Economic Freedom and Public Policy: Economics as a Moral Discipline - - PowerPoint PPT Presentation

Economic Freedom and Public Policy: Economics as a Moral Discipline

Lionel Robbins Memorial Lectures

Lord Turner

Chairman of the Financial Services Authority, the Climate Change Committee and the Overseas Development Institute

Howard Davies

Chair, LSE

1

Lecture III Economic Freedom, Public Policy and the Discipline

• f Economics

London School of Economics 13 October 2010

Adair Turner Lionel Robbins Memorial Lectures Economics after the crisis: Objectives and means

2

Starting Point: The Instrumental Conventional Wisdom

Free markets Allocative efficiency Growth Human happiness Inequality: Justified because it helps deliver growth Free markets

3

Happiness and income per capita in the USA

Source: Bruno Frey & Alois Stutzer, Happiness and Economics, Princeton University Press, 2002

4

Income and Human Contentment: Possible stylised pattern over time

Income / Contentment Pre-industrial societies The Great Transformation Economic and technological progress Income Human wellbeing contentment / happiness

China Africa Developed economies

5

• 3. Congestion externalities

Three distinct reasons why relative income matters

• 1. Rising

expenditure on fashion and branded goods Concern for relative status in itself Relative income influences absolute living standard Rising average incomes degrade quality of some forms of consumption

Higher relative income increases happiness Happiness a function

• f others’

income as well as

• wn
• 2. Increased competition

for inherently limited supply positional goods

6

“Distributive” versus “creative” activities

“Creative” “Distributive” Winning increasing income at expense of

• thers

Increasing the net real income available for consumption

Source: See Roger Bootle, The Trouble with Markets, chapters 4 and 5

7

Health and social problems

Income Inequality

Source: Wilkinson & Pickett, The Spirit Level , Penguin 2009

8

USA debt as a % of GDP by borrower type

Source: Oliver Wyman

Household Corporate Financial

1929 1935 1941 1947 1953 1959 1971 1977 1983 1990 1996 2002 2007

• 1929

1935 1941 1947 1953 1959 1965 1971 1977 1983 1990 1996 2002 2007

9

Global issuance of Collateralised Debt Obligations: Cash and synthetic

Source: IMF Global Financial Stability Report, 2006

50 100 150 200 250 300 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Synthetic Cash $bn

10

Complete markets as a route to…

Credit derivatives “enhance the transparency of the markets’ collective view of credit risks.. [and thus]… provide valuable information about broad credit conditions and increasingly set the marginal rice of credit. Therefore, such activity improves market discipline” “There is a growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors has helped make the banking and

• verall financial system more

resilient … The improved resilience may be seen in fewer bank failures and more consistent credit provision”.

… efficiency … and stability

IMF, Global Financial Stability Review, April 2006

11

Share of the financial industry in US GDP

1 2 3 4 5 6 7 8 9 50 70 90 10 30 50 70 90

1850 1910

Source: Philippon, T (2008), The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence. (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)

%

1850 1910

12

Historical 'excess' wage in the US financial sector

0.1 0.0 0.1 0.2 0.3 0.4 0.5 10 11 12 13 15 16 17 18 20 21 22 23 25 26 27 28 30 31 32 33 35 36 37 38 40 41 42 43 45 46 47 48 50 51 52 53 55 56 57 58 60 61 62 63 65 66 67 68 70 71 72 73 75 76 77 78 80 81 82 83 85 86 87 88 90 91 92 93 95 96 97 98 00 01 02 03 05

• +

1910 2000

1910 2000 'Excess' wage

Source: Philippon, T and Reshef A (2009). Wages and Humal Capital in the US Financial Industry: 1909-2006, NBER Working Paper No 14644.A. Resh (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)

13

Growth not the objective but by-product of other desirable objectives Policy implications Implications for the discipline of economics

14

The case for growth

Growth in low and middle income countries The poor in rich countries Economic regression in absence of markets The journey, not the destination Economic freedom as an end per se Avoidance of involuntary unemployment

+

15

The internally contradicted argument

Economic growth in rich countries still matters because it matters to poorer citizens Economic growth is maximised by significant inequalities / incentives Therefore don’t worry if economic growth is combined with increasing inequality

16

The case for growth

Growth in low and middle income countries The poor in rich countries Economic regression in absence of markets The journey, not the destination Economic freedom as an end per se and avoidance of involuntary unemployment

17

Keynes, The General Theory

“There is social and psychological justification for significant inequalities of incomes and wealth… … dangerous human proclivities can be canalised into comparatively harmless channels by the existence of

• pportunities for money-making and private wealth

which, if they cannot be satisfied in this way, may find their outlet in cruelty, the reckless pursuit of personal power and authority, and other forms of self-

• aggrandisement. It is better that a man should tyrannise
• ver his bank balance than over his fellow citizens.”

(Chapter 24)

18

The case for growth

Growth in low and middle income countries The poor in rich countries Economic regression in absence of markets The journey, not the destination Economic freedom as an end per se and avoidance of involuntary unemployment

19

Happiness, income and changing aspirations

Income Happiness

Aspiration 1 Aspiration 2 Aspiration 3

Flat line of long-term happiness

1 2 3

20

The case for growth

Growth in low and middle income countries The poor in rich countries Economic regression in absence of markets The journey, not the destination Economic freedom as an end per se and avoidance of involuntary unemployment

21

Amartya Sen, “Development as Freedom”

“… the freedom of people to act as they choose in deciding where to work, what to produce, what to consume…” “The merit of the market system does not lie only in its capacity to generate more efficient culmination

• utcomes but also in the processes by which those
• utcomes are achieved”

(Chapter 1, The Perspective of Freedom)

22

Growth not the objective but by-product of other desirable objectives Policy implications Implications for the discipline of economics

23

Four clear policy implications

Maximise stability and minimise downsides

• Financial regulation and macro-economic management
• Climate change mitigation

Maximise public choice: especially at local level Minimise positional goods competition

• Welcome population stabilisation

24

Happiness, already achieved income, and changing aspirations

Happiness Income

Plus: Happiness as function of relative as well as absolute income 1 2 3 4

25

Do we “need to grow” to afford public expenditure?

Health Education Debt servicing In general no, if main cost is salaries which rise proportionally with average GDP per capita Yes, if macro-instability or fiscal profligacy generate high stock of debt relative to GDP

26

Costs and benefits of higher capital and liquidity standards

• Standard evaluation techniques
• Compare costs & benefits using a discount rate which accords

equal weight (in any given year) to costs and benefits

• Consequence: will undervalue stability and over-value minor

increments to growth, if people highly value already achieved wealth/income and avoided unemployment, and deeply dislike setbacks Possible costs to GDP growth

• Long-term?
• Transitional

Benefits of reduced probability

• f negative setbacks

Vs

27

Estimating GDP

Long-term trends and cross-country comparisons between rich countries have uncertain meaning Annual or quarterly changes are crucial guide to inflation targeting and economic stabilisation

Lionel Robbins: “both the concept of world money income and of national money income have strict significance

• nly for monetary

theory”

Measured value of financial services? Distributive rent extracting versus “creative” activities Increasing % of income devoted to housing house prices increase: inflation or real income?

28

Four clear policy implications

Maximise stability and minimise downsides

• Financial regulation and macro-economic management
• Climate change mitigation

Maximise public choice: especially at local level Minimise positional goods competition

• Welcome population stabilisation

29

Growth in UK living standards: with 80% emissions cut

GDP per capita 2006=100

75 150 225 300 2006 2020 2030 2040 2050

338 100

1.0 – 2.0% lower

Business as usual 80% emissions cut

30

Costs of climate change

Conceptually clear – but difficult to quantify, e.g. changes in agricultural yields Inherently uncertain

• Contingent social and political responses

Small probability catastrophic losses

31

The impact of discount rates

Discounted

• at 4% real

£3.67 today 6% of GDP today

• at 2% real

£59 today 100% of GDP today

Assuming 2% per annum growth: 100 %

• f GDP in 2150 is worth

£1000 in 2150 is worth

32

Discount rate and declining marginal utility

r = η (g) + δ

g = growth rate δ = the rate of pure time

preference

η = the elasticity of the marginal

utility of consumption

Stern’s base case η = 1 g = 1.9 δ = 0.1 r = 2.0%

Utility Consumption

The flatter the curve becomes, the higher η, and the higher the discount rate

33

Happiness already Achieved Income and Changing Aspirations

Happiness Income

Plus: Happiness as function of relative as well as absolute income 1 2 3 4

34

Three problems with the standard discount rate approach

• Losers in future may be

poorer than rich big emitters today

• Small probability of

catastrophic losses

• Losses of

environmental goods – species, beauty, diversity – valued in themselves Discount rate should be negative Discount rate applied to those losses should be negative Gains of economic income cannot offset environmental losses

35

Four clear policy implications

Maximise stability and minimise downsides

• Financial regulation and macro-economic management
• Climate change mitigation

Maximise public choice: especially at local level Minimise positional goods competition

• Welcome population stabilisation

36

Four clear policy implications

Maximise stability and minimise downsides

• Financial regulation and macro-economic management
• Climate change mitigation

Maximise public choice: especially at local level Minimise positional goods competition

• Welcome population stabilisation

37

Population growth and stabilisation: UN medium projections

5.0 5.5 6.0 6.5 7.0 7.5 8.0 8.5 9.0 9.5

2005 6.5 7.7 8.3 8.8 9.2 2020 2030 2040 2050

• 100

200 300 400 500 600 2005 2020 2030 2040 2050

2005 2020 2030 2040 2050

World population (bn) EU 27 and UK population (m)

Source: UN Medium Projections

60 65 68 70 72 495 513 519 520 515

38

Four clear policy implications

Maximise stability and minimise downsides

• Financial regulation and macro-economic management
• Climate change mitigation

Maximise public choice: especially at local level Minimise positional goods competition

• Welcome population stabilisation

Overall Objective: Creating a stable environment in which freedom to choose can be allowed expression while minimising downside consequences and setbacks

39

Two unclear issues

• 1. Are some goods / services more important to human

wellbeing / happiness than others – even when counted equally in GDP?

• 2. How much inequality is fair / optimal / unavoidable?

40

Different marginal utility of different “goods”

Utility / Happiness Utility / Happiness Utility / Happiness Income Income Income

Good health? Branded fashion goods? Congestion and environmental damage?

41

42

Sub-optimal consumption choices

Goods consumed as a result of public choice Social mores, herd-like fashion, and advertising Congestion and environmental externalities

43

Two unclear issues

• 1. Are some goods / services more important to human

wellbeing / happiness than others – even when counted equally in GDP?

• 2. How much inequality is fair / optimal / unavoidable?

44

How much inequality?

Inequality is justified because and to the extent that it delivers growth which delivers wellbeing; low taxation rates incentivise effort and entrepreneurship Relative income matters Standard responses inadequate

– Growth – Skills – Opportunity

Relative status competition invalidates standard incentive theory Economic freedom, and even perceived fairness, imply significant inequality The instrumental justification The reality

45

Growth not the objective but by-product of other desirable objectives Policy implications Implications for the discipline of economics

46

Economics in the dock

Assumption of rationality Mathematicisation: “physics envy” Focus on market completion and equilibrium Lack of enquiry about end

• bjectives

Prosecution

Always recognised imperfections Never monolithic

• Mirrlees, Stiglitz, Akerlof
• Kahneman
• Sen

Never said growth (rather than welfare) was objective

Defence

Prosecutors: Robert Skidelsky, Keynes: “The Return of the Master” John Cassidy: “How Markets Fail”

47

From Arrow-Debreu to the Washington Consensus: Three simplifications

Downplay of severity of market imperfections From Pareto equilibrium to good outcome – even without redistribution From equilibrium to growth as the objective

48

Economics for the real world, not for ease of modelling

• Is happiness the objective? Or welfare? Or freedom?
• How are they related to each other, and to income?
• Can we measure happiness or welfare?
• Inherent failures of complex markets
• Consequences of human mental processes – part

rational, part instinctive

• Inherent irreducible uncertainty, not mathematically

modellable probability distributions

Objectives Means

49

Keynes on economics

“economics is a moral and not a natural science” “no part of man’s nature or his institutions must be entirely outside [the economist’s] regard” The economist should be “mathematician, historian, statesman and philosopher in some degree”

* * * * * *

50

“Economics deals with ascertainable facts: ethics with valuations and obligations. The two field of enquiring are not on the same plane of discourse”

(Lionel Robbins, On the Nature and Significance of Economic Science, 1932, P.132)

“As against Robbins, Economics is essentially a moral science. That is to say, it employs introspection and judgement of value”

(John Maynard Keynes, Letter to Roy Harrod)

51

Lionel Robbins: Essay on the Nature and Significance of Economic Science

“Both the concept of world money income and of national income money have strict significance only for monetary theory” “There is no penumbra of approbation around the theory of

• equilibrium. Equilibrium is just equilibrium”

“It is highly desirable that the economist who wishes that the application of his science should be fruitful should be fully qualified in cognate disciplines and should be prepared to invoke their assistance”

* * * * * *

“There is nothing in economics which absolves us of the obligation to choose”

* * *