of information in the economy was developed in economic theory in the 1970s onwards and in a world of imperfect and asymmetric information, markets perform poorly. Managers of firms engage in short-termism, take on excessive risk and misstate their own and their firm's performance. While finance theory makes clear that much of the activity in the financial services sector is of no economic value and represents wasteful 'financial engineering'. In this real world, it is economically inefficient for firms to maximise shareholder value. On the macroeconomics side, monetary expansion cannot be an effective substitute for addressing real problems of infrastructure and education investment.

This book maintains that markets work best if individuals and firms behave ethically and responsibly. Employment should be a long-term relationship; firms should pay living wages, produce good products at a fair price, and pay their share of taxes. Where these standards don't hold, governments should not try to micromanage through regulation, but set up simple and straightforward policies.

1 In praise of common sense

Efficiency, ethics and economics

Alan Greenspan, the former Chair of the Federal Reserve, observed in 2007 (page 14): ‘If the story of the past quarter of a century has a one-line plot summary, it is the rediscovery of the power of market capitalism’. In light of the impending ‘financial crisis’ and ‘Great Recession’, it is ironic that he extols the virtues (page 10) of ‘a global capitalist economy that is vastly more flexible, resilient, open, self-correcting, and fast-changing than it was even a quarter century earlier’. Greenspan does express concern about the unequal distribution of income that he views as an unfortunate by-product of efficient pro-market policies.

In contrast, Joseph Stiglitz (2012) has argued that the redistribution of income to the top 1 per cent was the real objective of the policies. When new university students show up for their first economics lecture, they are told that there is an ‘equity–efficiency trade-off ’. An unequal distribution of income and wealth is the price paid for economic efficiency and growth. Stiglitz points out that this is not the correct message to be taken from good economic theory as it has developed over the last 40 years. Instead, experience particularly over the last two decades is that the better off have found, created and exploited loopholes in the economy. In doing so, they have enriched themselves precisely by distorting market outcomes, sacrificing economic efficiency and lowering economic growth. A fairer system would also be a more productive one.

There were valid economic efficiency reasons, not just concerns for equality, that led to previous general support for regulation, trade unions, employer/employee partnership, strong anti-trust legislation and a progressive tax system. There were good economic and not just social reasons for having the public sector provide some extremely important services and goods such as education, medicine and housing, as well as a strong welfare safety net. These efficiency arguments did not disappear when the political balance shifted in favour of the pro-market conservatism of Reagan and Thatcher.

Part of the purpose of this book is to re-state these efficiency arguments to take account of developments in economic theory and in the context of changes to the economic environment, notably through globalisation, in the last quarter century. But another purpose is to place these issues in a framework of ‘responsibility’ on the part of both individuals and institutions such as firms and government. We part company from the liberal voicing the slogan of ‘regulation’ as the solution to everything, in the same way as we ignore the conservatives waving the all-purpose banner of ‘free market capitalism’. It is simply not realistic to view unspecified ‘regulation’ as a simple answer to our extreme current dilemmas that range from planet-destroying climate change to generation-destroying high youth unemployment.

It is also not just a question of requiring the 1 per cent to be less greedy and more responsible. Responsibility applies not just to the 1 per cent, but instead to all of us. While the 1 per cent might have bought bigger yachts, the rest of us refinanced our houses time and again to buy large flat-screen televisions, new cars and holidays to exotic international locations. While taxes may have been cut disproportionately for the rich, they were cut for the middle class and the poor as well. We ran up our credit cards and took out huge student loans. In that sense, if the 1 per cent engaged in a ‘con trick’ over the last two decades, the rest of us were willing, greedy ‘marks’.

This is therefore one of those unkind books where the reader is saddled with some of the responsibility, not unlike the book by Bill Cosby and Alvin F Poussaint (2007), Come On People: On the Path from Victims to Victors, and that of David Callahan (2004), The Cheating Culture. The views of Cosby and Poussaint resonated in President Obama’s speech on the 50th anniversary of the March on Washington (28 August 2013):

And what had once been a call for equality of opportunity, the chance for all Americans to work hard and get ahead was too often framed as a mere desire for government support, as if we had no agency in our own liberation, as if poverty was an excuse for not raising your child and the bigotry of others was reason to give up on yourself.

Callahan focuses on the decline of ethics and the rise of cheating throughout our society. He observes (page 293):

Banishing the latest plague of market fundamentalism from U.S. society, forging a new social contract, reforming business and professions, teaching integrity to the young – these are the changes needed to dismantle the cheating culture.... Yes, the cheating epidemic writ large can be traced back to large-scale shifts in America over recent decades, but that doesn’t mean that as individuals we’re not responsible for our actions.

We focus upon ethical, responsible behaviour because it is vitally important as part of the process that can resolve the fundamental, as well as some less major, shortcomings of an unfettered market capitalism system. Regulation cannot efficiently replace ethical behaviour in a well-functioning economy. The purpose of effective economic law cannot be to micromanage firms and other institutions. Instead, the legal and regulatory framework should encourage good behaviour, discourage undesirable behaviour and prohibit bad behaviour.

This book is also a defence of economic theory as ‘informed common sense’. Economic theory learned the lessons of the 1970s and recognised the shortcomings of both unfettered markets and of simplistic Keynesianism. Nonetheless, current economic policy-makers have managed to grasp hold of simplistic microeconomic and macroeconomic models. It is this flawed approach to applying economic theory, and not the theory itself, that is to blame for where we are today. We can start to deal with our fundamental and serious economic problems today not by jettisoning good economic theory, but by applying it.

Economics is not rocket science

Economics is not rocket science, although the mathematics is similar. While we can and sometimes do construct complex Heath Robinson or Rube Goldberg models, this is not particularly elegant theory or a particularly good guide to sensible economic policy. As in other fields of reasoning, Occam’s razor of simplicity is a good principle.

As with rockets, we have extremely powerful policy tools at our disposal. Where we get into difficulties is if we try and fine-tune too much. The government can use strong incentives to get individuals and institutions such as firms to do what the government wants. It can usually go beyond incentives and simply order the behaviour it desires, although it needs to have an effective enforcement mechanism in place. We will argue in this book that the government should determine the important issues and put in place strong and simple policies to achieve the desired results. For the rest, it needs to rely upon establishing a system that – as we have just described – encourages good behaviour, discourages undesirable behaviour and prohibits bad behaviour.

The Federal Reserve during the ‘Great Recession’ sought to bring down unemployment by the following complex process. Through quantitative easing (the purchase of government debt and mortgage-backed securities), the Fed aimed to lower medium-term interest rates and drive up the stock market. Through the resulting wealth effect, households that own stocks will spend more. This additional spending will cause firms to hire more workers. As the new workers spend their incomes, there will be ‘take-off’ in the economy. Common sense is that, even if this trickle-down process were to work, it would not have much bang for the buck as each step imposes friction on the process. It is possibly for that reason that the Fed adopted unprecedented magnitudes of intervention.

If one wants to address unemployment, one should instead adopt policies that directly impact upon jobs. This could be government-funded infrastructure programmes or direct government employment of labour, it could be significant subsidies to firms to take on additional workers, or it could be laws against making workers redundant. There is no free lunch with any of these policies, but each is directly aimed at the issue of unemployment.

In this view, good economics is ‘informed common sense’ rather than rocket science. It is ‘informed’ in that economics is not ‘bean counting’. The economist is the guy in the room who just as frequently as not will tell management to spend more (by, for example, hiring more qualified workers and producing a better product) rather than less, and to invest for the future rather than engage in short-termism. We will tell governments to get families off welfare benefits and into jobs, even if that costs considerably more in the short run.

A good economist will not just say ‘leave it to the market’ since the ideal market is a theoretical construct that does not exist in reality. In the real world, there are specific institutions and individuals who make decisions and interact. Sometimes they do a good job, and sometimes they don’t. Their performance is often predictable on the basis of the structural framework and the incentives facing them. It is pointless to delegate the economy to ineffective markets and weak and poorly managed institutions.

Conversely, common sense also tells us that the government cannot sensibly micromanage the economy through heavy regulation and supervision in all areas. Regulations are costly to establish and enforce. Complicated tax and benefit systems are recipes for inefficient distortions in the economy. In the UK, we had a system where high London rents were paid by the government for the unemployed but not for those in low-wage jobs. Some on benefits were able to claim far more than the average income. That system clearly trapped individuals and families in extended or lifetime unemployment. Our job is, as much as anything, to determine the unintended consequences of policies such as this, so that they can be avoided.

The economist is, above all else, a technician. Keynes is frequently quoted: ‘If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.’ We are structural engineers rather than architects. Architects get to be creative and imagine artistic designs. Our task is to make sure that the building doesn’t fall down.

This does not mean that we should shy away from theoretical models, from ‘rocket science’. This is essentially a book in economic theory. A quote is sometimes credited to Ronald Reagan: ‘An economist is someone who sees something that works in practice and wonders if it would work in theory.’ In fact, it is rare that we can clearly see what works in practice. Did the Fed save us from a Great Depression, or has it created – as happened in Japan – lost decades of low growth?

In finding a mechanic to repair an expensive and complicated car, we would ideally want someone who understands the theory and design of the engine and the other parts of the car, not someone who just has extremely good observational powers. In part, this is so the mechanic has a framework to interpret the performance of the engine in front of him or her. Apprenticeship training of a car mechanic involves an exercise of breaking down an engine into all its components, and re-assembling the engine. This gives the mechanic understanding about the theory of motorcar engines and more than just the details of a Ford FE V8 engine, if that was the example in the apprenticeship exercise. We would want the mechanic to have a depth of understanding such that he or she could work on a car make or model they had never seen before, even if they didn’t have the owner’s manual and technical drawings. It should therefore by analogy not be surprising that a good economist has a firm foundation in economic theory, but is also able to go back and forth between observation, practice and theory.

In the same way as the mechanic who has broken down and re-assembled the Ford FE V8 engine, an economist who uses existing data needs to know the limitations of seeing just what is currently in practice. If the mechanic has worked on other engines, he or she will have some idea on how differences in similar engines can impact on output characteristics. But what if the mechanic is asked what would happen if we switched from a V8 to a 4 or 5 cylinder engine or an economist if we doubled income tax rates from 25 per cent to 50 per cent?

Much has been made of the idea that we cannot or did not predict ‘black swan’ events such as the ‘financial crisis’. The Queen has been quoted as saying about the financial crisis: ‘If these things were so large, how come everyone missed them?’ In fact, the archetypal ‘black swan’ event, black swans, would not perplex a theorist. We know there are black birds, so there is no particular reason to be surprised at coming across black swans. Similarly, many economists (Shiller 2000) saw the internet stock and housing booms as a bubble that would eventually burst. The rate of asset price appreciation meant that, in due course, the market value would swamp the rest of the economy and was therefore unsustainable. But to come to that conclusion required noting that what seemed to be working in practice – high growth rates in the economy – did not in fact work in theory and was ultimately unsustainable.

The current consensus

There is a remarkable degree of consensus today around the ‘Anglo-Saxon’ economic model. This involves a combination of pro-market microeconomic policies from Milton Friedman (1962) with macroeconomic policies from John Maynard Keynes. Economists as a group believe in the primacy of markets, in the benefits to deregulation, in the positive effects of low marginal tax rates, in flexible exchange rates and flexible labour markets, and in free trade and free economic migration. They also believe in central banks using discretionary monetary policy to avoid recessions. The microeconomics of Milton Friedman is combined, not with his views on monetary policy (that discretionary, activist policy should be avoided), but with an almost ‘cowboy’ Keynesianism that the central bank must do whatever it takes to avoid recession.

The Anglo-Saxon model is sometimes contrasted with the European model with its higher tax rates, greater regulation (notably of the labour market), and fixed exchange rates (the euro). Europe has a more conservative central bank (modelled in part on the old Bundesbank with its strong historical aversion to inflation). Europe does have free trade and migration within the community, but not generally to outside countries. Over time, the free trade and migration within Europe led the community to impose more common standards across the trading countries, and eventually for most countries in Europe to adopt the common currency. The idea was that countries would not then be able to ‘beggar thy neighbour’ by poor treatment of workers, by polluting the environment and by competitive devaluations.

It is not clear that the two models really differ all that much, except in degree. However, the differences make it clear where some problems are likely to arise. In the Anglo-Saxon model, there would be a ‘hollowing out’ of the middle class as industrial workers lose their status and indeed their jobs. The European model – given inflexible labour markets – is likely to lead to a shortage of jobs for new entrants to the labour market and, consequently, high youth unemployment. Both of these effects could be viewed as unintended consequences of a bundle of policies.

These largely distributional effects represent much of the boundaries of disagreement within the overall consensus in Economics. There is perceived to be an equity–efficiency trade-off. We can seek to make assembly line workers or new entrants to the labour force better off in terms of the wage rate, but at the cost of unemployment and lowered growth in the economy. From the perspective of the Anglo-Saxon countries, Europe has chosen greater ‘fairness’ at the expense of lower growth.

There is also, to some extent, a debate about the appropriate amount of regulation in the economy, with the Europeans adopting somewhat more regulation in general than in the Anglo-Saxon model. But on the issue of regulation, the divide is not as great as often stated, with both sides having a major role for regulation. As an example, pilots have strong self-interest in landing a plane safely. The airline, even if insured, would suffer badly in terms of customer demand from a crash, as would the manufacturer of the airplane. Nonetheless, it would be a remarkably strong proponent of market economics who would wish the government to stand back entirely, let the airline industry be completely unregulated and instead rely upon the self-interest of pilots, airlines and manufacturers.

Economists, then, seem fairly complacent in terms of our knowledge and display a strong consensus on how to apply our understanding. The debate is over a bit more or less redistribution, a bit more or less regulation and a bit more or less activism on the part of the central bank. In that context, it is perhaps surprising that the ‘consumers’ of our policies don’t seem to share our evaluation of our success. Pollsters regularly ask whether the US and the UK are currently going in the ‘right direction’ or the ‘wrong direction’. Polls (Real Clear Politics 10 July–4 August 2013; Ipsos-Mori 14 January 2013; Gallup 5 June 2013) show a negative balance for the US of 32 per cent (30 per cent saying that the country is going in the ‘right direction’ and 62 per cent saying it is going in the ‘wrong direction’); similar figures are shown for the UK. The European model does not fare any better, with only 17 per cent of the French – the most negative respondents – saying that the EU is ‘going in the right direction’.

It may be that publ...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• List of figures
• List of tables
• Preface
• 1 In praise of common sense
• 2 The limits to markets
• 3 Ecstasy economics
• 4 The role of managers
• 5 Ethics, incentives and affordability
• 6 Justice
• 7 Globalisation
• 8 Labour market flexibility
• 9 On booms and busts
• 10 What is to be done?
• Index