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Major Currents in Contemporary Economics Ryszard Rapacki (editor) Piotr Maszczyk Mariusz Próchniak Małgorzata Znoykowicz-Wierzbicka The textbook is co-financed by the European Union from the European Social Fund. Major Currents in Contemporary Economics Ryszard Rapacki (editor) Piotr Maszczyk Mariusz Próchniak Małgorzata Znoykowicz-Wierzbicka Major Currents in Contemporary Economics Warsaw 2012 This textbook was prepared for the purposes of International Doctoral Programme in Management and Economics organized within the Collegium of World Economy at Warsaw School of Economics. The textbook is co-financed by the European Union from the European Social Fund. This textbook is distributed free of charge. Contents PART ONE – INTRODUCTION Chapter 1. The state of contemporary macroeconomic debate – an overview of key issues and concepts (Ryszard Rapacki) . . . . . . . . . . . . . . 7 1. Setting the stage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 2. Main areas of disagreement and evaluation criteria . . . . . . . . . . . . . . . 10 3. Methodological framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 4. Major schools in modern macroeconomics . . . . . . . . . . . . . . . . . . . . . . 15 PART TWO – MAINSTREAM MACROECONOMICS Chapter 2. The monetarist school (Mariusz Próchniak) . . . . . . . . . . . . . . . . . 21 1. The quantity theory of money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 2. The expectations-augmented Phillips curve . . . . . . . . . . . . . . . . . . . . . . 23 3. Balance of payments theory and exchange rate determinants . . . . . . . 30 4. The orthodox monetarism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 5. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Chapter 3. The new classical school (Mariusz Próchniak) . . . . . . . . . . . . . . . 37 1. The structure of new classical models . . . . . . . . . . . . . . . . . . . . . . . . . . 37 2. Equilibrium business cycle theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 3. The policy implications of new classical approach . . . . . . . . . . . . . . . . 42 4. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Chapter 4. The real business cycle school (Mariusz Próchniak) . . . . . . . . . . . 51 1. Business cycle theories in historical perspective. . . . . . . . . . . . . . . . . . . 52 2. Cycles versus random walks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 3. Real business cycle theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 4. Real business cycle theory and stylized facts . . . . . . . . . . . . . . . . . . . . . 61 5. The policy implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 6. Selected criticism. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 7. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 5 Contents Chapter 5. The new Keynesian school (Małgorzata Znoykowicz-Wierzbicka) . . . 67 1. New Keynesian economics – core propositions and features . . . . . . . . . 67 2. Nominal and real rigidities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 3. Hysteresis and unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 4. New Keynesian economics and stylized facts . . . . . . . . . . . . . . . . . . . . 75 5. Policy implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 6. Assessment of new Keynesian economics . . . . . . . . . . . . . . . . . . . . . . . 77 Chapter 6. New developments in growth theory (Mariusz Próchniak) . . . . . . 79 1. The neoclassical growth theory: the Solow model and the Ramsey model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 2. Endogenous models of economic growth (Romer, Lucas) . . . . . . . . . . . 83 3. Neoclassical revival: the Mankiw-Romer-Weil (augmented Solow) model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 4. Growth empirics: growth determinants, convergence, growth accounting (TFP) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 5. Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 PART THREE – HETERODOX ECONOMICS Chapter 7. The economics of transition (Ryszard Rapacki). . . . . . . . . . . . . . 101 1. Understanding transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 2. Applicability of standard economic theories . . . . . . . . . . . . . . . . . . . . 104 3. What has economics learned from transition? . . . . . . . . . . . . . . . . . . 107 4. Summary and conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 Chapter 8. Do we have to change capitalism – the alterglobalist view (Piotr Maszczyk) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115 1. Materialism versus moral commitment . . . . . . . . . . . . . . . . . . . . . . . . 116 2. Economics and lack of moral responsibility . . . . . . . . . . . . . . . . . . . . 117 3. GDP fetishism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 4. Sustainable development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 5. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132 Chapter 9. New challenges facing the economic science – did economists really get it so wrong? (Piotr Maszczyk) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 1. Global economic crisis – diverging explanations and questions of efficient markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 2. Global economic crisis – fiscal stimulus and the questions of remedies . . . . 141 3. The future of macroeconomics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143 CHAPTER ONE Ryszard Rapacki The state of contemporary macroeconomic debate – an overview of key issues and concepts 1. Setting the stage Between the mid-1930s and the early 1970s, there was a generally accepted broad consensus among economists that centered on the orthodox Keynesian model.1 Since the mid-1970s, the prevailing consensus in macroeconomics has fallen apart and a number of competing schools of thought have emerged. They comprised in particular the monetarist school, the new classical school and the real business cycle theory. Their development, combined with the revival of the Keynesian tradition from the mid-1980s on, gave birth to the present status of the economic science or what became to be dubbed – the ‘mainstream’ (orthodox) macroeconomics. Simultaneously, the 1980s and the following decades witnessed the fast development of ‘heterodox’ economics. This broad category includes – inter alia – such currents as the new institutional economics, behavioral and experimental economics, evolutionary economics, economic sociology, and the alterglobalist view. They further extended the frontiers of economic analysis seeking to capitalize on possible synergies between the ‘orthodox’ economics and other social science disciplines, as a result of sticking to a broader research perspective and applying a more interdisciplinary approach. 1 Exception being the Soviet Union and – after the Second World War – the other centrally-planned economies where the dominant socialist ideology was deeply rooted in the Marxist political economy. 7 The state of contemporary macroeconomic debate – an overview of key issues and concepts Seen from a longer historical perspective, however, these tendencies can hardly be perceived as a surprise. The co-existence of competing schools in economics is not a recent phenomenon whatsoever – it suffices to compare the state of the discipline e.g. in the 19th century and the ‘cohabitation’ of a number of economic currents offering different views on the way the economy operates or should operate (to name a few, the classical school, the utopian socialist view, Marxian political economy, the neoclassical economics, etc.). The disagreements among economists are inherent to the very nature of the object being studied, which is the economic activity of individuals and societies or the way the economy operates. Normative judgments apart (which by definition are subjective and prone to be controversial), for a number of reasons there is a considerable space for diverging opinions even in the field of positive economics, i.e. on how the economy actually works.2 The first and most general reason is due to the fact that – unlike in most physical sciences – the very object of economic research that is the market economy seems to resemble a moving target as it undergoes a constant transformation. The forms of market exchange and economic cooperation as well as the key interrelationships, transmission mechanisms and feedbacks in the economy have been evolving over time, which puts a question mark over the robustness of many economic generalizations and makes the economic theories vulnerable to possible falsification with the new empirical evidence. Second, the same holds true for the behavioral patterns and social norms guiding the decisions and choices made by economic agents. As they have been changing too, the results of past research and the pertinent conclusions are not always consistent with the economic reality prevailing today. For example, even if we had a good estimate of the empirical magnitudes in the demand for money function for the period of 1950–70, would it be relevant after 2000, with credit cards and Internet shopping? (Begg, Fischer, Dornbusch 2008). Third, again in a sharp contrast with many disciplines within the physical sciences, economists can seldom undertake controlled laboratory experiments. As a result, to be able to make judgments on how the economy works, they have to rely on available historical data – such as the official statistics or empirical evidence generated through own research. Fourth, even the empirical research in economics does not always offer unequivocal answers and the most the economists can do in many instances is to arrive at tentative conclusions (Dornbusch, Fischer, Startz 2001). This may be due, among other causes, to the fact that the time series of data is too short to prove a given case (for instance, the full economic effects of the floating exchange rates introduced after 1973). 2 For an interesting discussion on the frontiers between positive and normative economics and the possible ways of their reconciliation, see Czarny 2010. 8 1. Setting the stage Finally, an important part of today’s behavior of economic agents – both firms and households – tends to be heavily influenced by their expectations of future events (Dornbusch, Fischer, Startz 2001). Although economists are capable of measuring quite precisely the actual outcomes of the current decisions of firms and households (e.g. the level of spending) they have no equivalent measures of current expectations (e.g. of future personal incomes and corporate profits) nor the full understanding of the way expectations are formed. This leaves a substantial room for diverging interpretations of the role of expectations as a determinant of today’s economic decisions. As a derivative, while looking at the same data different economic schools may view them differently. All the forgoing reasons combined offer a plausible explanation why economists may disagree even in their positive judgments. Notwithstanding the fact that many conclusions stemming from empirical studies are quite persuasive and widely accepted in the ‘mainstream’ economics essential controversies remain. What is important, the latter involve not just mere quibbles about points of detail but concern the most fundamental issues in key problem areas of economic research (such as e.g. factors of long-run growth, causes of short-term economic fluctuations, inflation and unemployment, and possible tradeoffs) that shape the very view of the world and determine policy prescriptions offered by different economic schools to the policy makers. Against this background, it is worth emphasizing however that the co-existence of different schools of thought in the contemporary economics does not only imply competition or rivalry – it may also entail complementarities and stronger incentives to learn from each other thus providing a fertile ground for the development of the entire economic discipline. A similar view can be found in the works of Snowdon, Vane, Wynarczyk (2002, p. 2) who claim that the co-existence of alternative explanations in economics is a sign of strength rather than weakness since it permits gains from intellectual trade and improved understanding. In fact, it was John Stuart Mill who first recognized, more than a century ago, that all parties involved gain from the comparative interplay of ideas (Mill 1982, p. 105).3 With this in mind, below we embark on the main task of the present chapter, which is to show the state of the contemporary economic debate and to briefly introduce the major currents or schools of economic thought. We will focus here only on those schools that represent the ‘mainstream’ macroeconomics while leaving for the later parts of this textbook, a more in-depth characteristics of the selected currents in ‘heterodox’ economics. In order to pursue our objective, we will first (Section 2) sketch the main areas of controversies in 3 Stanley Fischer and Olivier Blanchard seem to represent an even more extreme view – they maintain that on the surface macroeconomics appears to be divided among competing schools but actually, this represents largely the public relations gimmick and reflects the strong incentives that exist in academia to differentiate products. This assertion implicitly implies that if you dig deeper much more similarities can be found. See Snowdon, Vane, Wynarczyk 2002, Interview with Stanley Fischer, p. 34 and Blanchard, Fischer 1998. 9 The state of contemporary macroeconomic debate – an overview of key issues and concepts ‘mainstream’ macroeconomics and outline the set of evaluation criteria that will organize our discussion and enable a comparative analysis – both in this chapter and throughout the whole textbook – of the coexisting economic schools. Next (Section 3), we will also briefly refer to selected methodological frameworks with a view to providing a useful benchmark for assessing the schools concerned. 2. Main areas of disagreement and evaluation criteria It may be convenient to organize our thinking about the co-existing schools in contemporary macroeconomics around three concepts or a triad of key terms that appear to best characterize the prevailing general view on the way a market economy works: equilibrium – shock – adjustment (to a new equilibrium). If we add to this list two more concepts, i.e. the time dimension of economic activity and the propagation mechanism we are ready to embark on the discussion of the main areas of disagreement among economists. For most (if not all) economists the ideal state of economic affairs entails market or macroeconomic equilibrium. The notion of equilibrium may be interpreted in terms of a benchmark or – by analogy – a one-meter standard of Sèvres. Similarly, only few economists would dispute the view that – out of four main markets in the economy, i.e. those for goods, money, labour and foreign exchange – these are the financial markets, which display the fastest pace of adjustment while the slowest to clear is the labour market. What really feeds the ground for controversies in macroeconomic debates is the speed of adjustment (time required to clear) of each and every of the four markets, and the way the propagation mechanism works. For the sake of the present discussion, we will define the propagation mechanism as a mechanism through which a shock (or a disturbance) is spread throughout the economy (Dornbusch, Fischer, Startz 2001). Seen from the perspective just outlined the main disagreements in macroeconomics concentrate in five key areas. While briefly presenting the most salient features and the essence of pertinent controversies we will by the same token provide a set of criteria for the subsequent comparative analysis of the main currents in contemporary ‘mainstream’ macroeconomics. The five areas in question include the following: • market clearing, • hysteresis, • formation of expectations, • short run vs. long run, and (as a derivative) • demand-side vs. supply-side. 10 2. Main areas of disagreement and evaluation criteria Market clearing According to the standard definition, a market clears when the quantity supplied by sellers equals the quantity demanded by purchasers. The question of whether all markets clear and if so – how quickly, ranks among the most heatedly debated issues in the contemporary macroeconomics. At the one extreme, the classical analysis assumes that all markets clear – the economy is then at potential output and full employment. Both the expansionary monetary and expansionary fiscal policies are then helpless as the only effect they can produce is to raise the price level and accelerate inflation but not to increase output. At the other extreme, the Keynesian economics assumes that markets, and in particular the labour market, do not clear. This is mainly due to the sluggish adjustment of wages and other nominal variables. Under such circumstances a fall in aggregate demand for goods and in the derived demand for labour reduce output and employment. The expansionary fiscal and monetary policies are then effective and increase the actual output. As of today, the economic profession continues to be divided in addressing the question of market clearing. On the one hand, with the revival of the new Keynesian economics after 1980 and the development of microeconomic foundations supporting the assumption of wage stickiness and other nominal rigidities the prevailing belief that markets automatically clear has been undermined. On the other hand however, the emergence of the real business cycle school and its attempt to explain even the short run fluctuations with market clearing models shed a new light on the determinants of potential output and equilibrium unemployment and empowered the advocates of the market clearing approach with new intellectual weapons. Hysteresis Economists are also divided into two broad camps in their views regarding the status of hysteresis as part of the propagation mechanism or the number of possible long-run equilibria in the economy. Hysteresis occurs when the adjustment path an economy follows in the short run, reacting to a shock, determines the position of its long-run equilibrium. According to the first view, the economy always returns to its original equilibrium position after the adjustment process is completed. Hence, hysteresis does not exist or is irrelevant – the short-run evolution of the economy does not affect its long-run behavior including its unique equilibrium position. In contrast, the second view claims that the short-run performance of the economy does affect its behavior in the long run. This implies that there are multiple possible equilibria in the long run and hysteresis is important as part of the explanation on how the economy works. 11 The state of contemporary macroeconomic debate – an overview of key issues and concepts Formation of expectations The third area of disagreement in macroeconomics concerns the role of expectations as determinants of current decisions and the way expectations are formed. Most economists subscribe to the view that beliefs about the future affect current decisions. However, some controversies remain over the nature of expectations formation. In this respect, three distinct approaches can be singled out. 1. Some economists assume that expectations are given or exogenous. Although they are accounted for as a possible explanatory variable in their studies, they are not explained in a pertinent economic model. 2. The second approach makes expectations endogenous or being determined within a given economic model. The proponents of this view rely on a simple rule of thumb, which consists in assuming that expectations are extrapolative (or adaptive). This is equivalent to say that – while forecasting future events or behavior of an economic variable – people tend to simply extrapolate the trends experienced in the recent past. 3. The third, most numerous, group of economists builds their models based on the assumption of rational expectations. Similar to the second approach, expectations here are endogenized. In contrast to the latter, however, the rational expectations hypothesis claims that – while forecasting the future – economic agents make good use of all information available today and are not systematically wrong in their predictions. Even if sometimes they overshoot or undershoot in their forecasts, the errors get noticed, which brings about an amendment to the information basis and revision of the expectations formation until predictions are on average correct (Dornbusch, Fischer, Startz 2001). Short run vs. long run (demand-side vs. supply-side) The relative importance attached to the short run and the long run by different schools in macroeconomics, as a time frame of their analyses, may in part reflect their diverging value judgments about the tradeoffs involved in assessing benefits and costs of different government policies. On the other hand, the different views on the relative significance of the short vs. the long run may be to some extent seen as a function of disagreements prevailing in the three areas just discussed. If we are convinced that it takes little time for markets to clear, it follows that there is no much room for the demand management policy in the short run and the supply-side policy becomes important as a tool for raising potential output and equilibrium employment in the long run. Conversely, if we believe in the possibility of high levels of Keynesian unemployment in the short run, we may be tempted to judge that 12 3. Methodological framework the short-run benefits of restoring the full employment more than offset the risk of reducing potential output in the long run. Similarly, the more one’s horizon is short-run, the more plausible it becomes to treat expectations as exogenous or to neglect the role of hysteresis as part of the propagation mechanism (Begg, Fischer, Dornbusch 2008). Apart from outlining the context for a comparative analysis or describing the main areas of disagreement between alternative economic schools, any assessment of a particular theory must also include its capability of explaining the ‘stylized facts’ that characterize macroeconomic phenomena (Greenwald, Stiglitz 1988). According to Snowdon et al., the ‘stylized facts’ may be defined as the broad regularities, which have been identified in the statistical property of economic time series (Snowdon, Vane, Wynarczyk 2001, p. 29). The greatest deal of controversy in macroeconomics appears to concern the causes of fluctuations in the level of economic activity. That is why in the ensuing discussion (and throughout the whole textbook) we decided to use the explanatory power of alternative economic schools with regard to major stylized facts of the business cycle as a means of evaluating these theories. The major ‘stylized facts’ as summarized by Abel and Bernanke (1992), are as follows: 1. Output movements tend to be correlated across all sectors of the economy. 2. Industrial production, consumption and investment are procyclical and coincident. Government purchases also tend to follow the same trend. 3. Investment is much more volatile during the business cycle than consumption, although spending on consumer durables is strongly procyclical. 4. Employment is procyclical while unemployment counter-cyclical. 5. The real wage and average labour productivity are procyclical although the real wage is only slightly procyclical. 6. The money supply and share prices are procyclical and lead the cycle. 7. Inflation (and by the same token the price level) and nominal interest rates are procyclical and lagging. 8. The real interest rate is acyclical (Snowdon, Vane, Wynarczyk 2001, pp. 30–31). 3. Methodological framework With a view to further enhance our understanding of the differences and similarities between the major currents in contemporary macroeconomics, in this section we will briefly discuss some key methodological issues seeking to provide a useful framework or a reference point for the ensuing comparative assessments. In their methodological debates, deeply rooted in the philosophy of science, economists have in particular drawn on ideas from the ‘growth of knowledge’ theories in order to account for the historical evolution or current status of their discipline (see Snowdon, Vane, Wynarczyk 2001). 13 The state of contemporary macroeconomic debate – an overview of key issues and concepts The ‘growth of knowledge’ theories associated with Popper, Kuhn and Lakatos have become popular among economists as models for the development of their discipline and a useful methodological framework enabling an in-depth comparative analysis and appraisal of different theories, research programs and paradigms. Popper (1959) pointed out to a logical asymmetry between verification and falsification of the prevailing theories, with a strong bias towards the latter. In his view, while it is not sufficient to prove theories by confirmation we can disprove them by refutation. Seen from the perspective adopted in this textbook, worth emphasizing is the fact that the growth of economic knowledge has not followed the path predicted by Popper. There is no evidence of serious Popperian falsificationism in economics – the new ideas tend to be accepted without the complete rejection of the old ones (Snowdon, Vane, Wynarczyk 2001). According to Kuhn (1970), the development of science exhibits a cyclical pattern: the periods of continuity and progress are followed by the time spells characterized by a serious anomaly or crisis, which may be conducive to discontinuity or revolution leading to the emergence of a new scientific paradigm. His view has been widely adopted and applied by economists to their own discipline. Unlike Popper’s methodology, however, which emphasizes the need of criticism and permanent revolution, Kuhn puts a stress on tenacity and commitment to defend a paradigm from attacks (Snowdon, Vane, Wynarczyk 2001). In his view, revolutions are only occasional occurrences marked by intense competition between paradigms. Yet, in economics the end of controversy implies as a rule an acceptance of the new paradigm without destroying the old one (Kuhn 1977). This may explain why the contemporary macroeconomics can support at the same time a number of incompatible schools or research traditions. In turn Lakatos (1978) in his methodology shifts emphasis from a single theory or hypothesis to scientific research programmes or a series (or succession) of theories that are genetically linked together. A research programme is composed of three main building blocks: the hard-core, positive heuristic and a protective belt of auxiliary hypotheses. The hard core of a research programme spells out a fundamental set of statements about the world, consisting of deep and fertile hypotheses, which are conventionally accepted as irrefutable (Snowdon, Vane, Wynarczyk 2001). An example of hard-core propositions within macroeconomics is Keynes’s replacement of classical and neoclassical belief in rational economic calculation based on certainty equivalence with pervasive uncertainty (see Blaug 1980). The positive heuristic of a research programme in turn describes the paths of research to be pursued, i.e. it provides a future research strategy or agenda. For instance, the basic positive heuristic of orthodox Keynesian economics boils down to the endeavour aimed at explaining the volatility of output and employment by 14 4. Major schools in modern macroeconomics analyzing fluctuations in the aggregate demand for output while that of orthodox monetarism is to explain sustained variations in the rate of inflation by sustained prior variations in the growth rate of money supply (Snowdon, Vane, Wynarczyk 2001). Lakatos makes also a distinction between progressive and degenerative research programmes the key evaluation criterion being the concept of a novel fact. The latter entails the production of new empirical evidence that extends the frontiers of our knowledge and understanding of the world. However, putting an equality sign between the results of empirical research only (or novel facts) and the scientific progress seems problematic as it neglects the contribution of purely theoretical or conceptual advances to the stock of available knowledge. Criticism aside, the Lakatosian methodology has gained a remarkable popularity among economists one of the underlying reasons for that being its stress put on competition between coexisting currents or research programmes and its allowance of comebacks of previously degenerating currents. Still another methodological perspective can be found in Laudan’s (1977) approach. His problem-solving model acknowledges equal importance of conceptual and empirical issues, with scientific progress measured both in terms of increasing the stock of empirical evidence and the elimination of conceptual difficulties (Snowdon, Vane, Wynarczyk 2001). In his view, the value of a theory depends upon how many problems it solves relative to its competitors. Worth stressing is also one more distinctive feature of his methodological framework: in contrast to both Kuhn (paradigm) and Lakatos (research programme) Laudan makes the research tradition rather than the individual theory, the primary focus of interest (different research programmes can represent the same research tradition). Wrapping up the foregoing account of methodological debates in the last three decades we are confident that some of the insights derived from this debate will be helpful in organizing and supporting our thinking of the complex developments in the contemporary macroeconomics. They are briefly outlined in the next section and discussed in a much greater detail in the subsequent chapters of this textbook. 4. Major schools in modern macroeconomics Apart from the general reasons discussed in Section 1, one more important determinant of a specific nature should be added to our list of factors that can be hold responsible for the (re-)emergence of different schools of thought in contemporary macroeconomics in a particular historical period, i.e. since the early 1970s. This was the first oil shock of 1973 and its consequences that highlighted the failure of the orthodox Keynesian economics to offer satisfactory explanation of the changing world and resulted in the breakdown of the Keynesian consensus. They also triggered a heated debate among economists 15 The state of contemporary macroeconomic debate – an overview of key issues and concepts on how to best explain the new economic reality and to make the theory again fitting the facts. The diversity of views in this regard has logically led to their gradual evolution into more ‘institutionalized’ currents or schools. Another possible angle of looking at the possible driving forces behind the unfolding evolution of the contemporary ‘mainstream’ macroeconomics boils down to contrasting two seemingly incompatible theories, i.e. the neoclassical microeconomics (the Walrasian theory of general equilibrium) and the orthodox Keynesian macroeconomics. During the ‘golden age’ of the Keynesian consensus, the two sub-disciplines led separate lives even accounting for Paul Samuelson’s atttempt at producing a neoclassical synthesis (Samuelson 1955). By 1973 the sharp differences between these two strands of economics could not be ignored (Snowdon, Vane, Wynarczyk 2001). According to Greenwald and Stiglitz (1987), there were two broad options for their reconciliation. Either the macro theory could be adapted to micro foundations or the micro theory adapted to fit the macroeconomic framework. While the former approach gave birth to the new classical school the latter evolved into the new Keynesian economics. In the subsequent part of this section we will provide a concise picture of the most prominent currents in the contemporary macroeconomic debate, following a chronological order of their emergence and development. According to the most widespread view, four such currents can be thought of as components of the ‘mainstream’ macroeconomics today: the monetarist school, the new classical school, the real business cycle theory and the new Keynesian economics. We will briefly outline the most salient features of each of these schools below. The monetarist school The immediate cause of the monetarist counter-revolution in the early-1970s was the apparent failure of orthodox Keynesian economics to address the growing problem of inflation (Snowdon, Vane, Wynarczyk 2001). However, the origins of monetarism can be traced back to the late 1950s and the work of Milton Friedman and his followers. Monetarists believe that although the economy may temporarily depart from its potential output level, as a result of shocks, full employment is restored within few years and the economy returns to its unique, original long-run equilibrium. As a result, the effectiveness of monetary policy as a tool of demand management is limited – the main effect of monetary expansion is higher prices and inflation. The latter critically depends on the growth rate of nominal money supply. The new classical school The development of the new classical school was inspired by pioneering works of Robert Lucas (1972, 1973) in the early-1970s. The analysis here is 16 4. Major schools in modern macroeconomics classical since it assumes wage and price flexibility, which ensures the return of the economy to its unique long-run equilibrium position at full employment and potential output. One of the possible implications of this assumption is that hysteresis is unimportant. At the same time, the analysis is new, as it believes that the whole adjustment process to a shock (or market clearing), including (rational) expectations, wages and prices is almost instant (Blanchard 2009). The monetary and fiscal policy can at best affect the composition of full-employment aggregate demand but not its level. The real business cycle theory The origins of this new current in macroeconomics can be traced in the innovative work of Kydland and Prescott, published in 1982. As a matter of fact, the approach dubbed the real business cycle theory belongs essentially to the same family as the new classical economics – both believe in a very fast market clearing and rational expectations. However, the former is both more extreme and more general than the latter. It is more extreme because it neglects deviations from the potential output even in the short run. Instead, it assumes that all fluctuations in the level of output are fluctuations of the potential output alone. Simultaneously, the real business cycle theory is more general compared to a new classical approach as it concentrates its explanatory power on making explicit the microeconomic foundations for the intertemporal decisions of economic agents – households, firms and governments (Begg, Fischer, Dornbusch 2008). The new Keynesian school The new classical approach (including the real business cycle theory) has been challenged by a group of prominent economists4 who – particularly since the mid-1980s – have revitalized the Keynesian analytical tradition and formed the new Keynesian school. Referring back to our earlier remarks in this section, instead of adapting the macro theory to orthodox neoclassical market-clearing micro foundations, the new Keynesians chose the opposite option, i.e. to adapt the micro bases to their macro theory (Snowdon, Vane, Wynarczyk 2001). The proponents of the new Keynesian approach highlight the role of nominal rigidities, which make the wages and prices sticky and the whole adjustment process sluggish (Hillier 1991). In their view, the latter can take many years. Moreover, as a result of hysteresis, there might be multiple long-run equilibria in the economy – once adjustment is completed a new eventual equilibrium 4 The group includes – inter alia – Nobel Prize laureates George Akerlof, Edmund Phelps, Joseph Stiglitz and James Tobin and such reputed scholars as Ben Bernanke, Olivier Blanchard, Rudiger Dornbusch, Stanley Fischer, Gregory Mankiw and David Romer. 17 The state of contemporary macroeconomic debate – an overview of key issues and concepts position is likely to be different from the original one. In such a world, there is a substantial scope for the demand management policies that are quite effective in liquidating (or at least narrowing) the output gap and restoring long-run equilibrium. As a recap of our hitherto discussion, Table 1 below provides a stylized summary of the main differences and similarities between the four alternative views on the modus operandi of the contemporary market economy. Table 1. A stylized summary of major currents in macroeconomics Area Monetarist school New classical school Real business cycle theory New Keynesian school Market clearing Quite fast Very fast Instantaneous Quite slow Speed of adjusting expectations Slower Rapid Very fast Fast or slow Relative weight of short run/long run Long run more important Little difference since adjustment is fast No difference as adjustment is instantaneous Don’t forget short run Full employment Never far away Always close Always present Not easy to achieve and may take time Hysteresis Irrelevant Irrelevant Non-existent Might be a problem Demand management vs. supply-side policy Supply more important; avoid swings in demand Forget demand; supply side is what matters Only supply side matters Demand matters too Source: Adapted and extended from Begg, Fischer, Dornbusch 2008, p. 624. Bibliography Abel, A., B.S. Bernanke, 1992, Macroeconomics, New York, Addison Wesley. Begg, D., S. Fischer, R. Dornbusch, 2008, Economics, 9th edition, Maidenhead, McGraw-Hill. Blanchard, O.J., 2009, Macroeconomics, 5th edition, Upper Saddle River, Pearson Prentice Hall. Blanchard, O.J., S. Fischer, 1998, Lectures on Macroeconomics, Cambridge, The MIT Press. Blaug, M., 1980, The Methodology of Economics or How Economists Explain, Cambridge: Cambridge University Press. 18 4. Major schools in modern macroeconomics Czarny, B., 2010, Pozytywizm a sądy wartościujące w ekonomii (Positivism and Value Judgments in Economics), Warszawa, Oficyna Wydawnicza SGH. Dornbusch, R., S. Fischer, R. Startz, 2001, Macroeconomics, 8th (International) Edition, McGraw-Hill. Greenwald, B.C., J.E. Stiglitz, 1988, Keynesian, New Keynesian and New Classical Economics, Oxford Economic Papers, March. Greenwald, B.C., J.E. Stiglitz, 1987, Examining Alternative Macroeconomic Theories. Hillier, B., 1991, The Macroeconomic Debate. Models of the Closed and Open Economy, Oxford and Cambridge, Blackwell. Kuhn, T.S., 1977, The Essential Tension, Chicago, University of Chicago Press. Kuhn, T.S., 1970, The Structure of Scientific Revolutions, Chicago, University of Chicago Press. Kydland, F.E., E.C. Prescott, 1982, Time to Build and Aggregate Fluctuations, Econometrica, November. Lakatos, I., 1978, The Methodology of Scientific Research Programmes, Cambridge, Cambridge University Press. Laudan, L., 1977, Progress and its Problems, London, Routledge and Kegan Paul. Lucas, R.E. Jr., 1972, Expectations and the Neutrality of Money, Journal of Economic Theory, April. Lucas, R.R. Jr., 1973, Some International Evidence on Output-Inflation Tradeoffs, American Economic Review, June. Mill, J.S., 1982, On Liberty, Harmondsworth, Penguin English Library. Popper, K.R., 1959, The Logic of Scientific Discovery, London, Hutchinson. Popper, K.R., 1961, The Poverty of Historicism, London, Routledge and Kegan Paul. Samuelson, P.A., 1955, Economics, 3rd edition, New York, McGraw Hill. Snowdon, B., H. Vane, 2002, An Encyclopedia of Macroeconomics, Cheltenham, Edward Elgar. Snowdon, B., H. Vane, P. Wynarczyk, 2002, A Modern Guide to Macroeconomics. An Introduction to Competing Schools of Thought, Cheltenham, Edward Elgar. 19 CHAPTER TWO Mariusz Próchniak The monetarist school In this chapter we present the main characteristics of the monetarist school. We start with a quantity theory of money (which was explored by monetarists during the 1950s and the first half of the 1960s). Then we describe the monetarist development of the Phillips curve (second half of the 1960s). At the end we present the monetarist approach to the balance of payments and exchange rate determination (the 1970s). 1. The quantity theory of money Let us start with the traditional approach of the quantity theory of money. This theory is based on the following equation: MV = PY , (1) where: M – nominal money supply, V – the velocity of money circulation in the economy, P – the average price level in the economy, Y – real income, output, GDP. It is assumed that the speed of money circulation (V), i.e. the average frequency across all transactions with which a unit of money is spent, is constant. The main implication of the quantity theory of money is as follows: given a constant income (which takes place when output is at its potential level), the increase in the nominal money supply leads to inflation. In other words, the increase in the nominal money supply only raises the nominal income (PY), and not the real income (Y). This theory is over 500 year old, and according to some economists it even comes from Confucius. The monetarists defend it as they argue that inflation is mostly caused by changes in nominal money supply. The monetarist school is identified with Milton Friedman. He may be regarded as the founder of this mainstream in economics. The monetarist school is based 21 The monetarist school on the quantity theory of money. In 1956, Friedman re-established this theory, treating it not as a theory of the general price level or monetary income, but as a theory of the demand for money. According to Friedman, the demand for money (like the demand for all other assets) depends on four factors: • income (which determines the maximum amount of money that people want to have), • rate of return on money in comparison with the rate of return on other financial and real assets, • expected rate of inflation, • consumer preferences. Thus, the demand function for real money balances can be written as follows: MD = f (Y , r , π e , µ ), P (2) where: MD – nominal money demand, P – the average price level, Y – permanent income, r –rate of return on financial assets, πe – expected inflation rate, µ – consumer preferences. The left-hand side of this equation, i.e. the nominal money demand to price ratio, is equal to the demand for real money balances. Income, that appears on the right-hand side, is a measure of wealth and it represents the budget constraint. Equation (2) is a simplified version of the Friedman’s demand function for money balances. This equation implies that the demand for money increases with income, but decreases with both the rate of return on other financial assets and the expected inflation rate. Based on Equation (2), we can explain the ‘core’ of the monetary approach, i.e. the way the increase in nominal money supply causes inflation. If the rates of return on various financial assets are different, the structure of individuals’ wealth is not optimal. Thus, utility-maximising consumers should change their portfolio of assets until the rates of return are equal. This mechanism is a key element in monetary approach as it directly shows how changes in nominal money supply affect the real output and prices. Suppose initially that the economy is in equilibrium. This means that the wealth is divided between the real and financial assets in such a way that the marginal rates of return on different types of assets are equal. Assuming further that the central bank performs open market operations in order to increase the monetary base. As a result, the nominal money supply increases. Since the marginal rate of return on any asset decreases with an increase in its stock, monetary expansion will decrease the marginal rate of return on money. As a result, utility-maximizing individuals get rid of money and buy other assets (financial and real assets such 22 2. The expectations-augmented Phillips curve as consumer goods). This leads to an increase in their prices; in other words – it accelerates inflation. Everything will be stabilized at a point at which marginal rates of return on different types of assets are equal. In this way Friedman explained why the increase in nominal money supply causes inflation. The monetary approach to the quantity theory of money can be summarized as follows. First, the increase in nominal money supply is the main factor stimulating inflation and nominal income growth. Second, given a stable money demand, the instability in the real economy is mainly caused by the fluctuations in money supply, triggered off by the central bank’s policy. Third, the money supply should grow at a constant rate corresponding to the real GDP growth rate, leading to long-term price stability. 2. The expectations-augmented Phillips curve The second stage of the analysis of the monetarist school is to show how the monetary expansion influences the real and nominal economic variables. The most important papers in this field have been published by Friedman in 1968 and Phelps in 1967. These authors extended the original analysis of the Phillips curve. In textbook terms, the Phillips curve shows the relationship between unemployment and inflation. It is illustrated in Figure 1a. The relationship is negative, which means that higher inflation is accompanied by lower unemployment, and vice versa: lower inflation rate corresponds to higher unemployment. This curve is named after the New Zealand economist Alban William Phillips. In 1958, Phillips showed the existence of a statistical relationship between the unemployment rate and the growth rate of nominal wages in the UK during 1861–1957. This relationship was negative and non-linear. The original Phillips curve is illustrated in Figure 1b. When the unemployment rate was about 2.5%, the growth rate of nominal wages was about 2%. Nominal wages tended to stabilize at the unemployment rate of around 5.5%. Figure 1. The Phillips curve Inflation rate π Growth rate of money wages 2% Unemployment rate U (a) 2.5% 5.5% Unemployment rate U (b) 23 The monetarist school In mathematical terms, the Phillips curve can be written as follows: . W = f (U) or π = f (U ) , (3) . where W is the growth rate of money wages (dot over a variable means its time derivative), π is the rate of inflation, and U is the unemployment rate. The Phillips curve has been used by many Keynesians as an evidence that there is a long-run stable relationship between inflation and unemployment. The government may, therefore, pursue a combination of fiscal and monetary policy to choose any point on the Phillips curve, depending on whether the government prefers lower inflation or lower unemployment. The above reasoning, however, turned out to be false. Since the end of the 1960s, past trends in the economy have reversed. In the 1970s, both the U.S. and UK often recorded simultaneous increase in inflation and unemployment. The non-existence of a stable long-run negative relationship between inflation and unemployment was observed at the same time by Friedman and Phelps. In their opinion, the original specification of the Phillips curve was misleading due to the fact that the rate of increase in money wages does not depend on the rate of inflation. In 1968, Friedman suggested that the original Phillips curve, showing the negative relationship between the growth rate of money, wages and unemployment, was misspecified. Although nominal wages are established in wage negotiations, both workers and firms are interested in real, rather than nominal wages. Since wage negotiations take place at discrete time intervals, the anticipated real wage depends on the expected rate of inflation during the employment contract. Friedman argued that the Phillips curve should include real wages, i.e. it should illustrate the relationship between the growth rate of real wages and the unemployment rate. Therefore, Friedman has expanded the analysis of the Phillips curve introducing an additional variable: the expected rate of inflation. As a result, the growth rate of money wages depended not only on the unemployment rate (that measures the output gap) but also on the expected rate of inflation. Mathematically, this can be written as follows: . W = f (U ) + πe, (4) where πe is the expected inflation rate. After introducing the expected rate of inflation, the analysis becomes more complex. We do not have one unique Phillips curve. We obtain a family of Phillips curves for different expected rates of inflation. In other words, we have infinitely many Phillips curves showing a negative relationship between the growth rate 24 2. The expectations-augmented Phillips curve of nominal wages and the unemployment rate, each of which corresponds to a different expected rate of inflation. This is illustrated in Figure 2. For simplicity, we assume that labour productivity growth is zero. Therefore, if nominal wages are constant, price level is. constant as well implying a zero expected rate of e inflation. In other words: W = π = π , W = const., P = const. Figure 2 shows five Phillips curves: PC0, PC1,…, PC4. The curve PC0 shows a negative relationship between the growth rate of money wages and the unemployment rate in the absence of inflationary expectations. This nonexpectations augmented Phillips curve intersects the horizontal axis at the natural rate of unemployment (NARU or U*) or the non-accelerating inflation rate of unemployment (NAIRU).5 Figure 2. The expectations-augmented Phillips curves Growth rate of money wages π4 π3 PC4 π2 PC3 π1 PC2 PC1 U* NAIRU Unemployment rate, U PC0 The curves PC1,…, PC4 illustrate a negative relationship between the growth rate of money wages and the unemployment rate for different expected rates of inflation. Expected rate of inflation shifts the Phillips curve parallel upwards by a distance equal to the expected rate of inflation. For example, the curve PC1 corresponds to the expected inflation rate π1, the curve PC2 corresponds to the expected inflation rate π2, and the curve PC4 represents the expected inflation rate π4. 5 The concepts of NARU and NAIRU stem from a slightly different economic reasoning, even though they rather represent the same economic category. NARU is the unemployment level in the labour market equilibrium. If the labour market is in equilibrium, the demand for labour equals the supply of labour. There is no involuntary unemployment, and the output is at its potential level (there is neither excess demand nor excess supply). Zero output gap means that there are neither deflationary nor inflationary pressures. Hence, if the labour market is in equilibrium, there exists the non-accelerating inflation rate of unemployment (NAIRU). 25 The monetarist school We now combine the short-run and long-run analysis, showing the short-run and long-run effects of the monetary expansion. The effects of the increase in nominal money supply are illustrated in Figure 3. In Figure 3, SRPC0 and SRPC1 represent the short-run Phillips curves (SRPC0 corresponds to a lack of inflationary expectations). LRPC is the long-run Phillips curve (which will be explained in greater detail later in this section). Figure 3. Short-run and long-run Phillips curves π, πe F G e π SRPC1 e π E U1 U* NAIRU U SRPC0 At the initial equilibrium, the economy is at point E. The inflation rate and the growth rate of nominal wages are both zero. Unemployment is at its natural level (U*), and the output is at the potential level. There are no inflationary expectations. In other words: W = const., P = const.; π = 0, πe = 0. Now suppose that monetary authorities decide to pursue an expansionary policy: central bank increases the nominal money supply in order to boost the economy. As a result, the aggregate demand and output both increase: output exceeds its potential level and unemployment decreases to U1. This leads to an increase in both prices and nominal wages, but prices adjust faster than wages. Since at the starting point the inflation rate was zero, workers initially treat the increase in money wages as the increase in real wages and supply more labour. In other words, . workers exhibit money illusion. Although nominal wages rise at a rate W1 , real wages decline. The economy moves to the point F on the short-run Phillips curve SRPC0. In the next periods, 26 2. The expectations-augmented Phillips curve however, workers will adjust their inflationary expectations to the actual rate of inflation. They will recognize that real wages have fallen despite the increase in nominal wages. Therefore, they will insist to raise their nominal wages, which shifts the short-run Phillips curve parallel upwards from SRPC0 . to SRPC1. Nominal wages will raise at a rate of W1 plus the expected rate of inflation. Since the growth rate of nominal wages exceeds the actual inflation rate, real wages will raise. It implies that firms will fire workers yielding an increase in unemployment. This adjustment process occurs until the economy reaches a new long-run equilibrium point G. At point G, real wages are at the initial level and the labour market is in equilibrium with the natural rate of unemployment. Based on this analysis we may conclude as follows: a negative relationship between the growth rate of nominal wages and the unemployment rate does not exist if workers – in wage negotiations – fully anticipate future inflation, i.e. when the expected inflation rate equals the actual rate. This means that if output is at the potential level and unemployment stands at the natural level, the growth rate of nominal wages is equal to both the actual and the expected inflation rate. Thus, money wages are constant only if there are no inflationary expectations. Hence, the long-run equilibrium may occur at point E, at point G, as well as at any other point corresponding to the natural rate of unemployment (a particular point depends on the expected rate of inflation). Connecting these points, we get the long-run Phillips curve (LRPC). It always intersects the horizontal axis at the natural rate of unemployment (U* or NAIRU). On the long-run Phillips curve, the growth rate of nominal wages is exactly equal to the inflation rate (i.e. real wages are constant), while the expected inflation rate is equal to the actual rate of inflation (i.e. inflation is fully anticipated). The analysis carried out by Friedman helped to combine the existence of the neutrality of money in the long run with the fact that money influences the real economy in the short run. Adaptive expectations hypothesis When we look at the above analysis in terms of expectations, it follows that monetarists assume the existence of adaptive (in other words: error-learning or extrapolative) inflationary expectations. Adaptive expectations are based on the assumption that the future is an extension of the recent past. It means that workers formulate their inflationary expectations extrapolating past inflation rates. Therefore, if the government changes its monetary policy, the expected inflation gradually adjusts to the actual inflation and output may vary around the potential level in the short run. 27 The monetarist school Policy implications of the expectations-augmented Phillips curve The above analysis allows us to draw some recommendations for economic policy. 1. The short-run effects of an expansionary monetary policy According to monetarists, the vertical Phillips curve concerns the long run. In the short run, the economy moves along the short-run Phillips curve implying a trade off between inflation and unemployment. Monetary expansion could therefore lead to a short-run increase in output over the potential level and a shortrun decrease in unemployment below the natural rate. This outcome occurs because inflation is unexpected (monetarists assume the adaptive expectations hypothesis). As soon as workers adjust their inflationary expectations and fully anticipate the inflation rate (including it in wage negotiations), the short-run Phillips curve will shift upwards and the unemployment rate will return to the natural level. Monetarists believe that the economy returns to long-run equilibrium with potential output and full employment during a relatively short period of time (2–3 years). 2. The accelerationist hypothesis The second policy implication of monetarism concerns the accelerationist hypothesis. According to this hypothesis, if the government wants to keep output permanently above its potential level, such a policy will result in accelerated inflation. This is because the persistent excess of output can only be achieved by a continuous monetary expansion. 3. The effects of anti-inflationary policy Monetarists argue that inflation is a monetary phenomenon caused by an increase in money supply. Thus, the reduction of inflation can be achieved by a decline in the growth rate of money supply. In the short run the economy may deviate from the potential output and full employment, implying that anti-inflationary policy will result in a temporary increase in unemployment. The more rapid is the reduction in inflation planned by the government, the higher will be a temporary increase in unemployment and the greater costs of anti-inflationary policy. Therefore, when pursuing anti-inflationary policy, the government faces the following dilemma: it can reduce inflation rapidly at the cost of high unemployment, or it can choose a gradual (long-run) deceleration of inflation at the expense of only a small increase in the level of unemployment. Both variants are illustrated in Figure 4. Figure 4 shows the long-run and short-run Phillips curves. Initially, the economy is in the long-run equilibrium given by point E, with the inflation rate (π1) equal to the growth rate of money wages. Inflation is fully expected: π 1 = π e. 28 2. The expectations-augmented Phillips curve Let us consider the first policy option. If the government chooses a policy of a rapid reduction in inflation, it sharply reduces the growth rate of money supply. In the short run, the economy moves to the point G and unemployment rises to U3. When workers adjust their inflationary expectations to the new growth rate of money supply, the short-run Phillips curve will shift from SRPC1 to SRPC3. As a result, the economy moves to a new long-run equilibrium given by point F, where unemployment is at the natural level and inflation equals π3, that is less than π1. In this policy option, a new inflation target is achieved quickly, but at the cost of high unemployment. Figure 4. The effects of anti-inflationary policy π, LRPC π1 π2 π3 E H J F G K SRPC1 SRPC2 SRPC3 U* NAIRU U1 U2 U3 U On the other hand, if the government chooses a policy of a gradual reduction in inflation, the growth rate of money supply decreases initially only slightly. In the short run, the economy moves to the point H and the unemployment rises to U2. When workers adjust their inflationary expectations, the short-run Phillips curve will shift downwards to SRPC2 and the economy tends to reach the point J. Inflation rate falls to π2. However, the inflation target is π3, not π2. Thus, the government pursues a policy of a further reduction in the growth rate of money supply. A similar mechanism leads the economy through the point K to the new long-run equilibrium point F. In this policy option, the process of reducing inflation lasts longer than in the previous case, but it does not result in a large increase of unemployment as before. 29 The monetarist school 3. Balance of payments theory and exchange rate determinants The third stage in the development of monetarism includes the theory of the balance of payments and exchange rate determination. This phase dates back to the 1970s. The most important papers have been written by Johnson in 1972 and Frenkel and Johnson in 1976 and 1978. The system of fixed exchange rates We begin the analysis with the presentation of the monetary approach to the balance of payments under the system of fixed exchange rates. The monetarist approach focuses primarily on the money market, at which the interdependence between money demand and money supply is treated as the main factor determining the balance of payments outcome. The monetary approach to balance of payments is based on four major assumptions: a) demand for money is a stable function of a specified number of variables, b) in the long run, the economy is in equilibrium with the potential level of output and the natural rate of unemployment, c) in the long run, the central bank cannot sterilize or neutralize the impact of the balance of payments deficit or surplus on the domestic money supply, d) the prices of similar tradable goods are equal in all countries in the long run. Here, we present a simple model of balance of payments for a small open economy (under the system of fixed exchange rates), developed by Johnson in 1972. The Johnson’s model is based on three major assumptions: a) real income is constant at the potential output level and the natural rate of unemployment, b) the law of one price holds at the goods and financial markets, c) domestic interest rates and domestic prices are pegged to global levels. Demand for real money balances (MD/P) is a function of two variables: real income (Y) and interest rate (r), according to the equation: MD = f (Y , r ). P (5) The money supply (MS) equals domestic credit D (that is, the money created by the country’s banking system) plus the money corresponding to changes in foreign exchange reserves (R): MS = D+R. 30 (6) 3. Balance of payments theory and exchange rate determinants The money market is in equilibrium when the demand for money equals the money supply: MD =MS. (7) Substituting (7) into (6) we obtain: MD = D+R or R=MD −D. (8) Let us consider the effects of an expansionary monetary policy, namely the growth in domestic credit (D). We assume that initially the economy is in equilibrium. Since the price level, real income and interest rate are all exogenous, nominal money demand (MD) cannot increase after a domestic credit growth (see Equation 5). Thus, the excess supply in the money market (in relation to demand) implies that consumers will buy foreign goods and services and foreign securities. This will lead to a deficit in the balance of payments. Since we consider a system of fixed exchange rates, monetary authorities intervene in the forex market. The central bank buys up national currency in exchange for foreign currency, reducing international reserves (R decreases). As we can see, an increase in one component of money supply – domestic credit (D) – results in a decrease of another component of money supply – foreign exchange reserves (R). International reserves decline until the money market returns to equilibrium and the balance of payments deficit disappears. In the new equilibrium point, the volume of money supply (MS) is the same as initially. The increase in domestic credit has been fully offset by a decrease in foreign reserves. Summing up, under the system of fixed exchange rates any discrepancies between money supply and money demand lead to imbalances in the balance of payments (deficit or surplus). Then, the adjustment process starts, that is there is a change in the volume of foreign reserves. As a result, the economy returns to equilibrium where the demand for money equals the money supply and foreign reserves are constant. Now we will present the policy implications of the model. First, the model implies that disequilibria in the balance of payments are automatically adjusted (corrected). Any discretionary government policy is not needed to improve the balance of payments outcome. If the demand for money does not equal money supply, individuals are engaged in transactions with foreign countries, trying to get rid of or acquire real money balances through international markets for goods and securities. This leads to a deficit or surplus in balance of payments. External imbalances imply the adjustment process in terms of changes in international reserves. As a result, the economy returns to money market equilibrium at the initial level of money supply. 31 The monetarist school Second, the analysis confirms that for a small country with fixed exchange rates the national money supply is an endogenous variable. If domestic credit increases, the balance of payments deficit causes a fall in foreign reserves and money supply decreases to the initial level. Similarly, if domestic credit declines, the balance of payments surplus leads to an increase in foreign reserves and the money supply increases to the initial level. The volume of money supply always returns to the starting point. This analysis suggests that monetary policy affects only the structure of money supply (i.e. its division between domestic credit and international reserves), but not the volume of money supply itself. In a small open economy, monetary policy in the long run does not influence any variable except the size of foreign reserves. Therefore, expansionary monetary policy does not affect neither inflation rate in a given country, nor the domestic interest rates, nor the rate of economic growth.6 Third, the presented model implies that in a world with fixed exchange rates inflation is seen as an international monetary phenomenon. The source of inflation is the excess of global demand as compared with the level of output, but the excessive demand must result from global, not domestic expansionary monetary policy. The increase in world monetary expansion (resulting from an expansionary monetary policy pursued by one big country or simultaneously by many small countries) leads to an increase in global demand, causing world inflation.7 The system of floating exchange rates Now we describe the monetary approach to exchange rate determination. The monetary approach to exchange rate determination is the model of the monetary approach to the balance of payments, presented earlier, applied to the floating exchange rates. This analysis was explored by Frenkel and Johnson in 1978. As in the case of fixed exchange rates, we will analyse the effects of expansionary monetary policy. The economy is initially in equilibrium and exchange rates are floating. Under the floating exchange rate system, the balance of payments is always zero. This follows from the fact that exchange rate adjusts to maintain equilibrium in the forex market (it happens when demand for a given currency equals its supply). In the system of floating exchange rates, there is neither 6 Slightly different is a case with a relatively large country (compared with the rest of the world). Expansionary monetary policy of this country, however, may accelerate global inflation. 7 For example, according to monetarists, the acceleration of inflation in Western economies in the 2nd half of the 1960s was caused by the U.S. monetary expansion to finance the expenditure related to the Vietnam war (until 1971, Western countries maintained a system of fixed exchange rates against the U.S. dollar, namely the Bretton Woods system, so the model presented here is correct to such an analysis). 32 4. The orthodox monetarism surplus nor deficit in the balance of payments and international reserves are constant. Referring to Equation (6), since R is constant, the source of monetary expansion can only be the growth of domestic credit (D). Suppose that monetary authorities raise domestic credit. To determine the response of the demand for money caused by the increase in money supply, let us refer to Equation (5). After multiplying both sides by P, this equation takes the form: M D = P ⋅ f (Y , r ) . (9) Assuming that output (Y) is constant at the potential level (with natural unemployment) and the interest rate (r) is also constant (because it is pegged with the world level), the growth in money demand (MD) may occur only due to the increase in prices (P). Hence, monetary expansion, namely the growth of money supply, leads to higher prices. Given higher prices, higher nominal money demand equals the increased money supply and money market is in equilibrium. Let us present in detail the adjustment process that occurs at the forex market. Excess money supply relative to demand leads to higher demand for foreign goods and securities. At the forex market, the supply of domestic money increases, leading to a depreciation of national currency under the system of floating exchange rates. Depreciation of domestic currency results in higher domestic prices leading to an increase in nominal demand for money. Demand for money raises until it equals the increased money supply and the money market equilibrium is restored. As we can see, the growth of money supply causes a depreciation of the nominal exchange rate. This model shows that the exchange rate between the two currencies depends on the relative money supplies in these two countries. For example, if there were only two countries and both of them increased the money supply by the same amount, the real exchange rate between the currencies of these two countries would not change. To wrap up, in the system of floating exchange rates, the increase in domestic credit leads to a nominal depreciation of domestic currency and to inflation. 4. The orthodox monetarism The most important findings and implications of the orthodox monetarism can be summarized as follows. First, changes in the money supply are the most important factor responsible for changes in money income and inflation. Second, the economy is inherently stable. However, it can be disturbed by irregular monetary growth. But the economy returns quite rapidly to long-run 33 The monetarist school equilibrium that occurs at the potential output level and the natural rate of unemployment. Third, in the long run, there is no trade off between inflation and unemployment. The long-run Phillips curve is vertical and intersects the horizontal axis at the natural rate of unemployment (NARU or U*) or non-accelerating inflation rate of unemployment (NAIRU). Fourth, both inflation and the balance of payments are treated as monetary phenomena. Fifth, the monetarists are averse to an active stabilisation policy (both monetary and fiscal). The monetary policy should be conducted carefully to ensure long-run price stability. 5. Summary 1. Monetarism is identified with Milton Friedman. The monetarist school is based on the quantity theory of money. The monetarist approach to the quantity theory of money implies that: (a) the increase in nominal money supply is the main factor stimulating inflation and nominal income growth; (b) given a stable money demand, the instability in the real economy is mainly caused by the fluctuations in money supply; (c) the money supply should grow at a constant rate corresponding to the real GDP growth rate, leading to long-term price stability. 2. Friedman expanded the original analysis of the Phillips curve introducing an additional variable: the expected rate of inflation. According to monetarists, the traditional Phillips curve showing a negative relationship between inflation and unemployment concerns the short run. The inflationary expectations shift the short-run Phillips curve upwards by a distance equal to the expected rate of inflation. In the long run, the economy behaves according to the long-run Phillips curve, which is vertical and intersects the horizontal axis at the natural rate of unemployment (U* or NAIRU). 3. Therefore, monetary expansion could lead to a short-run increase in output over the potential level and a short-run decrease in unemployment below the natural rate. As soon as workers adjust their inflationary expectations and fully anticipate the inflation rate, the short-run Phillips curve will shift upwards and the unemployment rate will return to the natural level. Monetarists believe that the economy returns to long-run equilibrium with potential output and full employment during a relatively short period of time (2–3 years). 4. Monetarists argue that inflation is a monetary phenomenon caused by an increase in money supply. Thus, the reduction of inflation can be achieved by a decline in the growth rate of money supply. But, in the short run, the economy may deviate from the potential output and full employment, implying that anti-inflationary policy will result in a temporary increase in unemployment. 34 5. Summary 5. The monetarist approach to the balance of payments implies that for a small country with fixed exchange rates the national money supply is an endogenous variable. Therefore, expansionary monetary policy does not affect neither inflation rate in a given country, nor the domestic interest rates, nor the rate of economic growth. In such a world with fixed exchange rates inflation is seen as an international monetary phenomenon. By contrast, the monetarist approach to exchange rate determination states that in the system of floating exchange rates the increase in domestic credit leads to a nominal depreciation of domestic currency and to inflation. Bibliography Begg, D., S. Fischer, R. Dornbusch, 2005, Economics, London, McGraw-Hill. Polish translation: Begg, D., S. Fischer, R. Dornbusch, 2007, Makroekonomia, Warszawa, PWE. Snowdon, B., H. Vane, P. Wynarczyk, 2002, A Modern Guide to Macroeconomics. An Introduction to Competing Schools of Thought, Cheltenham-Northampton, Edward Elgar. Additional bibliography Frenkel, J.A., H.G. Johnson, 1976, The Monetary Approach to the Balance of Payments, London, Allen and Unwin. Frenkel, J.A., H.G. Johnson, 1978, The Economics of Exchange Rates, Reading, Mass., Addison-Wesley. Friedman, M., 1956, The Quantity Theory of Money. A Restatement, in: Studies in the Quantity Theory of Money (ed. M. Friedman), Chicago, University of Chicago Press. Reprinted in: The Optimum Quantity of Money (ed. M. Friedman), 2007. Friedman, M., 1968, The Role of Monetary Policy, American Economic Review, March. Johnson, H.G., 1972, The Monetary Approach to Balance of Payments Theory, in: Further Essays in Monetary Economics (ed. H.G. Johnson), London, Macmillan. Phelps, E.S., 1967, Phillips Curves, Expectations of Inflation and Optimal Unemployment Over Time, Economica, August. Phillips, A.W., 1958, The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957, Economica, November. 35 CHAPTER THREE Mariusz Próchniak The new classical school The new classical school is the economic school of thought, whose origins date back to the 1970s (although some elements, such as the rational expectations hypothesis, have been introduced into economics in the early 1960s). The new classical economics is obviously linked with the traditional classical school (e.g. the Walrasian theory of general equilibrium), but its emergence results directly from the development of monetarism, a new trend in the economic thought. We can even say that the new classical school evolved out from the monetarism in the 1970s. Indeed, certain views in both schools are the same (e.g. the fact that an increase in the nominal money supply causes inflation). Representatives of the new classical school include, inter alia, Robert Lucas, Robert Barro, Edward Prescott, Thomas Sargent (U.S.), and Patrick Minford (UK). 1. The structure of new classical models The new classical school is based on three assumptions: • the rational expectations hypothesis, • continuous market clearing, • the aggregate supply hypothesis. The last two ones may also be referred to as the natural rate hypothesis. Before we discuss these assumptions in detail, let us explain the name of the school: a new classical economics. First, the analysis is carried out in a classical way because it is assumed that wages and prices are flexible (perfectly elastic). This implies that an economy returns to equilibrium at the potential level of output and the natural rate of unemployment. 37 The new classical school Second, the analysis is new because it explains exactly what is the speed of the adjustment process. According to the new classical school, both prices and wages adjust almost immediately (continuously). It means that an economy fairly rapidly returns to the potential output level. The standard classical analysis did not give a precise explanation of the period covered. According to the most common interpretation, it was a time long enough to fully adjust wages and prices, that is to achieve the potential output (full employment). New classical economics says, both wages and prices adjust almost immediately (continuously). In other words, the actual output almost always equals the potential output and the observed unemployment rate equals the natural rate. Only unexpected shocks may yield temporary deviations of output and employment from their natural levels. In this situation, there is no hysteresis phenomenon. According to the new classical school, government policy (both fiscal and monetary) can only influence the structure of aggregate demand at full employment level. The volume of aggregate demand is determined by the level of potential output. Now we will discuss in detail the three assumptions which constitute the core of the new classical economics. The rational expectations hypothesis The rational expectations hypothesis can be derived from the work of John Muth in 1961, although some economists suggest that the model of rational expectations was presented by Tinbergen 30 years earlier. This hypothesis was not quickly used by economists and it took almost 10 years before it began to be widely taken into account in macroeconomic models by Lucas and other supporters of the new classical school. The hypothesis of rational expectations is used in the economic literature in different forms. It is worth quoting the two versions: weak and strong. On the one hand, a weak version of the rational expectations hypothesis states that rational economic agents, when formulating expectations (forecasts) about future values of variables, use in the best (most efficient) way the set of all available information about the factors that – according to their opinion – affect a given variable. In other words, expectations are formed rationally in line with the behaviour of utility-maximizing individuals. For example, if agents believe that inflation is equal to the growth rate of money supply, inflationary expectations will be formulated by economic agents using all available information on the planned scale of monetary expansion. On the other hand, a strong version of the rational expectations hypothesis (formulated by Muth) assumes that subjective expectations about future values of economic variables made by individuals will coincide with objective (true) mathematical conditional expectations of these variables. Using the example 38 1. The structure of new classical models of the expected rate of inflation, the rational expectations hypothesis can be written as follows: π te = E (π t | Inft −1 ) . (1) In the above equation, πte is the expected rate of inflation between period t and t + 1, while E(πt|Inft–1) is the expected inflation rate conditional on a set of information available to economic agents in period t – 1. It is worth noting that rational expectations hypothesis does not mean that economic agents foresee the future correctly. Rational expectations do not imply perfect economic forecasts. For example, expectations about future inflation are based on a model which, according to individuals, is appropriate for this type of analysis. However, individuals may make errors in forecasting because they do not have access to the full set of information. But given rational expectations, individuals’ forecasts will be correct in the average terms: there will not be any systematic errors up or down. If such systematic errors occurred, individuals would learn from their mistakes and would revise their forecasts to eliminate this problem. More formally, a strong version of the rational expectations hypothesis implies: π te = π t + ε t , (2) where πte and πt are the expected and actual inflation rates between period t and t + 1 respectively, εt is a random factor. A random factor has a zero mean and it is not correlated with the set of information available during the time of formulating expectations (otherwise, individuals would not take fully into account all available information). Summing up, the rational expectations hypothesis assumes that forecast errors have the following characteristics: a) they are random with a zero mean, b) they do not depend on errors made in previous periods (there is no systematic tendency to make errors biased upwards or downwards), c) they have the lowest variance in comparison with any other forecasting method. Continuous market clearing Another assumption of the new classical school is that markets clear continuously in line with the Walrasian tradition. At any point of time, the markets are clear, i.e. they are in equilibrium where demand equals supply. When we apply this assumption to the whole economy, it turns out that the economy 39 The new classical school is continuously in equilibrium (both in the short run and long run). Therefore, the new classical models are treated as equilibrium models. The fact that markets are always in equilibrium implies that prices are flexible (perfectly elastic). Flexibility of prices allows the markets to clear continuously. The assumption of continuous market clearing is much more controversial than the rational expectations hypothesis. The controversies concern in particular the labour market. The assumption adopted by the new classical economists implies that anyone who wants to work can find a job at a wage rate that clears the labour market. Thus, the new classical school treats unemployment as an entirely voluntary phenomenon. The aggregate supply hypothesis The aggregate supply hypothesis – like the rational expectations hypothesis – is described in the literature in several ways. Here we will present the two approaches. 1. The intertemporal substitution model of labour and leisure The first approach is based on the intertemporal model of labour-leisure choice, derived from the paper written by Lucas and Rapping in 1969. In each period, an individual decides to divide his time between work and leisure. The choice depends on the actual level of real wages in relation to the expected (normal) real wages. If the actual wage rate in the current period is higher than expected, the individual will work more (and have less leisure) in the current period, anticipating that in the future – when the real wage will be lower than expected – he will work less and have more free time. This model is called the intertemporal substitution model because it includes the trade off between the current and future leisure. This model implies that changes in employment are treated as a voluntary choice of workers who supply labour depending on their expectations about real wages. 2. The Lucas ‘surprise’ supply function The second new classical approach to the aggregate supply hypothesis refers to the papers written by Lucas in 1972 and 1973. This approach shows how the supply of firms depends on the actual and expected inflation rate. We assume that firms know the prices only at those markets at which they trade, while the prices in other markets (i.e. the general price level in the economy) is known by the firms with a significant delay. Whenever firms face an increase in the price of their output, they must decide whether this increase occurs only in their markets (and may reflect the increase in consumer demand for their goods and services), or whether this increase corresponds to an increase in the general price level in the economy (which may result from the growth of nominal demand in all markets). In the former case, the appropriate firms’ response is to increase the 40 2. Equilibrium business cycle theory output, while the latter case does not involve any supply responses. In other words, firms have to distinguish between absolute and relative price changes. If we apply the above reasoning to both the supply of labour by workers and the supply of goods by firms, we get the so called Lucas ‘surprise’ supply function: Y − Y * = α (P − P e ) or Y − Y * = α (π − π e ). (3) In the above equation, Y is the actual output, Y* is the level of potential output, while P, Pe, π, πe denote respectively the actual or expected levels of prices or inflation. Equation (3) implies that output is different from the potential level when the actual price level or the actual rate of inflation does not equal the expected value. For example, if the observed price level (or inflation) exceeds the expected value, economic agents are ‘surprised’ by the price increase and supply more labour and more output to the market. As a result, both output and employment are greater than their potential or natural levels. We shall return to this case later in the chapter when we analyse in detail the implications of government policy. Graphical analysis presented there will facilitate the understanding of this approach. 2. Equilibrium business cycle theory We have just shown that the volume of aggregate supply depends on relative prices (the difference between the expected price level and the general price level in the economy). This hypothesis provides the basis for explaining the fluctuations in output and employment by new classical economists. Important papers in this field were written by Lucas in 1975 and 1977. According to the new classical school, unanticipated shocks in aggregate demand (resulting mainly from unanticipated changes in money supply) yield errors in inflationary expectations. Although the new classical school assumes the existence of rational expectations, errors are likely to be made as a result of unanticipated changes. Such errors in inflationary expectations imply that both output and employment may deviate from the long-run equilibrium level (i.e. the potential or natural level). The direct cause is the fact that given imperfect (incomplete) information, firms and workers treat changes in the general price level as changes in relative prices and, as a result, supply to the market more or less labour (in the case of workers) or goods and services (in the case of firms), compared to the natural level. We now explain the equilibrium business cycle theory based on the growth in money supply. Initially, output and employment are at natural levels. Suppose the central bank adopts an unanticipated expansionary monetary policy. As we have shown, this leads to an increase in the overall price level in the economy. 41 The new classical school But firms control continuously only the prices at the markets at which they trade. Therefore, firms erroneously treat the increase in the general price level as the increase in relative prices for their output and begin to supply more goods and services. A similar illusion affects workers: they treat the increase in nominal wages as the increase in real wages and supply more labour. As a result, output and employment will temporarily exceed the natural level. As soon as firms and workers recognize that there are no changes in relative prices, output and employment will return to the potential (natural) level. As we can see, the fluctuations in output and employment (around the natural level) result from random shocks (caused mainly by unanticipated changes in money supply), which leads to expectational errors. However, the rational expectations hypothesis, which constitutes the basis of the new classical school, assumes that such errors are random and they do not reveal any systematic tendency to deviate up or down. As a result, output and employment will vary randomly around the potential (natural) level. It is worth noting that, in contrast to monetarism, the new classical school does not assume the existence of information asymmetry between firms and workers. Both of them treat the increase in the general price level as the increase in relative prices and supply more goods (firms) or more labour (workers). On the other hand, in the Friedman model analyzed in the previous chapter, fluctuations of output and employment around the natural level resulted, inter alia, from the fact that workers were fooled. 3. The policy implications of new classical approach In this section, we will illustrate in detail the government policy implications according to the new classical school. This issue was briefly discussed at the beginning of the chapter. Here we extend the analysis and we show, inter alia, its graphical representation. For this purpose, we use the AD-AS model with inflationary expectations. The expectations-augmented supply functions Figure 1 shows the derivation of the expectations-augmented aggregate supply curve. This curve is derived from the labour market. Panel (a) of Figure 1 shows three labour demand functions that correspond to three different price levels (P1 > P0 > P2) as well as the expectations-augmented labour supply curve that is associated with the expected price level of P0. If the actual price level is equal to P0 (and therefore equal to the expected level), the nominal wage will be set at W0 to clear the market. In the labour market equilibrium, the real wage will equal W* and employment will be at the natural level of L* (full employment). This outcome will occur in the absence of any expectational errors 42 3. The policy implications of new classical approach made by workers or firms. However, if the observed price level is P1 but workers do not change inflationary expectations and expect the price level of P0, then firms are eager to raise nominal wages and increase employment – labour demand rises to DL(P1) – meanwhile workers will want to supply more labour because they believe that real wages have increased. In this case, that is when workers expect the price level of P0 and the actual price level is P1 and is well-known by firms, the employment will be L1 (more than L*) and the nominal wage will be set at W1. The money wage W1 is greater than W0, but the real wage W1/P1 is less than W* (otherwise firms would not employ more than L* workers). Figure 1 W P SL[ t-1E(Pt ) = P0 ] W1 EAS[ t-1E(Pt ) = P0 ] W0 P1 W2 DL(P1 ) P0 P2 DL(P0) DL(P2) L2 L* L1 (a) L Y2 L2 → Y2 L* → Y* L1 → Y1 Y* Y1 Y (b) (a) The labour market and the expectations-augmented labour supply curve (b) The expectations-augmented aggregate supply curve Panel (b) of Figure 1 shows the expectations-augmented aggregate supply curve associated with the expected price level of P0. This curve is derived from the expectations-augmented labour supply function. Y* is the volume of potential output. If the actual price level is P0, workers’ inflationary expectations are formulated correctly and the labour market is in equilibrium with the natural employment L*, which corresponds to the potential level of output Y*. However, if the actual price level is different than P0 (still assuming the expected price level to be P0), workers make expectational errors and employment will be more or less than L*, which corresponds to the volume of output greater or less than Y* (e.g. the employment L2 is associated with the output of Y2). The above analysis is conducted in line with the new classical approach. When 43 The new classical school deriving the expectations-augmented labour supply curve, we have assumed – in line with the classical view – that labour market clears and money wages are flexible. The fluctuations in employment around the natural level L* are the result of expectational errors. Thus, we can say that the analysis is based on the natural rate hypothesis with flexible nominal wages that clear the labour market given workers’ price expectations. Expectations-augmented aggregate supply curves can be derived for different levels of expected prices. As a result, we get the family of such curves shifted in parallel to each other. For each curve, the price level depicted on the vertical axis and corresponding to potential output (Y*) must be equal to the expected price level for which a given EAS curve was derived. In other words, if output is equal to the potential level, the expected and observed prices are the same. Figure 2. The equilibrium in the economy according to the new classical school P LAS EAS[ t-1E(Pt ) = P4 ] P4 P0 EAS[ t-1E(Pt ) = P0 ] E EAS[ t-1E(Pt ) = P3 ] P3 AD Y* Y In order to obtain a full picture of the AD-AS model, we have to derive the long-run aggregate supply curve (LAS) and the aggregate demand curve (AD), also known as the macroeconomic demand schedule (MDS). These functions are derived in a standard way. As the expectations-augmented aggregate supply curves concern the short run, they can be treated as the short-run aggregate supply functions (SAS). The full picture of the AD-AS model in line with the new classical approach is shown in Figure 2. The equilibrium is at point E – at the intersection between AD, EAS and LAS functions (in equilibrium, the price level plotted on the vertical axis must be the same as the expected price level for which a given EAS curve was derived). The equilibrium point at the potential output level results, inter alia, from the fact that new classical economists assume the rational expectations 44 3. The policy implications of new classical approach hypothesis. Rational expectations are formulated based on a good knowledge of the parameters of the model describing the economy and complete available information. In other words, rational economic agents formulate their expectations knowing the position of the EAS and AD curves. In such a situation, workers expect the prices to be P0. Thus, the point of intersection between the LAS and AD functions lies on that EAS curve which is derived for the expected price level of P0. According to the new classical school, the economy will be in disequilibrium (output different than potential level) only due to expectational errors arising from unknown random shocks. The rational expectations hypothesis implies that differences between the expected and actual inflation rate are random and no systematic downward or upward deviations occur. Hence, the economy almost immediately returns to the potential level. The effects of expansionary government policy As we have already presented the behaviour of the economy according to the assumptions of the new classical school, we can analyse the government policy implications. We will consider the effects of expansionary policy in two variants: • policy is unanticipated, • policy is anticipated. We will conduct the analysis based on the monetary policy. The results, however, will be the same for fiscal policy. The most important here is the fact whether the policy is anticipated or unanticipated, and not whether the increase in aggregate demand is caused by monetary or fiscal expansion. Figure 3. The effects of anticipated and unanticipated expansionary policy P LAS P2 P1 P0 EAS[ t-1E(Pt ) = P2 ] G F Anticipated expansionary policy: E → G Unanticipated expansionary policy: E → F → G EAS[ t-1E(Pt ) = P0 ] E AD1 AD0 Y* Y1 Y 45 The new classical school Figure 3 illustrates the analysis. Initially, the economy is in equilibrium at point E, where the curves AD0, LAS and EAS intersect (at point E, the EAS function must correspond to the expected price level of P0). This is the long-run equilibrium. Indeed, if workers estimate the aggregate demand to be at AD0 level, they expect the price level of P0 and, on this basis, they formulate inflationary expectations reflecting by the EAS[t–1E(Pt) = P0] curve. As the new classical school assumes that expectations are rational and, moreover, if we assume that there are no unexpected shocks, then the economy will be in long-run equilibrium given by point E with potential output and natural unemployment. 1. Unanticipated expansionary monetary policy Suppose that an unanticipated increase in aggregate demand takes place due to an expansionary monetary policy (as we said earlier, this analysis will also be proper when an unexpected increase in aggregate demand is caused by fiscal expansion). The aggregate demand curve shifts rightwards to AD1. Firms misinterpret the increase in the general price level in the economy as an increase in their relative prices and consequently increase the volume of output. To attract more workers, firms will raise money wages. Similarly workers, who expect the price level of P0, treat the increase in money wages as an increase in real wages and supply more labour. The economy moves from point E to F: output increases from Y* to Y1 and the price level raises from P0 to P1. Point F will not be a long-run equilibrium because it includes expectational errors. In fact, real wages have fallen, not risen, while the relative prices have not changed (there was only an increase in the general price level). Assuming rational expectations, workers will recognize that the new demand curve is AD1. Given the aggregate demand of AD1, a potential output is achieved when the prices are P2. Workers will review their inflationary expectations: they will expect the price level of P2. As a result, a short-term aggregate supply curve shifts upwards to EAS[t–1E(Pt) = P2]. The economy achieves the new long-run equilibrium given by point G. At point G, the volume of output and employment is the same as at E (natural level), but the prices are higher. 2. Anticipated expansionary monetary policy Suppose that an anticipated increase in aggregate demand takes place due to expansionary monetary (or fiscal) policy. For example, the central bank announces in advance the increase in nominal money supply. Under such circumstances, workers expect the aggregate demand curve to be in the AD1 position. Hence, they immediately revise their inflationary expectations and expect the price level of P2. The move of the aggregate demand curve to the right (upwards) will be offset by an immediate shift of the EAS curve to the left (also upwards). The economy moves from point E directly to a new longrun equilibrium G. Even in the short run, there is no increase in output and 46 3. The policy implications of new classical approach employment: output and employment are continuously at their natural levels. To wrap up, the new classical school states that: • anticipated growth in money supply leads only to an increase in prices and does not affect the volume of output and employment even in the short run (the shift from point E to G), • unanticipated growth in money supply leads similarly to an increase in prices, although in the short run it causes a temporary increase in output and employment (the shift from point E to F to G). As we can see, the demand-management policy cannot be – according to the new classical school – a source of sustainable economic growth. This is also known as the policy ineffectiveness proposition. The new classical policy ineffectiveness proposition was first presented by Sargent and Wallace in 1975 and 1976. It is worth noting that the anticipated growth in money supply (the shift from E to G) is consistent with the orthodox monetarist approach in the long run, while the unanticipated increase in money supply (the shift from E to F to G) is compatible with the orthodox monetary approach in the short run. The costs of anti-inflationary policy The second important implication of the new classical approach focuses on the costs (in terms of lost output and employment) of anti-inflationary government policy. New classical economists – like monetarists – believe that inflation is a monetary phenomenon and is caused by the excessive growth of money supply. The representatives of various schools of economic thought differ, however, in what are the costs of anti-inflationary policy. New classical economists believe – as we have just shown – that anticipated changes in fiscal or monetary policy do not affect the volume of output and employment even in the short run: output is continuously at its potential level and employment is at the natural level (the economy moves along the LAS curve upwards or downwards depending on whether the policy is expansionary or restrictive). Thus, if monetary authorities announce a tightening of monetary policy, rational economic agents will revise their inflationary expectations downwards. Referring to Figure 3, the economy moves from point G to E: the volume of output does not change and the price level (inflation rate) decreases. This is because the shift of the aggregate demand function from AD1 to AD0 due to tightening of monetary policy is accompanied by a simultaneous shift of the EAS curve downwards, resulting from an immediate revision of inflationary expectations. Summing up, the new classical school states that government can reduce inflation without any loss of output and employment. The sacrifice ratio is zero.8 8 The sacrifice ratio is the amount of output that an economy endures in order to reduce inflation. 47 The new classical school Let us compare these conclusions with the monetarist school discussed in the previous chapter and the Keynesian model presented later in the book. On the one hand, monetarists argue that the tightening of monetary policy leads to a fall in output and a rise in unemployment in the short run. The output returns to the potential level only in the long run when workers adjust their inflationary expectations to the new situation. The sacrifice ratio is greater than zero, and its size depends mainly on the speed of adjustment in expectations to monetary policy changes, that is on the credibility and reputation of the monetary authorities. On the other hand, in the Keynesian model, the sacrifice ratio is high. Due to rigidity of prices and wages, a drop in aggregate demand causes a fall in output and employment (according to Keynesians, it happens even if economic agents have rational expectations). The increase in the sacrifice ratio is further strengthened by the hysteresis effect, i.e. the situation when the reduction in aggregate demand and a recession both lead to an increase in the natural rate of unemployment. Economic growth determinants Another policy implication of the new classical approach focuses on economic growth determinants. According to the new classical school, economic growth determinants are the supply-side factors. This follows from the fact that output is assumed to be at the potential level and the economy records only the natural rate of unemployment. In such circumstances, changes in output and employment reflect equilibrium supply decisions of workers and firms, given their perception of relative prices. According to the new classical economics, labour market is continuously in equilibrium. Unemployment is entirely voluntary because the unemployed people simply do not want to work given the existing real wage. In such a situation, stimulating aggregate demand does not lead to growth in output and employment. The only thing the government can do is to affect the supply-side of the economy. The government should conduct activities that improve microeconomic incentives of workers and firms to supply more labour and to produce more output. The examples of supply-side actions pursued by the government to stimulate economic growth include, inter alia: • to increase productivity of inputs to production and total factor productivity, • to increase economic efficiency by e.g. faster privatization, structural reforms, favourable changes in institutional environment, • to cut taxes, especially marginal income tax rate, that increases incentives to work, • to raise labour market elasticity (in terms of wages and employment conditions), 48 4. Summary • to reduce the power of trade unions, • to increase mobility of workers (both geographically and structurally). The Lucas critique of the econometric modelling of government policy effects According to the new classical school, the econometric modelling of government policy effects is useless. This is known as ‘the Lucas critique’ and was first presented by Lucas in 1976. He criticized the use of large-scale econometric models to evaluate the effects of different government policies because these models are based on past values of the parameters while they may vary due to changes in economic policies. This follows from the fact that economic agents can adjust their behaviour to the new environment. The Lucas critique has important policy implications. As policy makers cannot estimate the impact of new or revised government actions on the parameters of the model, simulations based on the existing econometric models cannot be used to assess the effects of different economic policies. 4. Summary 1. The new classical school is based on three assumptions: (a) the rational expectations hypothesis, (b) continuous market clearing, (c) the aggregate supply hypothesis. (The last two ones may also be referred to as the natural rate hypothesis). Thus, output is assumed to be at the potential level and the economy records only the natural rate of unemployment. 2. Anticipated growth in money supply leads only to an increase in prices and does not affect the volume of output and employment even in the short run. Unanticipated growth in money supply leads similarly to an increase in prices, although in the short run it causes a temporary increase in output and employment. 3. Inflation is a monetary phenomenon and is caused by the excessive growth of money supply. Thus, government can reduce inflation without any loss of output and employment. The sacrifice ratio is zero. 4. Business cycles result from random shocks (caused mainly by unanticipated changes in money supply) that lead to expectational errors. The rational expectations hypothesis says that such errors are random and they do not reveal any systematic deviations up or down. Hence, both output and employment vary randomly around the potential (natural) level. 5. Economic growth determinants are the supply-side factors. 49 The new classical school Bibliography Begg, D., S. Fischer, R. Dornbusch, 2005, Economics, London, McGraw-Hill. Polish translation: Begg, D., S. Fischer, R. Dornbusch, 2007, Makroekonomia, Warszawa, PWE. Hillier, B., 1992, The Macroeconomic Debate. Models of the Closed and Open Economy, Oxford, Blackwell Publishers. Snowdon, B., H. Vane, P. Wynarczyk, 2002, A Modern Guide to Macroeconomics. An Introduction to Competing Schools of Thought, Cheltenham-Northampton, Edward Elgar. Additional bibliography Lucas, R.E., 1972, Expectations and the Neutrality of Money, Journal of Economic Theory, April. Lucas, R.E., 1973, Some International Evidence on Output-Inflation Tradeoffs, American Economic Review, June. Lucas, R.E., 1975, An Equilibrium Model of the Business Cycle, Journal of Political Economy, December. Lucas, R.E., 1976, Econometric Policy Evaluation: A Critique, in: The Phillips Curve and Labor Markets (eds K. Brunner, A.H. Meltzer), Amsterdam, North Holland, Carnegie-Rochester Series on Public Policy. Lucas, R.E., 1977, Understanding Business Cycles, in: Stabilization of the Domestic and International Economy (eds K. Brunner, A.H. Meltzer), Amsterdam–New York, North Holland. Lucas, R.E., L.A. Rapping, 1969, Real Wages, Employment and Inflation, Journal of Political Economy, September/October. Muth, J.F., 1961, Rational Expectations and the Theory of Price Movements, Econometrica, July. Sargent, T.J., N. Wallace, 1975, Rational Expectations, the Optimal Monetary Instrument and the Optimal Money Supply Rule, Journal of Political Economy, April. Sargent, T.J., N. Wallace, 1976, Rational Expectations and the Theory of Economic Policy, Journal of Monetary Economics, April. 50 CHAPTER FOUR Mariusz Próchniak The real business cycle school We know from the previous chapter that during 1972–82 the dominant new classical theory was the monetary surprise model developed by Lucas in 1972 and 1973. This model implies that unanticipated changes in nominal money supply cause temporary deviations of output and employment from the potential level. However, anticipated changes in money supply do not influence the real economy, which is known as the Sargent-Wallace policy ineffectiveness proposition. Despite strong influence of the Barro-Lucas-Sargent-Wallace surprise monetary explanation of the business cycle, until 1982 these models shared theoretical and empirical impasse.9 In such circumstances, some supporters of the new classical school began looking for a modified concept of the business cycle, which would be free from theoretical and empirical weaknesses. The outcome was a real business cycle theory. It replaces the impulse mechanism of the previous models (i.e. unanticipated growth of money supply) with the supply-side shocks in the form of random technological changes. Since the early 1980s, the main new classical explanation of the business cycle began to focus on real rather than nominal shocks. This theory was named the real business cycle school. Its origin dates back to 1982 when Kydland and Prescott developed a non-monetary equilibrium model. This model, supplemented by Long and Plosser in 1983, constitutes the basis of the real business cycle theory. As the real business cycle theory is derived from the new classical school, the ‘core’ remains the same. Both currents assume rational expectations and continuous market clearing. Moreover, as it will be discussed later, the real business cycle theory does not distinguish between the short run and the long run. Hence, the conventional definition of hysteresis does not apply here. 9 A similar monetary approach to business cycle analysis belongs to monetarists. 51 The real business cycle school Main supporters of or contributors to the real business cycle school include, inter alia, Finn Kydland, Edward Prescott, John Long, Charles Plosser, Robert Barro, Sergio Rebelo (U.S.). 1. Business cycle theories in historical perspective Real business cycle theory assumes that there are large random changes in the pace of technological progress. Such supply-side shocks in the production function cause fluctuations of output and employment. This theory is largely a response to earlier monetary business cycle models and shows an increased interest in the supply side of the economy. The idea that business cycles are caused by real, not nominal forces is certainly not a new idea. The real business cycle model developed by Kydland and Prescott in 1982 belongs to a broad family of models that played an important role in the literature before Keynes’ General Theory. For example, changes in the level of technology were important in Schumpeterian analysis of short-run instability and long-run dynamics of a capitalist economy. In 1939, Schumpeter – like today’s supporters of real business cycle theory – treated business cycles and economic growth as interrelated phenomena. This follows from the fact that the introduction of a new technology affects long-run productivity growth as well as short-term fluctuations of output. Following the publication of Keynes’ General Theory, business cycle models were based on the multiplier-accelerator mechanism. These models also had a real character, but included the demand-side perspective: business cycles resulted from fluctuations in real aggregate demand, which were primarily caused by unstable investment expenditures. Multiplier-accelerator models ceased to play a dominant role in the economic literature in the early 1960s. During the 1960s, macroeconomic analyses abandoned to focus on business cycles and dealt primarily with an analysis of methods and actions that may improve the macroeconomic performance. In the 1970s and 1980s, the interest in analysing cyclical fluctuations came back. The real business cycle theory, developed in the 1980s, was a competition not only for earlier Keynesian models (focusing on fluctuations in aggregate demand), but also for monetarist models and the early new classical models (that highlight the monetary approach to the business cycle). The transition from a monetary to real approach of the business cycle has been reinforced by two other factors. The first was the increase in oil prices in the 1970s, which stressed the importance of the supply side of the economy. Second, Nelson and Plosser in 1982 indicated that real shocks may play a much more important role in explaining output fluctuations than monetary shocks. According to these authors, empirical evidence shows that output follows a path known as a random walk. 52 2. Cycles versus random walks 2. Cycles versus random walks The traditional approach to business cycle and economic growth analysis is the following: the economy exhibits a long-run trend of output, but real GDP fluctuates around this trend. These fluctuations have, however, a shortrun nature and, in the long run, GDP returns to a trend path. The problem facing economists is to separate the two components of output dynamics: trend and cyclical fluctuations. In the traditional approach, short-run GDP fluctuations around the trend result mainly from the volatility in aggregate demand. All deviations of output from the trend are therefore treated as temporary. Such a traditional approach is supported by Keynesians as well as monetarists and new classical economists, although there are some differences (sometimes very significant) between these schools. For example, according to Keynesians, deviations of actual output from the trend may be severe and take a relatively long time (so these economists support the government stabilization policy), while monetarists and especially proponents of the new classical school treat deviations as much smaller and shorter (so they are against an active government intervention aimed at stimulating aggregate demand). Despite some differences, in all these schools the business cycle (or more precisely – the time path for GDP) can be written as follows: GDPt = gt + α ⋅ GDPt −1 + ε t , (1) where gt is the average GDP growth rate (that is, a deterministic trend), εt is a random factor (with a zero mean) representing random shocks, and α is a parameter in the interval (0;1). Given such a traditional approach to the business cycle, suppose that in period t there is a positive shock, lasting one period. Referring to Equation (1), it means that εt increases. This causes the deviation of output above the trend line. As time passes, however, output will return to the trend. This is because the parameter α ranges between 0 and 1. Thus, output in period t depends on the output from the previous period, but to a lesser degree. The traditional approach to the business cycle, where output exhibits short-run fluctuations around the trend line, is shown in Figure 1a. The figure illustrates the effects of a single positive shock. For example, if in the period t0 there is an unanticipated increase in money supply, the economy will return to its potential level at the time of t1. This analysis is fully consistent with the new classical school. In 1982, Nelson and Plosser criticized the traditional approach to the business cycle. They showed that monetary disturbances do not explain much of the observed fluctuations in output. These authors argue that the primary source of 53 The real business cycle school output fluctuations is stochastic variation due to real factors. Nelson and Plosser came to this conclusion by examining the U.S. economy. They could not reject the hypothesis that U.S. GNP followed a path of a random walk. Thus, they state that the majority of changes in output is permanent, not temporary. After the shock, the economy does not return to the previous trend path. We can say, therefore, that GDP behaves in line with a random walk. A random walk path with drift is described by the following equation: GDPt = gt + GDPt −1 + ε t , (2) where gt is a drift of output. Figure 1. Business cycle: (a) the traditional approach, (b) a random walk GDP GDP t0 t1 (a) Time (t) t0 Time (t) (b) The main difference between equations (1) and (2) is that in Equation (2) the parameter on GDP from the previous period is equal to 1. This means that any shocks in productivity are permanent. They bring the economy to a new path. In other words, the increase in output lasts forever (the economy does not return to the previous trend line).10 A random walk approach to the business cycle is illustrated in Figure 1b. As we can see, after a positive shock at time t0 there is a permanent increase in the level of output as compared with the earlier trend. The results obtained by Nelson and Plosser have important implications. If the shocks due to technological changes that lead to an increase in production are random and frequent, then GDP, which follows a random walk, will behave as it would reveal cyclical fluctuations. In this case, however, fluctuations in GDP reflect fluctuations in the potential output; not deviations of the actual output 10 This follows with the assumption that there will not be any negative shocks which move down the path at which the economy is currently situated. 54 3. Real business cycle theory from the deterministic trend. In other words, that what seems to be fluctuations around the trend is the volatility of the trend itself, as a result of various supply-side shocks that have permanent nature and put the economy on a new path of economic growth. Hence, although in traditional terms the analysis of economic growth was separated from the business cycle analysis, Nelson and Plosser indicate that such analyses cannot be treated separately. The forces that yield economic growth are the same as those that cause cyclical fluctuations. Proponents of the real business cycle theory integrated the growth theory with the theory of cyclical fluctuations. Since permanent changes in the level of GDP cannot result from monetary shocks (the neutrality proposition supported by new classical economists), the main sources of output fluctuations are real shocks. Proponents of the real business cycle theory point out that in well-developed market economies, supply-side shocks arise primarily from technological changes. These include changes in productivity caused by changes in labour and capital quality, new management strategies, inventing new products, and introduction of new production techniques. 3. Real business cycle theory The real business cycle theory is derived from the new classical school, so most of the assumptions remain the same. However, in some cases there are changes as compared with the new classical economics. Real business cycle theory is based on the following assumptions: • prices are flexible. It implies a continuous market clearing and a permanent equilibrium, • expectations are rational and there is no information asymmetry. Although some problems with information may occur (e.g. whether a given productivity shock is permanent or temporary), information on the general price level is publicly available, • consumers maximize utility and firms maximize profits given budget or resource constraints, • changes in employment reflect voluntary decisions of workers. Labour and leisure are characterised by high intertemporal substitution, • fluctuations in output and employment are due to random technological changes, • money is neutral, so that monetary policy does not affect real variables, • the distinction between the short run and the long run in the analysis of trend and cyclical fluctuations is abandoned. As we can see, the differences between the real business cycle theory and the new classical school concern mainly three aspects. First, the real business cycle theory ignores the distinction between the short run and the long run, 55 The real business cycle school integrating the theory of economic growth with the business cycle theory. Second, in the real business cycle theory there is no incomplete information on the general price level (while in the Lucas ‘surprise’ supply model described in the previous chapter the lack of knowledge on the general price level caused expectational errors made by both firms and workers). Third, the real business cycle theory assumes that shocks result from technological changes, and not – as in the new classical economics – from monetary sources. Technological shocks In line with the work of Frisch (1933), proponents of the real business cycle theory distinguish between the two mechanisms associated with shocks: • impulse mechanism, • propagation mechanism. Impulse mechanism is a shock that throws the economy off its previous steady-state. Propagation mechanism includes the forces which cause that abandoning of the steady-state is permanent and the economy moves towards a new growth trajectory. Real business cycle theorists argue that shocks are primarily caused by technological changes. Technical progress according to the real business cycle theory looks, however, slightly different than in the standard Solow model. In the Solow model, which will be discussed later in the book, technological progress is exogenous and occurs smoothly over time. In other words, the variable measuring the level of technology is growing at a constant rate, implying that output rises smoothly over time. By contrast, real business cycle theorists state that changes in the level of technology fluctuate randomly, so that economy behaves as if it showed business cycles. Let us discuss the effects of a positive supply-side shock. We use the figure depicting the production function and the labour market. The analysis follows a point of view of the real business cycle theorists. This is the example of the impulse mechanism. The upper part of Figure 2 shows the production function for a given physical capital stock (therefore, labour is plotted on the horizontal axis). The lower part of Figure 2 illustrates the labour market with standard labour demand and supply functions. We assume that initially the level of technology is low, that is, the variable A, representing the technology, is equal to A1. The production function is in the position Y = A1·F(K,L). Employment equals L1, and the output (GDP) amounts to Y1. Labour market is in equilibrium: given labour demand function of DL1 and labour supply function of SL, employment at the level of L1 corresponds to equilibrium real wage of W1. 56 3. Real business cycle theory Suppose now that a positive supply-side shock takes place caused by random technical progress. The level of technology rises to A2. The production function moves to a new position Y’ = A2·F(K,L). The shift of the production function affects positively the marginal product of labour. As a result, firms want to employ more workers and the demand for labour increases from DL1 to DL2. All these changes lead to an increase in output (from Y1 to Y2), employment (from L1 to L2), as well as an increase in real wages (from W1 to W2). Figure 2. The effects of a positive technological shock Output (Y) Y’ = A2 . F(K, L) Y2 Y = A1 . F(K, L) Y1 L1 Labour (L) L2 Real wage (W) SL W2 W1 DL2 DL1 L1 L2 Labour (L) In explaining how the economy responds to shocks, it is worth noting that real business cycle theorists argue that unemployment is entirely voluntary and the labour market is continuously in equilibrium. Thus, changes in employment reflect voluntary decisions of workers and firms. This phenomenon can be explained based on the intertemporal substitution model of labour and leisure, discussed in the previous chapter. According to this model, the volume of 57 The real business cycle school employment may fluctuate because decisions so as to divide time between labour and leisure depend on both the current and future real wages. Referring to Figure 2, the amplitude of the fluctuations in employment depends on the elasticity of labour supply with respect to real wages. When the curve is relatively inelastic (that is, quite steep), large fluctuations in real wages imply small changes in the level of employment. By contrast, if the labour supply curve is relatively elastic (flat), then small changes in real wages imply large changes in the level of employment. ‘Stylized facts’ of the business cycle seem to confirm this second option – small changes in real wages correspond to big changes in the volume of employment. Intertemporal labour substitution hypothesis Real business cycle theorists believe that a large share of employment fluctuations due to changes in real wages can be explained by the intertemporal model of labour and leisure. The intertemporal labour substitution hypothesis states that people supply more labour to the market and enjoy less leisure if real wages are temporarily high. By contrast, if real wages are lower than their long-run normal level, the supply of labour declines. This hypothesis was first presented by Lucas and Rapping in 1969. It explains the propagation mechanism that follows the impulse mechanism (technological shock). Intertemporal labour substitution hypothesis works in the following way. In each period, an individual allocates its time between labour and leisure. Individuals use labour income to purchase goods and services. The consumer’s utility function depends on two variables: consumption and leisure. When choosing the optimal time allocation, an individual takes into account both the current and future wage rate. Let us assume that real wage increases above the normal level. This change yields two effects: substitution and income effect. The substitution effect leads to an increase in the time devoted to labour in the current period. The income effect works in the opposite direction: since people are richer, they work less and choose more leisure. The total effect depends on which effect dominates. Real business cycle theorists distinguish between permanent and temporary changes in real wages due to technological shocks. Intertemporal labour substitution hypothesis yields two implications in this field. First, if both the shock and the resulting change in real wages are temporary, the volume of employment reveals significant fluctuations. For example, a temporary rise in real wages implies that individuals decide to increase significantly the current labour supply and enjoy less leisure in the current period. In the future, when people expect real wages to fall to the normal level, labour supply will decline. By contrast, if both the technological shock and the 58 3. Real business cycle theory change in real wages are permanent, the change in employment will not be so large as in the case of a temporary shock. In the extreme situation, if the income effect dominates, labour supply in the current period may even fall. Second, some economists (e.g. Barro 1981, 1993) point out the impact of real interest rate on the supply of labour. According to their view, an increase in the real interest rate raises the supply of labour in the current period. This is because the rise in real interest rate positively affects the value of income earned today in relation to income earned tomorrow. As we can see from the above model, labour supply depends on both the real wage (in the two periods) and the real interest rate. The slope of the budget line, which represents the intertemporal relative price, is equal to: (1 + R ) W1 , W2 (3) where: R – real interest rate, W1 and W2 – real wages in the current and future period respectively. Equation (3) implies that any event causing the increase in the real interest rate or a temporary increase in real wages in the current period as compared with the future leads to a rise in the current supply of labour and to the growth of employment. The IS-LM and AD-AS model according to the real business cycle theory The real business cycle theory assumes rational expectations, perfect price flexibility, and full information on changes in money supply. In this situation, money is completely neutral and nominal variables do not affect real variables. We will present the IS-LM model according to the real business cycle school. It is illustrated in Figure 3. The IS curve has a standard negative slope. It shows income and interest rate combinations yielding equilibrium at the goods market. The IS curve can also be interpreted as the real aggregate demand (RAD). The vertical line on the figure is the real aggregate supply function (RAS), which lies at the potential output level. The volume of potential output is determined by the production function. The position of the LM curve – assuming flexible prices and the neutrality of money – has a residual character. The LM/P function (where P is the price level) always intersects the IS curve at the potential output. This results from immediate price adjustments so that changes in money supply do not affect real variables. In further analysis, we can thus ignore the LM function. The equilibrium will be determined only by real forces represented by the RAD and RAS functions. This is illustrated in Figure 4. The RAS curve is now upward sloping but still every point on this curve corresponds to full employment. The positive slope follows 59 The real business cycle school from the fact that, given higher real interest rate, individuals supply more labour in the current period, which leads to an increase in output and employment (see Equation 3). Figure 3. The IS-LM model according to the real business cycle theory Real interest rate (R) RAS LM/P R* IS (RAD) Output, GDP (Y) Y* Figure 4. The AS-AD model according to the real business cycle theory: the effects of a positive technological shock Real interest rate (R) RAS1 RAS2 E Temporary technological shock: E → F Permanent technological shock: E → G G R1 F R2 RAD3 RAD2 RAD1 Y1 Y2 Y3 Output, GDP (Y) Let us present the effects of a positive supply-side shock due to technical progress. The analysis is based on the real business cycle aggregate demand and supply model. This is illustrated in Figure 4. Technological progress shifts the RAS curve rightwards from RAS1 to RAS2.11 At the same time, the RAD curve shifts rightwards as well. The magnitude of the shift of the RAD depends on the size of the wealth effect that stimulates consumer demand. 11 This is the same situation which is illustrated in Figure 2. There, technical progress shifted the production function from Y to Y’. 60 4. Real business cycle theory and stylized facts If technological shock is temporary, the wealth effect is small and consumer demand increases only slightly. The RAD curve shifts from RAD1 to RAD2 and the economy moves from point E to F. As a result, output increases from Y1 to Y2 and the real interest rate falls from R1 to R2. By contrast, if technological shock is permanent, the strength of the wealth effect is large and the RAD curve moves rightwards from RAD1 to RAD3 (the change in consumer demand is of similar size as the increase in output due to technological shock). In this situation, the economy moves from point E to G. The result is the rise in output from Y1 to Y3 given the real interest rate unchanged. The real business cycle model presented here can be summarized in several points: • there is no distinction between short-run and long-run aggregate supply functions (such a distinction played an important role in monetarist, new Keynesian, and early new classical models), • the model is completely real because both the nominal money supply and price level do not affect the real economy, • all points on the RAS curve correspond to full employment, • output and employment fluctuations are caused by technological shocks that shift the RAS curve. However, the model suggests that changes in real aggregate demand may also yield output fluctuations. 4. Real business cycle theory and stylized facts In the 1980s, rapidly growing interest in business cycles stimulated discussion on how well the business cycle mechanism according to various schools of economic thought fits the ‘stylized facts.’ We will focus here on cyclical fluctuations of prices and real wages. The real business cycle model assumes that fluctuations of prices are countercyclical. It is illustrated in Figure 5. The aggregate demand and supply curves are depicted in the coordinate system where price level is plotted on the vertical axis and GDP is plotted on the horizontal axis. The AD function has a standard negative slope. The AS curve is vertical due to the fact that output is at the potential level and prices are perfectly elastic. Suppose initially that the aggregate supply curve is AS1, which corresponds to the equilibrium price level of P1 and potential output of Y1. A positive technological shock shifts the AS curve rightwards. The increase in output from Y1 to Y2 is accompanied by a fall in prices from P1 to P2. Similarly, if there is a negative supply-side shock, output declines from Y1 to Y3 and prices rise from P1 to P3. 61 The real business cycle school Figure 5. Counter-cyclical behaviour of prices in the real business cycle model Prices (P) AS3 P3 AS1 AS2 G E P1 F P2 AD Y3 Y1 Y2 Output, GDP (Y) As we can see, in the real business cycle approach the direction of price changes is opposite to the direction of output changes. Thus prices (and inflation) are counter-cyclical. By contrast, Keynesian models, monetarist models, and the monetary misperception new classical models assume that prices behave rather procyclically. Given these theoretical discrepancies, what are the ‘stylized facts?’ Mankiw (1989) indicated that, in the absence of supply-side shocks (such as negative supply-side shocks caused by oil price hikes in the 1970s), prices behave rather procyclically in the real world and this is a well documented fact. In 1981, Lucas reached a similar conclusion. By contrast, some other authors suggest the existence of counter-cyclical fluctuations of prices and inflation. For example, Kydland and Prescott (1990) show that in the U.S. during 1954–89 prices revealed a counter-cyclical pattern. A similar finding was obtained by Blackburn and Ravn (1992) for the British economy. Counter-cyclical behaviour of prices has also been confirmed by Backus and Kehoe (1992) and Smith (1992). As regards real wages, the real business cycle theory states that they are procyclical. In turn, Keynesian, monetarist, and some new classical models treat real wages as counter-cyclical. What are the ‘stylized facts?’ For example, Gordon (1993) shows that – apart from the oil shocks in the 1970s – real wages do not show systematic movements, but empirical evidence rather confirms (although only slightly) the counter-cyclical behaviour of real wages. However, Kydland and Prescott (1990) argue in the opposite way: that real wages are procyclical. At present, economists mostly agree that real wages are slightly procyclical (see Fischer 1988). However, this view is embarrassing to both the supporters of traditional monetary approach to the business cycle as 62 5. The policy implications well as supporters of the real business cycle theory. If real wages were indeed only slightly procyclical, the labour supply curve would have to be very elastic (see Figure 2) and the large growth in employment would be accompanied by a slight increase in real wages. Significant intertemporal substitution of leisure is not, however, strong supported by empirical evidence. 5. The policy implications Before 1980, economists agreed – in general – in the following areas: 1. Business cycles are temporary fluctuations of output around the trend. The trend is an exogenous variable resulting from a smoothed technical progress. 2. Business cycles (instability of output) are undesirable because they reduce economic welfare. That is why the government should take actions to stabilize the rate of economic growth. 3. Monetary forces are a major cause of cyclical fluctuations. These views were accepted by Keynesians, monetarists, and new classical theorists. However, these schools differ in many respects, including what actions should be taken to reduce the magnitude of output fluctuations. For example, Keynesians support discretionary government policy while monetarists and new classical economists are in favour of constant growth in money supply. During the 1980s, the above way of thinking changed dramatically. Supporters of the real business cycle integrated the business cycle theory with the growth theory. They argued that observed short-run fluctuations in output and employment are what the standard neoclassical theory predicts. According to the real business cycle school, economic instability results from the behaviour of agents making optimal decisions in response to changes in economic conditions. Therefore, instability is not a bad outcome: it does not reduce economic welfare. The economy is in a Pareto optimal equilibrium during expansionary and contractionary periods. According to real business cycle theorists, government should not reduce fluctuations in output and employment. The main policy implication of the real business cycle school is as follows. The government stabilization policy is counterproductive. Fluctuations in output and employment are the optimal responses to changes in economic conditions resulting from different rates of technological progress. Thus, if fluctuations are Pareto optimal responses to shocks in the production function due to changes in technology, monetary policy is not responsible for the economic instability and it does not influence the real economy. Hence, money is super-neutral. According to real business cycle theorists, the economy is continuously in full employment equilibrium. Unemployment is always voluntary. Observed fluctuations of output occur at full employment level. Therefore, there is no 63 The real business cycle school room for government intervention aimed at achieving full employment, because the economy is still in that state. It is worth adding that, according to real business cycle school, a temporary rise in government spending leads to an increase in output and employment. This is because labour supply raises due to the increase in real interest rate resulting from larger aggregate demand. 6. Selected criticism The main criticism of real business cycle theory addresses the following issues. 1. In the real business cycle model, unemployment is entirely voluntary, although this needn’t be true in the real world (see, e.g., Great Depression during the 1930s or the Global Economic and Financial Crisis in 2009). 2. Recessions are treated as periods of technological regress. However, it is difficult to agree that the level of technology declines during recessions. 3. Technological shocks do not appear so often and they are not so large to fully explain the fluctuations in output. 4. Observed employment fluctuations are too large to be fully explained by intertemporal substitution of labour and leisure. 5. Demand-side policies may have long-run impact on the volume of output. For example, technical progress may depend on the size of demand, R&D expenditure, or learning-by-doing. Thus, changes on the supply side of the economy depend on changes on the demand side. 6. Empirical evidence shows that monetary policy does affect the real sphere of economy. For example, we could observe, based on historical data, that monetary disinflation policy in the UK led to a recession or economic slowdown. 7. The final criticism concerns representative agents. Real business cycle models ignore the issues related to information asymmetry, exchange, and coordination. These models aggregate actions of representative agents into the behaviour of the whole society. To learn more about the criticism of real business cycle theory, see e.g. Mankiw (1989) and Phelps (1990). 7. Summary 1. The real business cycle theory is the economic school of thought that is derived form the new classical macroeconomics and assumes rational expectations and continuous market clearing. 64 7. Summary 2. The real business cycle school integrates the theory of business cycles with the theory of economic growth. It does not distinguish between the short run and long run. 3. Business cycles are caused by real forces, namely technological changes. Money is super-neutral – it does not affect the real economy. Random technological changes yield permanent effects on potential output. In other words, GDP follows a random walk. 4. GDP fluctuations are treated as the fluctuations of potential output. During expansionary and contractionary periods the economy is at full employment level. Bibliography Snowdon, B., H. Vane, P. Wynarczyk, 2002, A Modern Guide to Macroeconomics. An Introduction to Competing Schools of Thought, Cheltenham-Northampton, Edward Elgar. Additional bibliography Backus, D.K., P.J. Kehoe, 1992, International Evidence on the Historical Properties of Business Cycles, American Economic Review, September. Barro, R.J., 1981, Output Effects of Government Purchases, Journal of Political Economy, December. Barro, R.J., 1993, Macroeconomics, 4th ed., New York, John Wiley. Blackburn, K., M.O. Ravn, 1992, Business Cycles in the UK: Facts and Fictions, Economica, November. Fischer, S., 1988, Recent Developments in Macroeconomics, Economic Journal, June. Frisch, R., 1933, Propagation and Impulse Problems in Dynamic Economics, in: Essays in Honour of Gustav Cassel, London, Allen and Unwin. Gordon, R.J., 1993, Macroeconomics, 6th ed., New York, Harper Collins. Kydland, F.E., E.C. Prescott, 1982, Time to Build and Aggregate Fluctuations, Econometrica, November. Kydland, F.E., E.C. Prescott, 1990, Business Cycles: Real Facts and the Monetary Myth, Federal Reserve Bank of Minneapolis Quarterly Review, Spring. Long, J.B., C.I. Plosser, 1983, Real Business Cycles, Journal of Political Economy, February. Lucas, R.E., 1972, Expectations and the Neutrality of Money, Journal of Economic Theory, April. Lucas, R.E., 1973, Some International Evidence on Output-Inflation Tradeoffs, American Economic Review, June. Lucas, R.E., 1981, Studies in Business Cycle Theory, Oxford, Basil Blackwell. Lucas, R.E., L.A. Rapping, 1969, Real Wages, Employment and Inflation, Journal 65 The real business cycle school of Political Economy, September/October. Mankiw, N.G., 1989, Real Business Cycles: A New Keynesian Perspective, Journal of Economic Perspectives, Summer. Nelson, C.R., C.I. Plosser, 1982, Trends and Random Walks in Macroeconomic Time Series: Some Evidence and Implications, Journal of Monetary Economics, September. Phelps, E.S., 1990, Seven Schools of Macroeconomic Thought, Oxford, Oxford University Press. Schumpeter, J.A., 1939, Business Cycles, New York, McGraw-Hill. Smith, R.T., 1992, The Cyclical Behaviour of Prices, Journal of Money, Credit and Banking, November. 66 CHAPTER FIVE Małgorzata Znoykowicz-Wierzbicka The new Keynesian school New Keynesian economics – core propositions and features New Keynesian economics arose in the late 1970s and 1980s as a response to the new classical revolution in macroeconomic thought, which called into question many achievements of the old Keynesian school. The new Keynesian approach was to remedy the shortcomings of the old Keynesian models, and in particular – to supplement aggregate demand analysis with a coherent theory of aggregate supply, encompassing explanation of price and wage rigidities (Snowdon, Vane 2005, p. 361). According to N. Gregory Mankiw and David Romer, there are two basic propositions of new Keynesian economics: 1. The violation of the classical dichotomy – changes in nominal variables influence output and employment in the short run. 2. Market imperfections (such as imperfect competition or asymmetric information) cause economic fluctuations (New Keynesian economics, p. 2). Main supplementing propositions of the new Keynesian approach include: • rejection of the assumption of continuous market clearing (in opposition to the monetarist, new classical and real business cycle approaches) and consequently – possible multiple equilibria in the economy with prices different from the market clearing levels (where an equilibrium is defined as a state where no agents have an incentive to change their behavior),12 12 According to R.J. Gordon, the absence of continuous market clearing is the essential feature of Keynesian economics. As this author puts it, a Keynesian model is by definition a non market clearing model, one in which prices fail to adjust rapidly enough to clear markets within some relatively short period of time. (…) in response to a decline in nominal demand, the aggregate price level will decline less tan proportionately over a substantial time period, during which the actual price level is above the equilibrium price level consistent with the maintenance of the initial equilibrium level of real output. The fact that the price level is too high means that the subequilibrium level 67 The new Keynesian school • pursuit of coherent microeconomic explanation of slow adjustment of wages • • • and prices to changing economic conditions and, in conclusion, the opinion that even small nominal price rigidities may generate considerable real effects, approval of the microeconomic principles of rational behavior of utility and profit maximizing economic agents and the rational expectations hypothesis by a vast majority of proponents of this approach in macroeconomics, recognition of both aggregate demand and supply shocks as factors determining the actual stage of the economy, recognition of active role of the government in the economy (the new Keynesian economists agree that government intervention can potentially improve the allocation of resources, although they are not unanimous with respect to desirability of active government policy) (Tsoulfidis, pp. 363–364; Snowdon, Vane 2005, p. 383). In general, the achievements of the new Keynesian school are sometimes summarized as attempts to build the microeconomic foundations of wage and price stickiness (Gordon, p. 478). However, it should be noted that under the heading of new Keynesianism a diversified group of authors and ideas is hidden, offering a multiplicity of mutually complementing explanations of wage and price rigidities and their macroeconomic consequences.13 2. Nominal and real rigidities The explanations of rigidities in the economy are divided into two main groups, focusing on nominal and real rigidities. Nominal rigidity occurs when the nominal price or wage level fails to adjust to the new market clearing levels resulting from the nominal demand disturbances, whereas a real rigidity is explained as the stickiness of a wage relative to another wage, of a wage relative to a price or of a price relative to another price (Gordon 1997, p. 505; Snowdon, Vane 2005, p. 366). As N. Gregory Mankiw underlines, the distinction made by the new Keynesians between nominal and real rigidities is very important: unlike nominal rigidities, real rigidities do not result in non-neutrality of money. However, both nominal and real rigidities cause unemployment and reinforce each other.14 of output actually produced is not chosen voluntarily by firms and workers, but rather is imposed on them as a constraint. It is the decline in nominal demand together with the absence of full price adjustment that causes the economic system itself to impose the constraint on each agent; nominal demand is insufficient to generate adequate real sales at the actual price level. See Gordon 1997, p. 500 (originally Gordon’s article was published in the Journal of Economic Literature, no. 28/1990, pp. 1115–71); Snowdon, Vane 2005, p. 383. 13 The proponents of the new Keynesian school include, inter alia, N. Gregory Mankiw, L. Summers, O. Blanchard, S. Fischer, E. Phelps, J. Stiglitz, G. Akerlof, J. Yellen, D. Romer, Ben Bernanke, R. Hall, J. Taylor. See Snowdon, Vane 2005, pp. 361–366. 14 See an interview with N. Gregory Mankiw reprinted in: Snowdon, Vane 1995. 68 2. Nominal and real rigidities Nominal wage and price rigidities are a common assumption of both traditional and new Keynesian economics. Nominal rigidities are the reason why short-term aggregate demand fluctuations may have real effects – in this sense, nominal rigidities explain the existence of business cycles. However, in contradiction to the orthodox Keynesian models, the new Keynesian approaches do not present fixed nominal prices and wages as an arbitrary assumption and try to provide microeconomic explanation to price and wage rigidities. The early new Keynesian attempts to explain nominal wage rigidities were based on nominal wage inertia resulting from long-term contracts. Long-term (explicit or implicit) wage contracts set wages on a certain level for an agreed period, and thus, prevent disadvantages (and costs) resulting from frequent changes of wages and prices.15 Since the nominal wages are temporarily sticky (till the end of the period of the current wage contract in force), monetary policy is not neutral in the short run, even if economic agents have rational expectations. Monetary policy may influence the real wage level, and thus, influence the level of output and employment in the short run, provided that monetary authorities are able to change the money supply in between periodic wage contract negotiations. Monetary policy remains neutral in the long run, when the nominal wages are fully adjusted. It is also worth noting, that according to E. Phelps, long-term wage contracts are advantageous for both companies and employees: they allow to avoid the transaction costs of frequent wage negotiations, decrease the risk and costs of failure of wage negotiations (e.g. in the form of a strike action undertaken by workers attempting to increase their bargaining power) and allow to avoid potential costs resulting from reduction of an individual firm’s relative real wages (if a company’s decision to decrease real wages in response to a negative demand shock was not immediately followed by other companies, workers experiencing decrease in relative wages would be encouraged to change their jobs) (Snowdon, Vane 2005, pp. 366–371). The new Keynesian economists also offer an explanation for nominal price rigidities. They explain short-run price adjustment by referring to microeconomic foundations of the macroeconomic adjustment processes. The distinctive feature of the new Keynesian school is the assumption of imperfect competition. Under imperfect competition, firms are not price takers – they are active price makers. Nevertheless, deciding on a change in pricing policy, profit maximizing companies take into account costs caused by price adjustment itself (called the menu costs – costs connected e.g. with preparation and dissemination of new price list and catalogues or negotiating new sales or purchase contracts). Such costs discourage companies from frequent price changes (especially when changes of 15 Frequent wage contracting is costly (eg. research on the wage structure outside the particular company, forecasts of the key variables taken into account during wage negotiations) and time-consuming both for the workers as well as for the companies. 69 The new Keynesian school factors determining the optimum price – such as the costs of production – are only of inconsiderable magnitude). According to the new Keynesians, the existence of the menu costs may result in considerable aggregate nominal price rigidity. Although the menu costs tend to be relatively small in individual cases, they are not inconsequential. In order to minimize the menu costs (which may be higher than the expected benefits of frequent price changes), companies prefer to adjust their prices intermittently rather than on a continuous basis. Additionally, the proponents of the menu-costs hypothesis point out to the aggregate-demand externalities to price adjustment: a price reduction by one firm benefits other firms in the economy (individual price reduction by one company slightly reduces the average price level and, as a result, raises the real monetary balances, which in turn causes the raise in aggregate income and the demand for goods produced by all the companies in the economy). The existence of the aggregate-demand externalities to price adjustment implies that even relatively small menu-costs incurred by an individual company may cause short-run price stickiness, and in result, generate large costs for the whole economy (Mankiw 2003, p. 510; Snowdon, Vane 2005, pp. 371–376). Moreover, the new Keynesians point out to another possible explanation of price (and in fact – wage) stickiness – the staggering and prices (and wages). Even when individual companies change their prices and wages frequently, the adjustment of wages and prices throughout the economy is not a simultaneous process: the overall adjustment of prices and wages is gradual (staggered). Under staggered price adjustment, a price increase by an individual company rises that company’s relative price (in comparison with its competitors). In order to avoid losing their consumers (resulting from relative price changes), individual companies prefer modest to substantial price adjustment. Therefore, staggering of prices explains the overall price stickiness. Moreover, the phenomenon of staggering may also explain wage stickiness. A decrease in money supply reduces aggregate demand and requires an equivalent fall in nominal wages to maintain full employment. If all wages in the economy were to be reduced simultaneously, all workers might accept the immediate reduction of wages (equivalent to the initial fall in money supply). Because wage-setting is staggered, an individual worker may not accept a substantial pay cut: this would result in a temporary fall in her/his relative wage (in comparison with other workers). Therefore, staggering of individual wages may explain the stickiness of the overall level of nominal wages (its slow response to changing economic conditions) (Mankiw 2003, pp. 512–513). Real rigidities may occur both in product market (real price rigidities) as well as in the labor market (real wage rigidities). Real price rigidity may be defined as a factor reducing the responsiveness of 70 2. Nominal and real rigidities firms’ profit-maximizing prices to variations in aggregate output resulting from variations in real aggregate demand.16 At a general level, real rigidities discourage companies from taking actions limiting aggregate output fluctuations. Price may be expressed as a mark-up on marginal cost (expressed as the nominal wage divided by the marginal product of labor). The size of this mark-up varies inversely with the price elasticity of demand. Decline in marginal cost may not lead to price reduction if the mark-up on marginal cost rises enough to offset the decline in marginal costs. Provided that the price elasticity of demand does not decline and the marginal product of labor does not rise with a reduction in input of labor, the menu cost may discourage a company from reducing its prices. Moreover, the mark-ups on marginal costs depend on the level of economic activity: they fall during booms (as maintaining oligopolistic collusion becomes more difficult) and rise in recessions (when collusion increases). Therefore, countercyclical behavior of markups also acts as a real rigidity. Real price rigidities may also be explained another way: the greater the decline in the elasticity of demand at the existing price as output falls, the more the marginal revenue curve facing a firm shifts to the left and the less incentive there is for a firm to reduce its price (Snowdon, Vane 2005, pp. 379–380; Romer, pp. 8–11). The new Keynesian economists suggest several other sources of real price rigidity: a) thick market externalities – the costs of searching desired goods and finding consumers are generally lower during economic boom (when markets are ‘thick’ – the level of trading activity is high) and higher in periods of low economic activity (when markets are ‘thin’). This leads to a strategic complementary: one firm’s optimal level of activity depends on the activity of other firms: marginal costs increase in recessions and decrease in booms, resulting in real price rigidity, b) customer markets – customer markets are defined as markets characterized by low frequency of search relative to the frequency of purchase. Buyers usually have imperfect information on the best offer available on the market: the costs connected with continuous search for the best offer imply that many consumers make repetitive purchases. Therefore, firms avoid frequent changes of prices, which would encourage their consumers to search for a new supplier. Moreover, an increase of prices by one company offering its goods at a consumer market would obviously be noticed by its consumers, whereas a price cut would have considerably smaller effects on the behavior of other firms’ consumers. In turn, companies trying to retain their current clients will contribute to price stickiness, c) input-output table theory – the concept of the input-output table describes the complexity of the supplier-producer relationships (a single company may be 16 See D. Romer, Real rigidities, in: The New Palgrave Dictionary of Economics 2008. 71 The new Keynesian school linked with many other cooperating companies facing different demand and supply shocks. Moreover, apart from the costs of materials supplied by other firms, an individual company’s short-run marginal costs are also influenced by the ability of the costs of labor to adjust to changing economic situation (which may depend on the scale of wage rigidities). A single company does not believe that the actions of all other economic agents (collaborating companies, workers) will allow its marginal costs to mimic nominal demand changes with minimal lags. Deciding on a price change, a firm must take into account its own demand and costs, as well as the pricing behavior of all other cooperating companies. Therefore, many companies decide to adjust their prices gradually, in line with other companies on the market, which in turn results in price staggering and aggregate output fluctuations (Gordon, p. 504), d) capital market imperfections – the cost of capital incurred by the firm tends to be countercyclical (during periods of high economic activity, companies may finance their investment projects at a lower costs, using internal financing, whereas in recessions, firms may have to rely on external – thus more expensive – financing). Countercyclical behavior of the costs of capital may increase the firm’s total costs in recession, and therefore – influence price rigidity, e) judging quality by price – under imperfect information, companies may use their pricing policy as a quality signal. Negative demand shock may not result in a price cut, if the company wants to signal preservation of high quality of offered goods (Snowdon, Vane 2005, pp. 380–383). As it has already been mentioned, real wage rigidity may be defined as stickiness of a wage relative to another wage or of a wage relative to a price. The distinctive feature of the new Keynesian approach to real wage rigidities is the definition of market equilibrium: an equilibrium may be reached at a real wage different from the market clearing real wage. Therefore, opposite to the new classical models, involuntary unemployment may occur even in the longrun equilibrium (Snowdon, Vane 2005, p. 383). The new Keynesian propositions explaining the phenomenon of real wage rigidity may be divided into three general groups: a) implicit contract theories – since workers and employers may have different tolerances towards risk, labor contracts may not only determine the cost of labor, but also have an insurance function. Companies, interested in securing loyalty of their employees, enter into unwritten (implicit) understandings with the workers: wages do not only represent payment for labor services in the current period, but may be treated as a form of insurance against the risk of workers’ income volatility. Employees may prefer lowering this risk to accepting wages varying in accordance with changing economic condition, although varying wages could be on average higher than the stable real 72 3. Hysteresis and unemployment wages negotiated with the company in an implicit contract (New Keynesian economics, p. 11; Snowdon, Vane 2005, p. 384), b) efficiency wage theories – efficiency wage theories are based on the assumption that the level of real wages may affect labor productivity. Therefore, rationally acting companies may be motivated to pay real wages exceeding the market clearing level. Firms identify interdependence between worker’s productivity (and thus – costs of production and profits) and the level of real wages (the higher the real wage, the greater the productivity). A pay cut may not lead to a reduction, but in fact – an increase of the costs of production (because of reduced productivity). Therefore, real wage rigidity may be advantageous for a profit maximizing company. Four different types of efficiency wages theories are identified: the adverse selection model (companies offering higher real wages may attract the most productive workers), the labor turnover model (high real wages reduce the risk of high – and costly – labor turnover), the shirking model (under asymmetry of information on the workers’ individual productivity and considerable costs of constant monitoring of workers’ efforts, high real wages deter workers from shirking and encourage them to increase their efforts) and the fairness model (worker’s productivity may also depend on sociological and psychological factors, such as the feeling of being fairly treated by the employer: workers’ productivity (efforts), turnover and absenteeism rates may be a function of the employees’ morale) (Snowdon, Vane 2005, pp. 388–394), c) insider-outsider theories – at the labor market, insiders (present workers) influence decisions concerning real wages and the level of employment at outsiders’ (the unemployed workers’) expense. The power of the insiders to influence a company’s wage policy results from considerably high costs of worker turnover (interviews, negotiations with prospective employees, training of new workers). Due to such costs, companies do not consider outsiders to be perfect substitutes for insiders. In order to avoid turnover costs, companies may decide not to lower wages even in case of an excess supply of labor. The insider-outsider theory of efficiency wages does not assume any direct effect of real wages on workers’ productivity (Snowdon, Vane 2005, pp. 394–396). 3. Hysteresis and unemployment The market-clearing models of the labor market assume that in case of an excess labor supply, decrease in wages should raise the quantity of labor demanded and restore labor market equilibrium. Nevertheless, even within the standard macroeconomic models, a distinction is made between the equilibrium unemployment (constant in the short run and determined mostly by real supply-side factors such as labor market institutions) and actual unem73 The new Keynesian school ployment (which deviates from the equilibrium unemployment). According to the proponents of the new Keynesian approach, because of the imperfections in its functioning, the labor market may reach equilibrium even with some involuntary unemployment. As it has already been mentioned in case of the rational expectations hypothesis, the new Keynesian school adopted some theoretical concepts from other macroeconomic schools. For example, the idea of the natural rate of unemployment and the expectations-augmented Philips curve were used to construct the NAIRU (non-accelerating inflation rate of unemployment) concept. The NAIRU is defined as the unemployment rate at which there is no immediate inflationary pressure. NAIRU is frequently used to estimate the natural rate of unemployment, although there are some differences between the two concepts. Unlike the natural rate of unemployment concept, the NAIRU does not represent the equilibrium level of unemployment: under imperfect competition at the labor and product markets, NAIRU may be defined as rate of unemployment resulting from the balance of power between workers and firms (balancing the real wage expected by the workers with feasible the real wage determined by the companies pursuant to their mark-ups and labor productivity). Despite of these differences, the terms natural rate of unemployment and NAIRU are used interchangeably (Snowdon, Vane 2005, p. 403). The concept of the natural rate of unemployment was challenged in 1980s – both actual and equilibrium (natural) rates of unemployment rose significantly in many European economies, which implied influence of aggregate demand shocks on both rates of unemployment. E. Phelps suggested possible explanation of this fact: borrowing the term ‘hysteresis’ from physics, Phelps suggested that following aggregate demand shocks, the natural rate of unemployment may be dependent on the course of the adjustment processes. According to the hysteresis concept, the natural rate of unemployment will increase if the actual rate of unemployment in the previous period was higher than the previous period’s natural rate of unemployment (Snowdon, Vane 2005, p. 405). Therefore, a negative aggregate demand shock will cause, in the short run, an output fall and an increase of actual unemployment rate. In the long run, the natural rate of unemployment will not return to its initial level. Therefore, recessions may have protracted effects. There are several explanations of the hysteresis effect, which may be classified within two main groups: duration theories (based on the distinction between short-term and long-term unemployment: i.a. because of depreciation of human capital, the bargaining power of the long-term unemployed decreases; this group exerts little pressure on wage setting) and insider-outsider theories (based on the distinction between the insiders and the outsiders at the labor market: in spite of involuntary unemployment, incumbent workers oppose wage cuts – as a result, the unemployed are not offered jobs).17 17 74 Find a detailed analysis of the hysteresis concept in: Blanchard, Summers 1991, pp. 235–243. 4. New Keynesian economics and stylized facts It is also worth mentioning that E. Phelps suggested another possible explanation of the natural (equilibrium) rate of unemployment fluctuations. Conclusions drawn from the dynamic intertemporal non-monetary equilibrium model suggest that the natural rate of unemployment should be treated as an endogenous variable, determined by both real aggregate demand shocks as well as aggregate supply shocks – technology changes, social preferences or values and institutions (Snowdon, Vane 2005, pp. 406–408). 4. New Keynesian economics and stylized facts The new Keynesian economics offers explanation to several business cycle stylized facts, such as: • the procyclical behavior of the main aggregate demand determinants (consumption, investment, government expenditure) as well as employment and productivity, • the procyclical character of money (which, as it was explained, is not neutral in the short run), • the procyclical behavior of inflation, • the procyclical character of the real wage unlike (in models assuming the sensitiveness of the efficiency wage to the rate of unemployment, real wages may be procyclical), • the phenomenon of unvoluntary unemployment (Snowdon, Vane 2005, pp. 408–409). (As the new Keynesian explanation of the above-mentioned stylized facts may be concluded form the previously discussed aspects of this school of macroeconomic thought as well as derived from the traditional Keynesian analysis, these aspects are not discussed further in detail). 5. Policy implications As it has already been mentioned, recognition of active role of the government in the economy is one of the core propositions of the new Keynesian approach. Nevertheless, the non-neutrality of money in the short run – a view shared by new Keynesians – does not imply their support for active use of monetary policy only for short-run gains in output and employment. In general, the new Keynesian school advocates policy intervention to offset the macroeconomic effects of considerable macroeconomic shocks (especially in case of unexpected shocks lowering both output and inflation) and recognizes the stabilizing role of both monetary and fiscal policy. Nonetheless, the New Keynesians are not unanimous with respect to the extent of discretionary 75 The new Keynesian school economic policy. N. Gregory Mankiw points out that discretionary policies are intrinsically inflationary. Being aware of discretionary monetary expansion aimed at reducing unemployment, economic actors accordingly adjust their inflation expectations. As a result, the short-run trade-off between inflation and unemployment may be deteriorated, if not eliminated.18 There is wide consensus among economists (not only new Keynesians, of course) that price stability is the primary goal of monetary policy. There is no agreement, however, with respect to the most appropriate monetary policy regime to achieve this goal. The new Keynesians’ support for a rule-based, rather than discretionary, monetary policy is based on the short-term non-neutrality of money, existence of substantial welfare costs attributed to inflation (especially unexpected inflation) and the need (and significance) of establishing credibility of monetary policy. Proponents of the rule-based monetary policy suggest different variants of monetary policy regimes. Four most popular solutions used in practice are: exchange rate targeting, monetary targeting, explicit inflation targeting and implicit inflation targeting (Snowdon, Vane 2005, pp. 411–419). As for the monetary policy tools, new Keynesians advocate the use of the interest rate rather than monetary aggregates targeting (Tsoulfidis, p. 379). The case for fiscal policy rules is more vague. The assessment of fiscal policy rules (such as the balanced budget rule) highly depends on circumstances: it may not be possible to design a universally correct fiscal policy rule. Therefore, some proponents of the new Keynesian economics (including J. Stiglitz) generally oppose introducing fixed fiscal policy rules because of irregular and unpredictable character of macroeconomic shocks (Snowdon, Vane 1995, p. 58). In some extreme cases, a budgetary deficit may be justified and even desirable in the short run, but in the long run, continuous deficits reduce national savings and economic growth. Moreover, many new Keynesian economists (including N. Gregory Mankiw) believe that monetary policy generally is a more useful tool of aggregate demand stabilization. To sum up, the most general principle that the majority of new Keynesians would share with respect to the role of government in the economy is that in periods of normal economic activity, economic policy should be conducted on a flexible basis (enabling the government to react to unexpected disturbances). Active government policy (being a trade mark of the old Keynesian school) is recommended in periods of severe macroeconomic shocks and recessions. Due to heterogeneity and multiplicity of ideas hidden behind the new Keynesian label, numerous specific economic policy measures are advocated by different authors (e.g. with respect to remedies to various identified reasons of nominal and real price and wage rigidities) (Tsoulfidis, p. 379). For example, taking into account the above discussed factors combining to real wage rigidity, the new Keynesian approach suggests several institutional reforms of the labor 18 76 See Mankiw 1992, pp. 559–565. 6. Assessment of new Keynesian economics market aimed at reducing unemployment, such as reforms limiting the power of the insiders and increasing the attractiveness of the outsiders at the labor market (softening job security legislation, reforms of industrial relations limiting the risk of strikes, vocational training for unemployed, policies increasing geographical mobility of labor, profit-sharing arrangements improving wage flexibility, reforms of the unemployment compensation systems aimed at increasing job search incentives) (Snowdon, Vane 2005, pp. 422–423). 6. Assessment of new Keynesian economics Critics of the new Keynesian school concentrate on several main objections: • concentration on theoretical aspects (explanation of the microfoundations of macroeconomics) at the expense of empirical research (however, this particular objection may be overruled by increasing popularity of the DSGE – dynamic stochastic general equilibrium – models), • existence of numerous unrelated theories within the school, hampering construction of a testable new Keynesian model, • the magnitude of influence of the relatively small menu costs on output and employment, • extensive emphasis on deriving rigidities from microeconomic foundations of macroeconomics, • acceptance (by many new Keynesians) of the rational expectations hypothesis, • extensive use of the IS-LM model to analyze aggregate demand (Snowdon, Vane 2005, pp. 430–431). Notwithstanding the above critical arguments, many economists regard the new Keynesian school as a valuable input to modern macroeconomics, and especially – a creative elaboration of the old Keynesian ideas. What the new Keynesian economists are especially proud of is – that at least in their opinion – the new classical argument that the Keynesian assumption of nominal rigidities lacked theoretical foundations has been refuted (New Keynesian economics, p. 15). Nevertheless, not all economists are optimistic with respect to comprehensiveness of wage and price rigidity theories proposed by the new Keynesian school. As R.J. Gordon noted, a satisfactory theory of price adjustment must explain phenomena revealed by empirical research, such as the variability of price adjustment parameters across industries, across countries and across historical intervals. In his opinion, much of new Keynesian theory did not succeed in explaining these facts 20 years ago, when he wrote the article on new Keynesian economics (Gordon, p. 479). It is still disputable whether this objection may be overruled now. It is also worth noting that the proponents of the new Keynesian approach have extensively used analytical concepts elaborated by other schools – such as the 77 The new Keynesian school monetarist idea of natural unemployment and expectations augmented Philips curve (adjusted to the NAIRU concept), the rational expectations hypothesis or the methodology of the DSGE (dynamic stochastic general equilibrium) models used by the proponents of the real business cycle school. Last but not least, the propositions of the new Keynesian school have recently attracted attention in the global crisis period. Economic policies conducted by many governments (and supported or coordinated by international organizations) may find theoretical underpinnings in the arguments presented by the new Keynesians. What is also important, the new Keynesian approach may also offer plausible explanation of both the causes and course of the global financial crisis.19 Bibliography Blanchard, O.J., L.H. Summers, 1991, Hysteresis in unemployment, published in: New Keynesian Economics, vol. 2: Coordination failures and real rigidities, eds N.G. Mankiw, D. Romer, Cambridge, Massachusetts, MIT University Press. Gordon, R.J., 1997, What is new-Keynesian economics?, in: A Macroeconomics reader, eds B. Snowdon, H.R. Vane, London, Routledge. Mankiw, N.G., 2003, Macroeconomics, 5th edition, New York, Worth Publishers. Mankiw, N.G., 1992, The reincarnation of Keynesian economics, European Economic Review, no. 36. New Keynesian economics, vol. 1: Competition and sticky prices, eds N.G. Mankiw, D. Romer, 1991, Cambridge, Massachusetts, MIT University Press. New Keynesian economics, vol. 2: Coordination failures and real rigidities, eds N.G. Mankiw, D. Romer, 1991, Cambridge, Massachusetts, MIT University Press. The New Palgrave Dictionary of Economics, 2008, 2nd ed, eds S.N. Durlauf, L.E. Blume, Palgrave Macmillan. Romer, D., 1993, The new Keynesian synthesis, The Journal of Economic Perspectives, vol. 7, issue 1 (winter). Snowdon, B., H.R. Vane, 2005, Modern macroeconomics. Its origins, development and current state, Cheltenham, Northampton, MA, Edward Elgar. Snowdon, B., H.R. Vane, 1995, New-Keynesian economics today. The empire strikes back, American Economist, no. 39 (spring). Stiglitz, J.E., 2009, The current economic crisis and lessons for economic theory, Eastern Economic Journal, no. 35. Tsoulfidis, L., 2010, Competing schools of economic thought, Berlin Heidelberg, Springer Verlag. 19 78 See Stiglitz 2009. CHAPTER SIX Mariusz Próchniak New developments in growth theory 1. The neoclassical growth theory: the Solow model and the Ramsey model The first works related to economic growth date back to the eighteenth and nineteenth centuries. During this period, Adam Smith, Thomas Malthus, David Ricardo and many years later, Frank Ramsey, Allyn Young, Joseph Schumpeter and Frank Knight provided many elements used in modern growth models (Barro, Sala-i-Martin 1995, p. 9). Here, we will not explore the old history and we will focus on contemporary models of economic growth. The first economist to formalize the analysis of economic growth was Robert Solow (1956). His model included the neoclassical production function and initiated an era of neoclassical models of economic growth. Neoclassical production function assumes constant returns to scale and diminishing marginal product of capital. To this day, the Solow model constitutes the basis for the contemporary theory of economic growth. But important works in this field appeared earlier. Harrod (1939) and Domar (1946) tried to combine the Keynesian analysis with the elements of economic growth. According to the Harrod-Domar model, the pace of economic growth is proportional to the investment rate (equal to the savings rate) and inversely depending on the marginal capital intensity of production. The growth rate of GDP is described by the following equation: gy = s , k (1) where: gy – real GDP growth rate, s – the investment rate (the savings rate), k – the capital intensity of production (investment outlays per unit increase in national income). 79 New developments in growth theory In 1928, Frank Ramsey published the article on optimal level of savings among nations. Currently, the Ramsey model is widely recognized as the neoclassical approach. But the Ramsey model gained significant acceptance among economists in the early 1960s, following the Solow model, so about 30 years after its development. The neoclassical group also includes the Diamond model (1965). Neoclassical models share one common disadvantage. They do not explain well the long-run economic growth. According to neoclassical theories, long-run economic growth depends on technological progress, which is exogenous. The desired property of the model would be to endogenize technical progress, so that economic growth could be explained within the model. Moreover, neoclassical models (in their basic forms) do not cope well with the explanation of differences in income levels between countries. Differences in physical capital stock are in fact too small to explain differences in income. We present in detail the two basic neoclassical models: Solow model and Ramsey model. The Solow model The Solow model, also called the Solow-Swan model, was developed by Robert Solow (1956) and Trevor Swan (1956). We present here the Solow model with labour-augmenting technological progress. Let F be the production function. Inputs to production are: physical capital K(t) and effective labour A(t)L(t), which is the product of the level of technology A(t) and population (labour force) L(t): F (K (t ), A (t ) L (t )). (2) The production function exhibits constant returns to both inputs (capital and effective labour) and diminishing marginal product of capital. One of the functions satisfying these assumptions is the Cobb-Douglas production function: F (K (t ), A (t ) L (t )) = K (t ) A (t ) L (t ) 1−α α , (3) where 0 < α < 1. Technology and population both grow at constant exogenous rates, equal to a and n respectively: . A (t) = a and A (t) . L (t) =n. L (t) (4) The increase in capital stock equals investment (savings) minus depreciation: . K (t) = sF (K(t), A(t) L(t)) – δK(t) , 80 (5) 1. The neoclassical growth theory: the Solow model and the Ramsey model where s is the exogenous savings rate and δ is the capital depreciation rate. The dynamics of the economy is analysed in terms of capital and output per unit of effective labour, denoted by k(t) and f(k(t)) respectively:20 k≡ K AL f (k ) ≡ and (6) F (K , AL ) K AL , = F = F (k ,1) = f (k ) . AL AL AL To find the equation describing the dynamics of the economy, we differentiate the definition of k (Equation 6) with respect to time and then we use formulas (4), (5) and (6). As a result, we obtain: . k = sf (k) – (n + a +δ)k . (7) The above equation is the basic formula describing the dynamics of the economy in the Solow model. The increase in capital per unit of effective labour equals actual investment sf(k) minus replacement investment (n + a + δ)k. Given that (i) marginal product of capital is positive and diminishing (f’(k) > 0 and f”(k) < 0), (ii) zero inputs yield zero output (f(0) = 0), and (iii) the production function satisfies Inada (1963) conditions (limk→∞f’(k) = 0; limk→0f’(k) = ∞), then the dynamics of the economy and the steady-state can be found graphically. This is illustrated in Figure 1. Figure 1. The transition period and the steady-state in the Solow model 20 In the rest of the chapter, we omit the time index t in order to preserve the transparency of the formulas. 81 New developments in growth theory The long-run equilibrium (steady-state) occurs at the point of intersection between sf(k) and (n + a + δ)k functions. At this point, output and capital per unit of effective labour are constant over time – Equation (7) implies that if sf(k) = (n + a + δ)k, then dk/dt = 0. Hence, what is the growth rate of total GDP (Y = F(K,AL)) and GDP per capita (Y/L) in the steady-state? In order to answer this question, we have to differentiate Y ≡ f(k)AL and Y/L ≡ f(k)A with respect to time (see Equation 6). This yields: . . . . Y f (k) A L = + + Y f (k) A L . and . . Y / L f (k) A = + . Y / L f (k) A (8) In the steady-state, output per unit of effective labour is constant (df/dt/f = 0), while technology and population both grow at constant rates equal to a and n respectively. Thus, we have obtained two important implications of the Solow model. In the steady-state (long-run equilibrium): • the growth rate of GDP equals technological progress plus population growth, • the growth rate of per capita GDP equals technological progress. These findings confirm also the weaknesses of neoclassical theories, discussed earlier, namely, that economic growth depends on exogenous variables, formed outside the model. The steady-state in the Solow model is stable. This means that regardless of the initial capital stock (except for k(0) = 0), the economy always tends towards the steady-state and, eventually, approaches it. If k(0) < k*, then sf(k) > (n + a + δ) k (see Figure 1), k will grow over time and eventually reaches k*. During the transition period, the growth rate of total and per capita GDP is higher than in the steady-state because capital and output per unit of effective labour both increase (df/dt/f > 0 in Equation 8). The above property of the Solow model, indicating a faster pace of economic growth during the transition period, has very important implications. Namely, the Solow model confirms the existence of conditional β-type convergence. Convergence (β-type) means that less developed countries (with lower GDP per capita) tend to grow faster than more developed ones. The catching-up process confirmed by the Solow model is conditional because it only occurs if the economies tend to reach the same steady-state. According to the Solow model, the steady-state may be dynamically inefficient. In other words, the long-run equilibrium needn’t be Pareto optimal. This results from the nature of the savings rate which is exogenously given. Too high savings rate leads to excessive capital accumulation in the economy and produces dynamic inefficiency. 82 2. Endogenous models of economic growth (Romer, Lucas) Finally, let us present the impact of an increase in the savings rate on the dynamics of the economy. According to the Solow model, the exogenous savings rate does not affect the pace of economic growth in the steady-state, but it influences the equilibrium level of income (higher savings rate means a higher position of sf(k) function and consequently a higher level of k*). The impact of a change in the savings rate on GDP growth is only temporary – higher savings rate accelerates economic growth during the transition period (when the economy is on the way towards the new steady-state). The Ramsey model The Ramsey model is named after Frank Ramsey, a British economist, who in 1928 published an article on the optimal level of savings. The Ramsey approach was extended by David Cass (1965) and Tjalling Koopmans (1965) and, therefore, bears the name of the Ramsey-Cass-Koopmans model. The main difference between the Ramsey model and the Solow model concerns the savings rate. The savings rate, which in the Solow theory was exogenous, in the Ramsey approach is endogenously given and results from optimal decisions made by utility-maximizing individuals. Due to complexity of mathematical calculations, we do not analyze in detail the dynamics of the model. We present only the main conclusions.21 In the steady-state, physical capital, consumption, and output per unit of effective labour are all constant. This means that GDP growth rate equals the sum of technological progress and population growth (the variables exogenously given) while the growth rate of per capita GDP equals technological progress. Thus, the Ramsey model gives the same answer as the Solow model to the question about the determinants of long-run economic growth. The Ramsey model – in contrast to the Solow model – is Pareto optimal. Endogenous savings prevent excessive accumulation of physical capital in the economy. Hence, dynamic inefficiency does not appear here. The Ramsey model – like the Solow model – confirms the existence of conditional β convergence. 2. Endogenous models of economic growth (Romer, Lucas) In the early 1970s – along with the oil crisis that changed dramatically the current trends of economic development of many Western countries – the growth theory left the main area of interest among economists. The breakthrough came 21 For a detailed analysis of various models of economic growth, see e.g. Barro, Sala-i-Martin 2003; Romer 2006. 83 New developments in growth theory only in 1986 with the article by Paul Romer, initiating an era of endogenous growth models.22 Endogenous models – as the name suggests – explain the economic growth in an endogenous manner, i.e. within the model. This feature contrasts with neoclassical growth theory where long-run growth depended on exogenous technological progress, introduced into the model along with other assumptions. Achieving endogenous growth is possible due to not including the neoclassical production function which assumes diminishing returns to accumulable inputs and constant returns to scale. Endogenous models assume that there are at least constant returns to accumulable inputs. The mechanism of endogenous growth can be explained by introducing into the Solow model the following production function: Y (t ) = AK (t ) . (9) The above function exhibits constant returns to capital, the only accumulable factor of production. Given the income identity Y = C + I = C + dK/dt and the equality of investment and savings I = sY (where s is the exogenous savings rate), the economic growth rate in such a model is given as follows: . Y = sA . Y (10) The above equation shows that endogenous growth is achievable without exogenous technical progress. Equation (10) implies that the economy is continuously growing at a rate of sA. It also indicates that the increase in the savings rate is sufficient to accelerate permanently the long-run rate of economic growth. Since the production function is of the form Y = AK, this simple growth approach is known as ‘the AK model.’ Endogenous growth occurs – in general – by eliminating the assumption of diminishing returns to accumulable inputs. In particular models, however, the introduction of constant returns takes various forms. The Romer learning-by-doing model is a one-sector model, in which long-run growth is achieved due to increasing returns to accumulable factors at the whole economy level. In the Rebelo23 and Lucas models, endogenous growth is possible due to the existence of two sectors, each of which exhibiting constant returns. Models with an expanding variety of products24 and models with an improving quality of products25 are known as R&D models. In these models, 22 The first works containing elements of contemporary endogenous models were published, however, much earlier – already in the 1960s (see e.g. Arrow 1962; Kaldor, Mirrlees 1962; Uzawa 1964, 1965; Shell 1966; Sheshinski 1967). 23 Rebelo 1991. 24 Romer 1990. 25 Aghion, Howitt 1992; Grossman, Helpman 1991. 84 2. Endogenous models of economic growth (Romer, Lucas) long-run economic growth is obtained by endogenizing technical progress, which is the output of the R&D sector. Here, we will briefly discuss two basic models of endogenous growth: the Romer learning-by-doing model and the Lucas two-sector model. Due to extensive calculations, we present only the main assumptions and implications of these models. The Romer learning-by-doing model The Romer model differs from the neoclassical models in that it does not assume diminishing returns to accumulable inputs. On the contrary, knowledge, which is the only accumulable factor of production, exhibits increasing returns at the social (whole economy) level. The rationale for adopting this assumption is that knowledge, being created through investment of individual firms, can spread freely throughout the economy and thus it can be used by all firms without incurring additional costs. Such a mechanism of knowledge diffusion is called learning-by-doing which means learning (i.e. acquisition of knowledge) through practice. The concept of learning-by-doing and the assumption of increasing returns both refer to the work of Arrow (1962). Due to increasing returns, the Romer model reveals an accelerating and permanent economic growth without introducing exogenous variables. The assumptions that lead to endogenous growth are the following. Let fi be the production function of an individual firm: fi (ai , ki , A ) , (11) where ai is the level of knowledge of an individual firm, ki represents other factors of production (capital, labour, etc.), and A is the general level of knowledge in the economy (the sum of knowledge possessed by N firms: A = Σi=1Nai). To simplify the analysis, we assume that other inputs are constant (ki = const.), which means that knowledge is the only accumulable factor of production. Since all firms are identical, we have: fi(ai,ki,A) = f(a,k,A) and A = Na. The production function exhibits increasing returns with respect to all inputs (a, k, A) and constant returns with respect to a and k: f (λ a, λ k , λ A ) > λ f (a, k , A ) and f (λ a, λ k , A ) = λ f (a, k , A ) . (12) Since all other factors of production except knowledge are constant (k = const.), production functions can be written as: • at the individual firm’s level: f (a, k , A ) = f (a, A ) , (13) 85 New developments in growth theory • at the social (whole economy) level: f (a, k , A ) = f (a, k , Na ) = F (a ) . (14) Differences in the production function lead to differences in the marginal product of knowledge. We assume that the marginal product of knowledge at the social level is increasing while from the firm’s point of view it is decreasing or constant: d 2 f (a, A ) da 2 ≤0 and d 2 F (a ) da 2 > 0. (15) The dynamics of the economy in the Romer learning-by-doing model differs from the dynamics of the economy in the neoclassical theory especially because there is no steady-state in the Romer model. At the optimal trajectory, a perfectly competitive economy reveals a permanent and accelerating economic growth. The pace of knowledge accumulation is increasing and asymptotically approaches its upper growth limit. Therefore, the growth rates of GDP and consumption increase as well. The Romer model does not confirm the existence of convergence between countries. Moreover, it suggests rather divergence trends. According to the Romer approach, the rate of economic growth increases with income meaning that more developed countries grow faster than less developed ones. Although GDP growth rates tend asymptotically towards the same upper limit, poor countries will grow more slowly because at any given point they have less knowledge. Thus, differences in income levels between countries are permanently increasing. Perfectly competitive economy in the Romer model is not Pareto optimal. This is because investments in knowledge made by a single firm lead to the increase of the overall level of knowledge which is a common input. But a single company in its investment decisions does not take into account these positive externalities. Marginal product of knowledge from the point of view of a single firm is less than the marginal product of knowledge at the social level. This means that a perfectly competitive economy accumulates too little knowledge and reveals lower growth than a centrally planned economy. The latter conclusion is a bit shocking at first glance. It results from the fact that the Romer model includes positive externalities. The concept of learningby-doing suggests that there is a need for government intervention to ensure a level of knowledge accumulation being optimal from the whole economy’s perspective. Without government involvement, individual firms will take into account only private costs and benefits. As a result, in a perfectly competitive economy both the level of knowledge and the pace of economic growth will be lower than in an economy with government intervention. 86 3. Neoclassical revival: the Mankiw-Romer-Weil (augmented Solow) model The Lucas model The Lucas model (1988) is a two-sector model of economic growth that includes – in addition to physical capital – also human capital. The concept of the economy consisting of two sectors refers to the work of Uzawa (1964, 1965). Therefore, the Lucas model is also called the Uzawa-Lucas model. Endogenous growth is achieved due to the existence of two sectors that both exhibit constant returns. The Lucas model explains very well the differences in income levels between countries. The economies, which at a starting point are capital scarce, achieve long-run equilibrium with low level of capital. The economies which are initially richer tend to steady-state characterized by higher capital level. However, the growth rate of GDP is the same in each steady-state. Thus, differences in income levels between countries will not disappear: the poor countries remain poor while the rich countries are still rich. The Lucas model, therefore, does not explain the phenomenon of convergence – in terms of both the comparison of various steady-states and the comparison of transition periods for the economies tending to reach the same steady-state. In the first case, it appears that in the long-run equilibrium the rate of economic growth does not depend on the level of capital and output. This means that countries grow at the same rate regardless of income level reached. In the second case, when we consider the transition period for economies striving for the same steady-state, it turns out that less developed countries may grow faster or slower than more developed ones. It depends on whether the low level of development results from the lack of physical capital (poorer countries would grow faster) or the lack of human capital (then poorer countries would record slower growth). 3. Neoclassical revival: the Mankiw-Romer-Weil (augmented Solow) model We present now the augmented Solow model developed by Mankiw, Romer, and Weil in 1992 (see also Romer 2006). Although the augmented Solow model is a continuation of the neoclassical growth theory and is not an endogenous approach, it is treated as the new growth theory mainly for two reasons. First, it was developed in the 1990s, so during the era of a new growth theory. Second, the inclusion of human capital makes this model similar to other endogenous formulas. The Mankiw-Romer-Weil (MRW) model shows, inter alia, that the neoclassical growth theory explains correctly the differences in income levels between countries and the phenomenon of conditional convergence. 87 New developments in growth theory The main difference between the basic and augmented Solow model is that the MRW model includes human capital. Human capital (H) is the third input, in addition to physical capital (K) and effective labour (AL). The production function has the form: Y = K α H β ( AL ) 1−α − β , (16) where α > 0, β > 0, α + β < 1. As we can see, the production function still shares all the neoclassical features, namely the diminishing marginal product of each input, constant returns to scale, and Inada conditions. In the MRW model, output may be devoted to consumption, accumulation of physical capital, or accumulation of human capital. The level of technology and the labour force both grow at constant exogenous rates, equal to a and n respectively (see Equation 4). Both types of capital depreciate at the same rate δ. Let sK be the income share spent on physical capital accumulation (that is, the savings rate), and sH – the income share spent on human capital accumulation. Thus, the time paths for physical capital and human capital are: . K=sKY – δK , (17) . H=sHY – δH . (18) The dynamics of the model is analysed for capital and output per unit of effective labour, denoted as k, h, and y: K k≡ ; AL H h≡ ; AL K α H β ( AL ) Y y≡ = AL AL 1−α − β = k α hβ . (19) In order to find equations describing the dynamics of the economy, we differentiate the definitions of k and h with respect to time. The result is: . k = sKy – (n + a + δ)k = sK kαhβ – (n+a+δ)k , (20) h = sHy – (n + a + δ)h = sH kαhβ – (n+a+δ)h . (21) . The above equations describe the dynamics of the economy in the MRW model. They are analogous to Equation (7) in the basic Solow model. The increase of human and physical capital per unit of effective labour is equal to the actual investment in a given type of capital net of replacement investment. In the steady-state, the capital per unit of effective labour is constant. Thus, setting (20) and (21) to zero, we get the stock of physical and human capital in 88 3. Neoclassical revival: the Mankiw-Romer-Weil (augmented Solow) model the long-run equilibrium: 1 s1K− β sHβ 1−α − β k* = , n + a +δ (22) 1 sαK s1H−α 1−α − β h* = . n + a +δ (23) Figure 2 illustrates the steady-state and the transition period in the MRW model. The dynamics of the augmented Solow model is considered in a two-dimensional space (k, h). The curves dk/dt = 0 and dh/dt = 0 in Figure 2 are determined by setting equations (20) and (21) to zero. These curves have the following functional forms: 1 . • the curve k&= 0 : β sK 1−α 1−α k = h , n + a +δ (24) 1 . • the curve h = 0 : n + a + δ α 1−αβ k = h . sH (25) Since β < 1 – α and 1 – β > α, the curve dk/dt = 0 is concave, while the curve dh/dt = 0 – convex. The steady-state is at the point of intersection between dk/ dt = 0 and dh/dt = 0 functions (point E). As in the basic Solow model, the long-run equilibrium is stable. From any starting point (e.g. A, B, C, or D), depending on the initial stock of physical and human capital, the economy is moving towards the steady-state according to equations (20) and (21). Figure 2. The transition peroid and the steady-state in the augmented Solow model k B . h= 0 C . k= 0 k* D A h* h 89 New developments in growth theory In the steady-state, physical capital, human capital, consumption, and output per unit of effective labour are all constant. This means that GDP growth rate equals the sum of technological progress and population growth (the variables exogenously given) while the growth rate of per capita GDP equals technological progress. Thus, the augmented Solow model gives the same answer as the basic Solow model and other neoclassical theories to a question about the determinants of long-run economic growth. In the MRW model, the investment rates in physical and human capital are exogenously given. Maximization of per capita consumption requires that these rates were equal to the factors’ shares in income. But in reality, the investment rates will be lower as compared with the consumption-maximizing level, because individuals value the current consumption more than the future consumption and therefore they do not choose high investment rates. This means that the MRW model reveals dynamic inefficiency. The Mankiw-Romer-Weil model, like other neoclassical approaches, confirms the existence of conditional convergence. 4. Growth empirics: growth determinants, convergence, growth accounting (TFP) Growth determinants In most of the empirical studies, economic growth determinants can be found using correlation or regression analysis. Correlation coefficient shows the relationship between the GDP growth rate and a variable tested as an economic growth determinant. In the regression equation, it is possible to test simultaneously many variables that are potential economic growth determinants. Regression equations in growth empirics usually take the following form: ggdpt = α 0 + α1 x1t + α 2 x2t + K + α n xnt + β1initialgdpt + β 2 dummyt + ε t . (26) The explained variable (ggdpt) is the GDP growth rate. The explanatory variables denoted as x1t, x2t, …, xnt are the variables that are tested as economic growth determinants. The set of these factors should be chosen by the author of a given study. The regression equation may include the GDP per capita from the previous period (initialgdpt) to control the influence of initial conditions; and/or dummy variables (dummyt) to assess the impact of a single shock on economic growth. εt is the random factor. Regression equations are estimated using various econometric techniques, e.g. ordinary least squares (OLS). Here, we present four models of economic growth derived from the author’s earlier research (Próchniak 2010a).26 The results are presented in Ta26 90 For another study of economic growth determinants in CEE-10 countries see: Rapacki, Próchniak 2010. 4. Growth empirics: growth determinants, convergence, growth accounting (TFP) ble 1. The models are estimated for the 10 Central and Eastern European countries (CEE-10). All the variables are taken as the 3-year or 2-year subperiod averages. Table 1. Empirical models of economic growth for the CEE-10 countries, 1993–2009 Variable Coefficient t-statistics p-value MODEL 1 Gross capital formation (% of GDP) General government balance (% of GDP) Lending interest rate (%) Private sector share in GDP (%) GDP per capita at PPP (constant 2005 US$) from the previous period Dummy (= 1 for the 2008–2009 period; = 0 otherwise) Constant R2 adjusted = 0.5881 n = 54 R2 = 0.6347 0.1572 0.2427 -0.0569 0.0696 1.81 2.05 -3.16 1.65 0.076 0.046 0.003 0.105 -0.0002 -2.02 0.049 -7.1788 -5.21 0.000 -0.1681 -0.05 0.962 F = 13.61 (p-value for F = 0.000) MODEL 2 Gross capital formation (% of GDP) Market capitalization of listed companies (% of GDP) General government balance (% of GDP) CPI inflation (%) GDP per capita at PPP (constant 2005 US$) from the previous period Dummy (= 1 for the 2008–2009 period; = 0 otherwise) Constant R2 adjusted = 0.5777 n = 55 R2 = 0.6246 0.1985 0.0620 0.2688 -0.0241 2.47 1.63 2.28 -3.66 0.017 0.111 0.027 0.001 -0.0002 -1.89 0.064 -4.6624 -3.92 0.000 2.0208 0.93 0.355 F = 13.31 (p-value for F = 0.000) MODEL 3 Gross capital formation (% of GDP) General government balance (% of GDP) CPI inflation (%) Private sector share in GDP (%) GDP per capita at PPP (constant 2005 US$) from the previous period Dummy (= 1 for the 2008–2009 period; = 0 otherwise) Constant R2 adjusted = 0.5547 n = 56 R2 = 0.6033 0.1510 0.2732 -0.0234 0.0971 1.78 2.26 -3.37 2.40 0.082 0.029 0.001 0.020 -0.0002 -1.56 0.126 -5.5737 -4.64 0.000 -3.0093 -1.03 0.308 F = 12.42 (p-value for F = 0.000) 91 New developments in growth theory Variable Coefficient t-statistics p-value MODEL 4 Gross capital formation (% of GDP) General government balance (% of GDP) Services, value added (% of GDP) CPI inflation (%) GDP per capita at PPP (constant 2005 US$) from the previous period Dummy (= 1 for the 2008–2009 period; = 0 otherwise) Constant R2 adjusted = 0.4895 n = 54 R2 = 0.5473 0.2125 0.1972 0.0973 -0.0220 2.59 1.56 1.50 -2.86 0.013 0.124 0.140 0.006 -0.0001 -1.34 0.186 -4.1980 -3.24 0.002 -4.2728 -0.98 0.333 F = 9.47 (p-value for F = 0.000) Estimation method: OLS. Explained variable: the growth rate of total real GDP. All the calculations are based on subperiod averages: 1993–95, 1996–98, 1999–2001, 2002–04, 2005–07, 2008–09. The models include six explanatory variables: four variables that are tested as economic growth determinants as well as GDP per capita from the previous period and a dummy variable to control the impact of global economic crisis. Among the four factors of economic growth, each equation contains gross capital formation and general government balance. The other two variables depend on the model: model 1 includes lending interest rate and private sector share in GDP, model 2 – market capitalization of listed companies and CPI inflation, model 3 – CPI inflation and private sector share in GDP, and model 4 – value added in services and CPI inflation. All these four models exhibit excellent statistical properties: explanatory variables (save a constant term) have all the expected sign and are significant with p-value less than 0.15 (only in one case p-value equals 0.19). R-square coefficients are very high ranging from 55% in model 4 to 63% in model 1. For example, R2 of 63% in model 1 means that the differences in the investment rate, budget balance, lending rate, private sector share in GDP, and initial income level (controlled for the impact of crisis) explain about 2/3 of total differentiation of the 3-year GDP growth rates in the CEE countries. If we substitute inflation rate for lending rate holding all other variables unchanged, we switch to model 3 which explains 60% of the variance in economic growth rates. This is still a very good result. In all these four models, the coefficient on initial income is negative and significant implying that our analysis confirms the existence of conditional β convergence among the new EU member countries: the negative relationship between initial GDP per capita level and subsequent GDP growth rate does occur when the other factors influencing the rate of economic growth are held constant. 92 4. Growth empirics: growth determinants, convergence, growth accounting (TFP) Convergence In empirical analyses, two most popular concepts of income-level convergence usually are tested: absolute β-convergence and σ-convergence. Absolute β-convergence exists when less developed economies (with lower GDP per capita) grow faster than more developed economies (with higher GDP per capita). σ-convergence appears when income differentiation between economies decreases over time. To verify the absolute β-convergence hypothesis, we estimate the following regression equation: 1 yT ln = α 0 + α1 ln y0 . T y0 (27) The explained variable is the average annual growth rate of real GDP per capita between period T and 0, while the explanatory variable is the log of the GDP per capita level in the initial period. If parameter α1 is negative and statistically significant, β-convergence exists. In order to verify the σ-convergence hypothesis, we estimate the trend line of dispersion in income levels between countries: sd (ln yt ) = α 0 + α1t . (28) The explained variable usually is the standard deviation of log GDP per capita levels between the economies, while the explanatory variable is the time variable. If parameter α1 is negative and statistically significant, σ-convergence exists. As an example of the empirical study, we present here the results of testing βand σ-convergence between the CEE-10 countries and the 15 old EU member states (EU-15). These findings are presented in the latest Poland’s competitiveness report published by the Warsaw School of Economics (Matkowski, Próchniak 2010). Figure 3. GDP per capita growth rate over the period 1993–2009 and the initial GDP per capital level Annual growth rate of real GDP per capita, 1993-2009 0,05 EST LAT POL SLK IRE LIT 0,04 SLV EU10 ROM 0,03 CZE HUN GRE 0,00 8,65 SPA EU10 (average) & EU15 (average) EU10 EU15 Trend line: EU10 and EU15 Trend line: EU10 (average) & EU15 (average) 8,85 LUX 2 R = 0.5485 SWE 0,02 0,01 g y = -0.0164y 0 + 0.1850 FIN BGR 9,05 9,25 POR UK EU15 BEL NET AUS DEN FRA GER ITA g y = -0.0226y 0 + 0.2424; 9,45 9,65 9,85 10,05 Log of real 1993 GDP per capita 10,25 2 R =1 10,45 10,65 10,85 93 New developments in growth theory Figure 4. Standard deviation of GDP per capita, 1993–2009 Standard deviation of log of real GDP . per capita 0,60 0,56 sd(y ) = -0.0100t + 0.6031 2 R = 0.8693 0,52 0,48 0,44 0,40 25 countries 2 regions 0,36 Trend line: country differentiation Trend line: regional differentiation sd(y ) = -0.0118t + 0.5441 2 R = 0.9251 0,32 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year The results are shown in Figure 3 and 4. The empirical analysis confirms the existence of β- and σ-convergence between the CEE-10 countries and the EU-15. The convergence has been evidenced for 25 individual countries as well as two regions (the average for the 15 old EU members and the average for the 10 new EU entrants). Growth accounting (TFP) Total factor productivity (TFP) is analyzed using the growth accounting framework. Growth accounting is based on the decomposition of economic growth initiated by Solow (1957). The starting point for this analysis is the macroeconomic production function of the following general form: Y = F(A, Z1,…, Zn), where Y – output (GDP), A – level of technology, Z1,…, Zn – measurable factor inputs. Two or three measurable factors are usually used in the empirical research: labour, physical capital, and sometimes human capital. Most of the analyses include two such factors: labour (L) and physical capital (K). Thus, the production function takes the form: Y = F(A, L, K). In order to break down the rate of economic growth, we differentiate the production function: . 94 (29) 4. Growth empirics: growth determinants, convergence, growth accounting (TFP) The above equation shows that the GDP growth rate is the weighted average of the growth rates of three factors: technology, labour, and physical capital. The weights are the factor shares in income, calculated as the marginal factor product (at the social level) multiplied by the quantity of the respective input and divided by the level of output. We assume the Hicks-neutral technological progress: F(A, L, K) = A⋅f(L, K). For such a production function, the technological share in income, i.e. the expression (∂F/∂A)A/Y in Equation (29), is simply 1. In order to calculate the TFP growth rate empirically, we have to make further assumptions concerning marginal factor products. It is impossible to estimate the marginal product at the social level. Thus, we assume that all markets are perfectly competitive and that there are no externalities. Given these assumptions, the marginal social product of capital ∂F/∂K equals the price of capital r, and the marginal social product of labour ∂F/∂L equals wage rate w. Let sK be the capital share in income (rK/Y), and sL – the labour share in income (wL/Y). Assume further that total income is obtained from labour and capital, i.e. Y = wL + rK. This yields: sK + sL = 1. Given all the above assumptions, Equation (29) can be expressed as: . . . . Y& A& K& L& = + sK + (1 − sK ) . Y A K L (30) The above equation is the basic equation in standard growth accounting. From this equation, we can calculate the TFP growth rate as the difference between the GDP growth rate and the weighted average growth rate of labour and physical capital: . . . . & YY& K & A L& K A TFP growth rate ≡ = − sK + (1 − sK ) . A Y K L (31) As an example of the empirical study, we present here the results of growth accounting for Poland. These findings are presented in the latest Poland’s competitiveness report published by the Warsaw School of Economics (Próchniak 2010b).27 27 The results of growth accounting for 27 transition countries are discussed in: Rapacki, Próchniak 2006. 95 96 contr. (% points) contr. (%) 1.9 38.0 2.1 3.8 4.3 1.0 5.0 43.0 32.4 23.5 44.2 100.0 1.0 contr. (%) growth (%) 2.2 1.6 3.0 6.8 19.0 growth (%) contr. (% points) 4.4 3.2 3.0 6.8 2007 5.0 contr. (%) 2006 100.0 contr. (% points) 1.6 25.8 1.1 18.4 3.5 55.8 6.2 contr. (%) growth (%) 3.2 2.3 3.5 6.2 2005 100.0 contr. (% points) 1.1 31.2 1.1 30.5 1.3 38.3 3.5 2004 100.0 contr. (%) growth (%) 2.2 2.2 1.3 1.2 2.0 3.7 5.3 3.5 -15.7 26.8 88.9 100.0 contr. (% points) -0.6 1.0 3.4 3.8 0.6 contr. (%) growth (%) -1.2 2.0 3.4 3.8 11.3 contr. (% points) -107.1 103.4 103.7 100.0 1.0 contr. (%) growth (%) -1.5 1.4 1.5 1.4 18.7 growth (%) contr. (% points) -3.0 2.9 1.5 1.4 2003 3.7 contr. (%) 3.5 2002 70.0 contr. (% points) -1.1 -99.1 2.2 195.5 0.0 1.1 100.0 2001 5.3 contr. (%) growth (%) -2.2 4.3 0.0 1.1 2000 100.0 contr. (% points) -0.8 -19.1 2.3 55.3 2.7 63.8 growth (%) 4.2 2.7 4.2 100.0 L -1.6 K 4.6 TFP GDP New developments in growth theory Table 2. Labour (L), physical capital (K), and TFP contribution to economic growth in Poland, 2000–2008 2008 contr. = contribution. The results are shown in Table 2. In 2000–08, Poland recorded an average TFP growth rate of 2.2% while the average TFP contribution to economic growth equaled 54.1%. Our results indicate that the increase in total factor productivity played a significant role in Poland’s economic growth. 5. Summary 1. The models of economic growth can be divided into two groups: neoclassical and endogenous models. The first ones are characterized by a neoclassical 5. Summary production function which exhibits diminishing returns to accumulable inputs and constant returns to scale. The endogenous models assume at least constant returns to accumulable inputs. The most important neoclassical approaches include the Solow, Ramsey, and Diamond models. The basic endogenous theories are the Romer learning-by-doing model, the Lucas model, and models with an expanding variety or an improving quality of products. The new growth theory also includes the Mankiw-Romer-Weil (augmented Solow) model. 2. Neoclassical growth theory does not explain well the determinants of long-run economic growth. According to these models, long-run economic growth depends on technological progress which is exogenously given. 3. The conditional β-convergence is confirmed by all neoclassical models. Endogenous growth models, however, do not confirm the existence of convergence. Some of them even indicate that economic growth increases with income suggesting rather divergence trends. Bibliography Barro, R., X. Sala-i-Martin, 2003, Economic Growth, Cambridge–London, The MIT Press. Mankiw, N.G., D. Romer, D.N. Weil, 1992, A Contribution to the Empirics of Economic Growth, Quarterly Journal of Economics, 107, pp. 407–437. Romer, D., 2006, Advanced Macroeconomics, New York, McGraw-Hill. Polish translation: Romer, D., 2000, Makroekonomia dla zaawansowanych, Warszawa, Wydawnictwo Naukowe PWN. Additional bibliography Aghion, P., P. Howitt, 1992, A Model of Growth through Creative Destruction, Econometrica, 60, pp. 323–351. Arrow, K., 1962, The Economic Implications of Learning by Doing, Review of Economic Studies, 29, pp. 155–173. Barro, R., X. Sala-i-Martin, 1995, Economic Growth, New York–St. Louis–San Francisco, McGraw-Hill. Cass, D., 1965, Optimum Growth in an Aggregative Model of Capital Accumulation, Review of Economic Studies, 32, pp. 233–240. Diamond, P.A., 1965, National Debt in a Neoclassical Growth Model, American Economic Review, 55, pp. 1126–1150. Domar, E.D., 1946, Capital Expansion, Rate of Growth, and Employment, Econometrica, 14, pp. 137–147. Grossman, G.M., E. Helpman, 1991, Quality Ladders in the Theory of Growth, Review of Economic Studies, 58, pp. 43–61. Harrod, R., 1939, An Essay in Dynamic Theory, Economic Journal, 49, pp. 14–33. 97 New developments in growth theory Inada, K.-I., 1963, On a Two-Sector Model of Economic Growth: Comments and a Generalization, Review of Economic Studies, 30, pp. 119–127. Kaldor, N., J.A. Mirrlees, 1962, A New Model of Economic Growth, Review of Economic Studies, 29, pp. 174–192. Koopmans, T.C., 1965, On the Concept of Optimal Economic Growth, in: The Econometric Approach to Development Planning, Amsterdam, North Holland. Lucas, R.E., 1988, On the Mechanics of Economic Development, Journal of Monetary Economics, 22, pp. 3–42. Matkowski, Z., M. Próchniak, 2010, Real Convergence or Divergence in GDP Per Capita, in: Poland. Competitiveness Report 2010. Focus on Clusters (ed. M.A. Weresa), Warsaw, World Economy Research Institute, Warsaw School of Economics, pp. 42–56. Próchniak, M., 2010a, Economic Growth Determinants in the 10 Central and Eastern European Countries, 1993–2009. Paper presented at the EuroConference 2010 ‘Challenges and Opportunities in Emerging Markets,’ organised by the Society for the Study of Emerging Markets, Milas (Turkey), 16–18 July. Próchniak, M., 2010b, Total Factor Productivity, in: Poland. Competitiveness Report 2010. Focus on Clusters (ed. M.A. Weresa), Warsaw, World Economy Research Institute, Warsaw School of Economics, pp. 171–179. Ramsey, F., 1928, A Mathematical Theory of Saving, Economic Journal, 38, pp. 543–559. Rapacki, R., M. Próchniak, 2006, Charakterystyka wzrostu gospodarczego w krajach postsocjalistycznych w latach 1990–2003 (The Characteristics of Economic Growth in Post-Socialist Countries, 1990–2003), Ekonomista, 6, pp. 715–744. Rapacki, R., M. Próchniak, 2010, Wpływ rozszerzenia Unii Europejskiej na wzrost gospodarczy i realną konwergencję krajów Europy Środkowo-Wschodniej (The Impact of EU Enlargement on Economic Growth and Real Convergence of the CEE Countries), Ekonomista, 4, pp. 523–546. Rebelo, S., 1991, Long-Run Policy Analysis and Long-Run Growth, Journal of Political Economy, 99, pp. 500–521. Romer, P.M., 1986, Increasing Returns and Long-Run Growth, Journal of Political Economy, 94, pp. 1002–1037. Romer, P.M., 1990, Endogenous Technological Change, Journal of Political Economy, 98, pp. S71–S102. Shell, K., 1966, Toward a Theory of Inventive Activity and Capital Accumulation, American Economic Review, 56, pp. 62–68. Sheshinski, E., 1967, Optimal Accumulation with Learning by Doing, in: Essays on the Theory of Optimal Economic Growth (ed. K. Shell), Cambridge, MA, The MIT Press, pp. 31–52. 98 5. Summary Solow, R.M., 1956, A Contribution to the Theory of Economic Growth, Quarterly Journal of Economics, 70, pp. 65–94. Solow, R.M., 1957, Technical Change and the Aggregate Production Function, Review of Economics and Statistics, 39, pp. 312–320. Swan, T.W., 1956, Economic Growth and Capital Accumulation, Economic Record, 32, pp. 334–361. Uzawa, H., 1964, Optimal Growth in a Two-Sector Model of Capital Accumulation, Review of Economic Studies, 31, pp. 1–24. Uzawa, H., 1965, Optimal Technical Change in an Aggregative Model of Economic Growth, International Economic Review, 6, pp. 18–31. 99 CHAPTER SEVEN Ryszard Rapacki The economics of transition 1. Understanding transition According to the widely accepted view, societies can be organized along the lines of two diametrically distinct institutional models, that is the market versus the central planning model in the economy, and the political democracy versus dictatorship model in the society in general.28 Whereas most ‘Western’ countries implemented the basic principles of the market-democracy system, the ‘Eastern’ countries applied the central plan-dictatorship model in a relatively pure form (Heiduk, Rapacki 2009).29 The turn of the 1980s and 1990s witnessed a dramatic change in this well-structured picture. With Poland in the late-1989 as a trail-blazer, the vast majority of ‘Eastern’ countries decided to start transforming their economic and political systems and to enter the road from the central plan to the market and from dictatorship towards political democracy. The group of transition countries (as they soon began to be named) comprised 28 members in East-Central and South-Eastern Europe and in Central Asia that regained their full political sovereignty or emerged as new independent state entities after the breakdown of the Soviet Union or the split of the former federal states (Yugoslavia and Czechoslovakia).30 28 Whether the market and democracy models on the one hand and the central plan and dictatorship models on the other are necessarily complementary remains a controversial issue. 29 The institutional system in some ‘Eastern’ countries in Asia (such as in particular China) does not fully fit this simple distinction as it exhibits a number of hybrid features. It is often dubbed a ‘developmental state model’ where political power is cemented over decades, and networks between politics, administration and business overlap or even overrule market mechanisms. 30 It has to be stressed, however, that – while talking about transition from plan to market – many scholars, politicians and representatives of international organizations alike – used to further extend the coverage of this category and include some countries of Eastern and South-Eastern Asia, 101 The economics of transition For the purpose of the present text we will confine the notion of systemic transformation to its narrower, economic dimension alone and define it as a long-term process that changes an economic system into an opposite one. Here, we will focus on a particular direction of this process, i.e. a shift from a centrally-planned economy to a market-driven one. In order to be successful, systemic transformation requires the implementation of the whole package of comprehensive and in-depth reforms – institutional, legislative, regulatory, organizational, etc. – that change the very nature of the economic system involved. The second key term that needs to be defined for the sake of the ensuing discussion is transition. The latter is closely interrelated with the notion of systemic transformation and means the road or the direction to be followed (including the target to be arrived) once a country decides to depart from the economic system based on central planning. Hence, transition economies are the former socialist countries, which are on the road from central plan to the market. It is also worth emphasizing that, based on our definition and the very etymology of the word ‘transition,’ it may be inferred that the present status of transition countries is only temporary – as soon as they succeed in building a fully-fledged market economy they will not any longer be considered ‘transitory.’ The length and outcomes of the transformation process critically depend on the initial conditions as well as on the timing and sequencing of systemic reforms. The former are shaped by a country’s past political, economic, socio-cultural and demographic trajectories (including the centrally-planned or command economy legacy31)32 as well as by its geographical location. The timing and sequencing are a derivative of the choice of transformation strategy (or reform path) and the commitment to reform of political decision-makers. In the most general terms, the choice of the reform path can be made essentially between the two extreme approaches: that of a shock therapy or a ‘big bang’ and that of a gradual change. The former concentrates the bulk of fundamental reforms at the beginning of transition. Because of the expected short time span involved, it might be difficult to unequivocally disentangle the sequencing of reform measures. The outcome seems to be highly uncertain due to possible cumulative effects, constructive or destructive, of various policies that are introduced at the same time. On the other hand, the gradualist approach requires a long-term timing and sequencing strategy with well-defined and well-managed transition phases. Sudden stops are possible. Under such an environment some problems with measuring the results of reforms may arise. Causal links might be reduced, disturbed or even reverted. which initiated market reforms on a limited scale well before 1989 (for China, for example, the starting year was 1978). This sub-group comprises in particular China, Mongolia and Vietnam. 31 For an extensive discussion of this problem, see e.g. Rapacki, Linz 1992. 32 As a general finding, it may be claimed that in this respect systemic transformation of former socialist countries towards the market system appears to follow a more universal pattern in the development of institutions, i.e. the path dependency. 102 1989 1989 1989 1989 1989 1989 1989 1991 1991 1978 Poland Hungary Czech Rep. Slovakia Slovenia Romania Bulgaria Russia Ukraine China Not relevant Not relevant 1990 1994 1991 1995 1995 1994 1991 (big bang) 1965 (gradual) 1990 (big bang) 1991 (big bang) 1992 (big bang) 1994 (big bang) 1984 (dual) 1995 1968 (gradual) 1991 (big bang) 1990 1990 (big bang) 1980 1992 1995 1994 1993 1990 1993 1993 1988 1992 Liberalization Stabilization Tax reform Source: Adapted from Roland 2000. Political reform Country 1978 1992 1992 1993 1991 1965 1991 1991 1982 1990 Entry Table 1. Stylized facts about the speed and sequencing of transition 1995 (gradual) 1994 (gradual) 1993 (mass) 1994 (gradual) 1991 (gradual) 1993 (gradual) 1992 (gradual) 1992 (mass) 1990 (gradual) 1990 (gradual) 1995 (gradual) 1995 (gradual) 1992 (gradual) 1991 1993 (gradual) 1989 (gradual) 1993 (gradual) 1993 (gradual) 1992 1993 (gradual) - - 1993 1994 1995 1989 1993 1993 1992 1992 Enterprise Bankruptcy Privatization restructuring reform - 1995 1992 1997 - 1993 1991 1991 1991 1993 Banking reform 1. Understanding transition 103 The economics of transition Between these two extreme approaches, there is also a third option available. Depending on the political decision-makers’ assessment of the initial conditions, their attitudes towards risk and their internal homogeneity and strength, mixed approaches are a feasible alternative (Heiduk, Rapacki 2009). As an illustration, Table 1 provides a summary of key stylized facts on the speed and sequencing of transition in ten selected transition economies. These facts combined can simultaneously indicate the kind of a reform path or transition strategy adopted in particular countries. In addition to nine East-Central European countries singled out earlier in the text, the table also includes China, i.e. a country that embarked on a ‘dual-track’ reform strategy. The latter can serve as a useful reference point, representing the third feasible approach to systemic transformation. 2. Applicability of standard economic theories Given its scale, complexity and the nature of problems to be tackled, it goes without saying that the process of systemic transformation or transition from socialist central planning to market allocation of goods and resources has been historically unprecedented. What is of particular significance for our discussion, while embarking on systemic transformation the countries involved not only lacked a relevant empirical reference point, in terms of actual experience of other countries; at the same time they could not rely on a well-formulated underlying theoretical framework to cope with multiple social, economic and political challenges inherent to the process of transition (Rapacki, Linz 1992). On the one hand, for obvious reasons the economic ideology that dominated the public debate and teaching curricula in socialist countries until 1989, disguised under the brand of ‘economic theory’ (i.e. the duo of ‘political economy of socialism’ and its twin sister – ‘the political economy of capitalism’), could not offer any useful hint or guidance on how to switch from socialism to capitalism. Much the same holds true – though for different reasons – for two other insights provided by the economic theory – the current called ‘sovietology’33 and – to a lesser extent – comparative economic systems.34 While the former focused on explaining the ‘modus operandi’ of the centrally-planned economy, seen from the Western perspective, the latter embarked on a comparative analysis of two competing economic systems. Admittedly, they shared two common features – they both displayed the symptoms of being backward-looking and – in a way – 33 The most prominent representatives of this current included such reputed scholars as – inter alia – George Blazyca, Morris Bornstein, Phil Hanson, Michael Kaser, David Kemme, Paul Marer, Alec Nove, and Mario Nuti. 34 Yet, some elements and conclusions of this branch of economics have been later implemented as useful guidelines for transition strategies within a broader framework of the Washington Consensus. See Section 3.2 of this text. 104 2. Applicability of standard economic theories static. This is equivalent to say that the research programs conducted by the two currents were apparently based on an implicit assumption of a ‘systemic status-quo.’ Even if they both were capable of describing and interpreting changes (reforms) occurring within each of the two systems, they had little to say on the transition from one system to another and in particular – from socialism to capitalism. On the other hand, the intellectual offer provided by the orthodox economic theories has not proved particularly well-suited to respond to the challenges posed by systemic transformation (at least at its early stages) either. The key reason behind a limited applicability of the theoretical frameworks embedded in ‘mainstream’ macroeconomics was the fact that they originally emerged and evolved with the overriding objective to explain the operation of a mature market economy relying on a well-developed institutional infrastructure. As a consequence, their explanatory power with regard to transition economies, which – especially at the initial phase of their transformation – displayed strong syndromes of a ‘systemic vacuum’35 turned out to be significantly constrained. This general shortcoming has been additionally strengthened in case of three major schools within the ‘mainstream’ macroeconomics – i.e. the real business cycle theory, the new classical school and the monetarist school – due to the set of specific assumptions embedded in the ‘hard core’ and the ‘protective belt’ of their research approach and regarding the way the market economy operates.36 The assumptions in question, which have apparently been incompatible with the ‘modus operandi’ of the emerging transition economies, include in particular a deterministic belief in full predictability of the outcomes of economic agents’ acts and decisions as well as in the rational nature of choices they make (hard core). Similarly, the assumption of perfectly competitive markets as a dominant mechanism of resource allocation and a belief in their automatic or semi-automatic clearing in a transition economy (protective belt) seem overly optimistic. Having faced this inconsistency the economic profession split in the prevailing views on the most appropriate research approach to systemic transformation. One group of economists believed that the unique nature of transition from plan to market called for a ‘Grand Theory,’ specific for this particular historical process (see e.g. Lavigne 1999). According to the opposite view, as the process of transition is by definition temporary, it has not required a specific theory, the more so the closer were the former socialist countries to the end-point on their road towards a fully-fledged market economy. Seen from this angle, the argument went, it would suffice to capitalize on the available economic theories or their blends, especially those ‘off-mainstream,’ perhaps with some 35 This is to say that while the central planning was already dismantled in these countries, the market mechanism has not yet been put on place. See e.g. Blazyca, Rapacki 1991; Nuti 1993 and 1996. 36 See Lakatos 1978; for a more detailed discussion of the methodological framework involved you can refer back to Chapter 1 of this textbook. 105 The economics of transition adjustments, amendments or extensions. With the benefit of hindsight, we know today that this was the second view that gained the most support and popularity among economists. As a result, in order to fully understand the nature of systemic transformation and to provide workable policy prescriptions, various analytical frameworks, including in particular ‘heterodox’ economic theories, have been used (Lavigne 1999). The first approach relied on the public choice theory, which applies the tools of economics to non-market decision-making, with a special emphasis on political decisions (see e.g. Murrell 1991). The proponents of this approach believed that the process of systemic transformation is very much determined by political factors. The second theoretical framework that was frequently called upon while studying the process of transition was the theory of the firm. Here, the focus shifted from the political stage to the microeconomic level or to enterprise as the core element of the transformation process. Within this approach, a special emphasis was laid upon such themes as property rights, transaction costs, industrial organization theory, incentives theory, principal-agent framework, decision-making in organizations in a context of bounded rationality, strategic behaviour and information asymmetry (see e.g. Frydman, Rapaczynski 1994; Frydman et al. 1993; Wijnbergen 1993). The third most prominent current in the economic literature dealing with systemic transformation has been rooted in the new institutional economics (or NIE). Compared to both the public choice theory and the theory of the firm, the latter has taken a much more comprehensive perspective on the key drivers of and interrelationships inherent to transition. One of the most representative approaches within this current was based on the evolutionary economics. It looked at the process of systemic transformation from a broad, historical angle and interpreted it as one more, specific path conducive to capitalism within a more universal phenomenon, i.e. the historical evolution of the market economy-political democracy system. The evolutionary view on the nature and course of transition from socialism to capitalism has been most extensively elaborated in the works of Peter Murrell and Yijiang Wang (1992, 1993 and 1995). The problem with the evolutionary view, however, is that it does not provide clear insights into what is going to happen next, once the market infrastructure is established (Lavigne 1999).37 37 It is worth emphasizing that since the very outset of systemic transformation there has not been a clear vision among the politicians and scholars of what exactly kind of capitalism ought to be built in particular transition countries. This assertion may sound striking given the varieties of capitalism existing just in the Western world (the Anglo-Saxon model, the Continental model, the Nordic model, and the Mediterranean or South European model, to name just the major ones) and surprisingly vast room allowed in many areas in the European Union for applying particular institutional arrangements in individual member countries. For details, see e.g. Hanson 2006 and 2007. 106 3. What has economics learned from transition? In the light of our earlier reservations regarding a limited applicability of the ‘mainstream’ macroeconomics in addressing the challenges inherent to the initial stages of systemic transformation, in may come as a surprise that this was notwithstanding the orthodox economics that ranked among the most influential (if not a number one) currents dealing with transition in the beginning of the 1990s. The blend of orthodox microeconomic and macroeconomic theory, that since 1989 has come to be dubbed a Washington Consensus view,38 got a strong support from international donor organizations and the most prominent representatives of the academic community, as an intellectual basis for standard reform packages advocated to transition countries. The great popularity of the Washington consensus, however, may not be that surprising if we look at the reasons behind its rise from the perspective of vested interests involved rather than just its intellectual content and merit. 3. What has economics learned from transition? 3.1. General lessons The hitherto transition experience, especially of those former socialist countries that managed to successfully transform their centrally planned economic systems into market-driven ones authorizes a number of useful lessons of a general nature. The following such lessons deserve special attention (see Rapacki, Heiduk 2009). 1. Shock therapy vs. gradualism. In a number of former socialist countries, and in particular in Poland, deep macroeconomic imbalances at the start of the process of systemic transformation39 called for a radical approach. As a general lesson, the choice and design of transformation strategy should take into account the initial conditions of the country involved including the command economy legacy. 2. Sequencing of the reforms. The pace and sequence of implementing particular components of the reform package depend again on initial conditions. If a deep macroeconomic disequilibrium is pervasive, a radical stabilization policy should be given priority, while the bulk of institutional reforms may be undertaken once basic equilibrium in the economy is restored. On the other hand however, some basic institutional changes even at the early stage of transition 38 The term Washington Consensus was initially coined in 1989 by John Wiliamson to describe a set of ten economic policy prescriptions that in his view should constitute the ‘standard’ reform package promoted by Washington-headquartered international financial institutions, such as the IMF and the World Bank, for developing countries affected by economic crises. The package rested on three pillars or catch-words: stabilization, liberalization and privatization. Subsequently, the term has come to be used in a different and broader sense, as a synonym for market fundamentalism and neoliberal policies in general. For more details, see Rodrik 2006. 39 See e.g. Blazyca, Rapacki 1991. 107 The economics of transition are crucial for the success of systemic transformation, as complexity is required to create the ‘critical mass’ of the reforms and to make them irreversible. Although the institutional changes may take a more evolutionary course, they should be implemented in their full complexity to ensure a positive synergy and the necessary complementarities. 3. As the experience of systemic transformation clearly demonstrates, at the early stages of institutional reforms a threat of ‘systemic vacuum’ may appear: the central planning system has been already dismantled, but the market mechanism has not yet become fully operational. 4. Relevance of historical traditions.40 With a view to making the transition more effective and to enhance its successful completion, it is advisable that the design of the transformation strategy and the accompanying economic policies be compatible with the national ‘identity’ or the prevailing pattern of personal characteristics of a country’s inhabitants. As a matter of illustration, the pertinent patterns established during systemic transformation in Poland can provide some useful lessons. Worth highlighting in this context is the significance of – historically determined – individual initiative and entrepreneurial flair as key drivers of Polish privatization in particular and systemic transformation in general after 1989. 5. The role of behavioral factors. Among the most critical (yet often underestimated or neglected) determinants of the transition process, the behavioral patterns inherited from the command economy are of particular importance. They encompass, inter alia, social perceptions, labour relations, egalitarian attitudes, a distorted work ethos, pervasive risk-averse behaviour, vested interests and widespread rent-seeking activities. As we have shown in other studies,41 being deeply rooted in the outgoing system the behavioral patterns in question tend to exhibit a strong persistence and inertia, thus impeding a smooth systemic transformation and inflating its costs. 6. The importance of the ‘external anchor.’ Given the recent experience of ten Central and Eastern European transition economies (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Romania, Slovakia and Slovenia), it can be inferred that the existence of an ‘external anchor’ or the prospect of EU membership can significantly accelerate the process of institutional reforms in the candidate countries. As shown, inter alia, in annual EBRD assessments,42 countries invited to join the European Union initiated their reforms earlier, implemented them much more effectively and with greater commitment, and today are much more advanced in the reform process than the remaining former communist countries. Moreover, the use of this ‘anchor’ can lead to different 40 In his famous book, El laberinto de la soledad, the Mexican Nobel prize-winner Octavio Paz went to an extreme, arguing that the contemporary Mexican identity was deeply rooted in the remote past, dating back to pre-Columbian times. See Paz 1959. 41 Rapacki, Linz 1992. 42 See e.g. EBRD 2008. 108 3. What has economics learned from transition? reform paths not only within the group of transition economies, but also in a much broader sample of countries. According to an IMF study, the quality of institutions in the new EU member states is currently higher on average than in other countries in the world at a comparable level of development. On the other hand, in the remaining transition economies, particularly CIS countries, the development of the institutional market infrastructure is slightly lower than in other countries with a similar level of GDP per capita.43 7. The experience of systemic transformation has shown that – even in the most successful transition countries – apart of desired or anticipated results, side effects or negative surprises may occur too. Instead of growth and prosperity, reform programs implemented in many countries tended to deliver rent seeking, stealing, corruption and economic decline. Simultaneously, in about all transition economies the process of systemic transformation was associated with growing income and wealth disparities. 8. The exchange rate regime and macroeconomic performance. Finally, as the experience of CEE transition economies indicates, a significant role as explanatory variable of the macroeconomic performance during systemic transformation has been played by the exchange rate regime adopted in a given country. The empirical evidence has shown that the transition economies with fixed exchange rate regimes (including those with currency board arrangements) or ‘fixers’ tended to display high rates of economic growth coupled with a relatively large scale of macroeconomic imbalances (in particular, excessive inflation and current account deficits). The opposite was true for those transition economies with floating exchange rate regimes (‘floaters’) – while economic growth there has been on average slower compared to ‘fixers,’ the scale of macroeconomic disequilibrium has been smaller (Rapacki, Heiduk 2009). 3.2. Diverging interpretations of transition While undertaking research programs on systemic transformation and making the pertinent policy recommendations economists tended to subscribe to either of two broad interpretations or visions of this process: the Washington Consensus view or the institutionalist-evolutionary perspective (Roland 2000). The former used to be also labeled – somewhat over simplistically – the big-bang or shock therapy view, and the latter the gradualist or incrementalist view. In this section, we aim to briefly summarize the differences between these two main visions of transition, both in terms of their theoretical underpinnings and practical implications. The Washington Consensus view on transition dominated the economic thinking in the beginning of systemic transformation. It strongly influenced the policy recommendations from international financial organizations (like 43 See IMF 2002, p. 102. 109 The economics of transition the IMF and the World Bank) and was supported by top economists from the leading Western universities (to mention only Jeffrey Sachs and Stanley Fischer). Intellectually, it is embedded in a blend of: (1) standard neoclassical price theory, (2) standard macroeconomics and international experience with stabilization programs, and (3) core elements of the theory of comparative economic systems (Roland 2000). The institutionalist-evolutionary perspective was a minority view at the outset of systemic transformation; however, it has gained an increasing support (particularly in academic circles) over time, as a function of the cumulative transition experience. Intellectually, it is rooted in (1) new institutional economics and its methodology shaped in particular by the development of non-cooperative game theory, (2) evolutionary economics, and (3) a philosophical skepticism, influenced by Hayek and Popper, with a strong emphasis on our relative ignorance of the dynamics of economic and social systems including their transformation, a stress on the uncertainty associated with societal engineering, and a strong aversion toward a Jacobin or Bolshevik-style one-shot, radical institutional transformation (Roland 2000). Table 2 provides a simplified summary of the most salient features of these two opposing visions of transition. The table content has been organized under three broad headings, i.e. (i) the political economy of reforms and their strategies, (ii) allocative changes, and (iii) governance changes. Table 2. A simplified summary of two different visions of systemic transformation Institutionalist-evolutionary perspective 1. The political economy of reforms and reform strategies Insistence on sure efficiency Insistence on aggregate Attitude toward gains; faith in social uncertainty; skepticism toward uncertainty engineering societal engineering Political economy Use of window of opportunity Ensuring continuous and emphasis to create irreversibility growing support for reforms Dependent on sequencing; can View of partial Creating rents that block either create momentum or stall reforms further reform progress reform process Very important but Of absolute importance. comprehensiveness of initial Necessity to jump-start reforms not necessary provided View of reform the market economy by initial reforms can create complementarities simultaneous introduction of momentum for further reforms. all key reforms Transitional institutions can develop and evolve gradually Middle class and new private Main support group Owners of privatized SOEs for reforms sector Washington consensus 110 3. What has economics learned from transition? Creation of institutional underpinnings of markets Focus of reforms to encourage strong entrepreneurial entry Comprehensive: legal and financial change, law Attitude toward Emphasis on adoption of laws enforcement, reform of institutional change government, development of self-enforcing social norms Using existing institutions to Creation of tabula rasa Attitude toward prevent economic disruption conditions by breaking existing and social unrest while initial conditions communist state structure developing new institutions Liberalization, stabilization, privatization 2. Allocative changes Main view of markets and liberalization Main attitude toward inefficient SOEs Main view of government Importance of institutional underpinnings needed to enhance market growth: Markets will develop minimum legal and contracting spontaneously provided environment, law enforcement, government does not political stability, building of intervene; supply and demand business networks and longas focus of analysis term partnerships; contracting agents and their institutional environment as unit of analysis Containment and politically feasible downsizing. Rely on Aggressive closing down evolutionary development of private sector to shrink state sector Weakening it as much Role of government in law as possible to prevent enforcement and in securing intervention in markets property rights 3. Governance changes Focus of privatization Fast transfer of ownership in private hands via mass privatization to break government power and jumpstart market economy. Faith in market to ensure efficient resale Main emphasis of Shrinking the size of government reform government Hardening budget constraint Exogenous policy choice that depends on political will Emphasis on organic development of private sector. Emphasis on sales to outsiders to achieve efficient transfer of ownership from the start Reform in the organization of government so as to align as much as possible the interests of government bureaucrats with the development of markets Endogenous outcome of institutional changes Source: Roland 2000. 111 The economics of transition 3.3. Transition research and economics As a result of research on transition, economics has learned a great deal of useful lessons. Many findings in transition literature may well be generalized and applied in institutional setups other than the specific context of systemic transformation alone. The main impact of research on systemic transformation of former centrally-planned economies into market-driven ones on the development of economic science in general consists in reinforcing the institutionalist perspective in economics. As a derivative, the focus of economic research has shifted from markets and price theory to contracting and the institutional environment (legal, social and political) of effective contract enforcement (Roland 2000). The key determinants of this trend included – on the one hand – the side effects or negative surprises associated with the implementation of reform strategies based on the Washington consensus (deep and prolonged output fall, government collapse, failures of mass privatization schemes) and on the other hand – positive experience of Chinese transition. In general, it turned out that the pillars of the Washington consensus, i.e. stabilization, liberalization and privatization policies, if not supported by adequate institutions, may not ensure successful outcomes. It is also worth emphasizing that transition studies have not only reinforced the existing perspective of the new institutional economics, but have simultaneously stimulated the exploration of new and more complex areas such as e.g. the dynamics of institutional change in the evolutionary perspective (Roland 2000). Moreover, much of the results in the transition research extend well beyond this particular area and have much broader and more universal implications. For example, the conclusions regarding the political economy of systemic transformation apply to other contexts such as the European integration or reforms in Latin America where problems of speed, sequencing and complementarities of reforms, and momentum effects play a vital role. Similarly, while dual-track liberalization is originally an institution inherent to transition in China, its principles apply to other kinds of reform in other countries such as e.g. labour market reform and pension reform. The analysis of liberalization and the output fall may also apply to all situations of unexpected liberalization – for instance the liberalization of capital markets in emerging economies. The same holds true for different institutional setups and their effect on solving coordination problems related to law enforcement. The economics of the soft budget constraint inherent to systemic transformation may also have much more general applications, that range from problems of bank bailouts (including the recent sub-prime financial crisis in the U.S.) to understanding the East Asian crisis of the end-1990s. The analysis of institutional mechanisms that harden the budget constraint also goes beyond 112 4. Summary and conclusions the experience of transition to include such issues as the role of fiscal federalism, decentralization of banking and banking reform and prudential regulation (Roland 2000). 4. Summary and conclusions As a wrap up of our discussion in this chapter, the following points are worth making. 1. Systemic transformation is a long-term process that changes a centrally-planned economy into a market-driven one. In turn, transition means the road or the direction to be followed once a country decides to depart from the economic system based on central planning. In the most general terms, the choice of the reform path is between two extreme approaches: a shock therapy and a gradual change. Mixed strategies or a dual-track approach is the third feasible option. 2. At the time of embarking on systemic transformation the countries involved could not rely on a well-formulated underlying theoretical framework. As a result, various analytical frameworks, including in particular ‘heterodox’ economic theories and – despite its limited applicability – some blends of the ‘mainstream’ economics, have been used. 3. While undertaking research programs on systemic transformation and making policy recommendations, economists tended to subscribe to one of the two broad visions of this process: the Washington Consensus view or the institutionalist-evolutionary perspective. 4. The main impact of research on transition on economic science in general has been to reinforce the institutionalist (or NIE) perspective in economics. 5. Moreover, economics has learned a great deal of useful lessons from transition. Many findings in transition research can be generalized and applied in a wide range of institutional contexts other than that of systemic transformation. Bibliography Blazyca, G., R. Rapacki (eds), 1991, Poland into the 1990s. Economy and Society in Transition, London, Pinter. EBRD, 2008, Transition Report 2008, London, November. Frydman, R., E.S. Phelps, A. Rapaczynski, A. Shleifer, 1993, Needed Mechanisms for Corporate Governance and Finance in Eastern Europe, Economics of Transition, vol. 1, no. 2, June, pp. 171–207. Frydman, R., A. Rapaczynski, 1994, Privatization in Eastern Europe: Is the State Withering Away?, Budapest, London and New York, Central European University Press. Hanson, P., 2006, The European Union’s Influence on the Development of Capitalism in Central Europe, Mimeo, London. 113 The economics of transition Hanson, P., 2007, The Task Ahead in Comparative Economic Studies: What Should We Be Comparing?, Japanese Journal of Comparative Economics, vol. 44, no. 1, January. Heiduk, G., R. Rapacki, 2009, The Road from Plan to Market: Comparing Poland and China, in: Driving Forces of Socialist Transformation. North Korea and the Experience of Europe and East Asia, eds. R. Frank, S. Burghart, Wien, Praesens. IMF, 2002, World Economic Outlook 2002, Washington D.C. Lakatos, I., 1978, The Methodology of Scientific Research Programmes, Cambridge, Cambridge University Press. Lavigne, M., 1999, The Economics of Transition. From Socialist Economy to Market Economy, Houndmills and London, MacMillan Press. Murrell, P., 1992, Conservative Political Philosophy and the Strategy of Economic Transition, Eastern European Politics and Societies, vol. 6, no. 1, pp. 3–16. Murrell, P., 1995, The Transition According to Cambridge, Mass., Journal of Economic Literature, vol. 33, March, pp. 164–178. Murrell, P., Yijiang Wang, 1993, When Privatization Should be Delayed: The Effect of Communist Legacies on Organizational and Institutional Reforms, Journal of Comparative Economics, vol. 17, no. 2, pp. 385–406. Nuti, M.D., 1993, Economic Inertia in the Transitional economies of Eastern Europe, in: Impediments to the Transition in Eastern Europe, eds. M. Uvalic, E. Espa, J. Lorentzen, Florence, European University Institute, pp. 25–49. Nuti, M.D., 1996, Transition or Mutations: for a New Political Economy of PostCommunist Mutations, Emergo, Journal of Transforming Economies, no. 7, Winter, pp. 7–15. Paz, O., 1959, El laberinto de la soledad, Mexico, D.F., Fondo de Cultura Económica. Rapacki, R., S.J. Linz, 1992, Privatization in Transition Economies: Case Study of Poland, Econometrics and Economic Theory Papers, no. 9011, Department of Economics, Michigan State University, East Lansing. Rapacki, R., G. Heiduk, 2009, The Road from Plan to Market: Lessons from the Experience of Poland, paper presented at the international conference on Korea and East Asia: Transformation of Socialist Systems, University of Vienna, 13–14 February. Rodrik, D., 2006, Goodbye Washington Consensus, Hello Washington Confusion?, Journal of Economic Literature, vol. XLIV, December, pp. 969–983. Roland, G., 2000, Transition and Economics. Politics, Markets and Firms, Cambridge, The MIT Press. Wijnberger, S. van, 1993, Enterprise Reform in Eastern Europe, Economics of Transition, vol. 1, no. 1, January, pp. 21–59. 114 CHAPTER EIGHT Piotr Maszczyk Do we have to change capitalism – the alterglobalist view To sum up the alteglobalists point of view on the modern economy and economics (this chapter is dedicated to the presentation of such perspective using the opinions of most prominent economists who sympathize with this movement, e.g. Stiglitz, De Soto, Serra, Sen, Fitoussi and many others) it is good to start with their most important thesis, which they have presented since the beginning of the current crisis. Their way of thinking is mostly like that: the global economy is passing the near-death experience, which is exposing not only flaws in the prevailing economic model but also flaws in developing and developed world society. Then all of us (which in their way of thinking is equal to civilization or mankind) should take this moment as one of reckoning and reflection, of thinking about what kind of society we would like to have and ask our political and economic leaders but ourselves as well, are we creating an economy that is helping us achieve those aspirations? From the alteglobalists perspective, human civilization has gone (and what is far more important is still going) far down an alternative path-creating a society in which materialism dominates moral commitment, in which the rapid growth that we have achieved is not sustainable environmentally and socially, in which we do not act together as a community to address our common needs, partly because rugged individualism and market fundamentalism have eroded any sense of community and have led to rampant exploitation of unwary and unprotected individuals and to an increasing social divide. Too many people had taken advantage of others. A sense of trust had been broken. There has been huge and widespread erosion of trust – and not just in the financial institutions (Stiglitz 2010). By now (end of 2010) economic system was saved, but at the 115 Do we have to change capitalism – the alterglobalist view cost that is still hard to believe (this cost is currently creating next wave of problems as a public indebtedness) and which would be paid by lots of next generations. But, and that’s what is positive in alterglobalists way of thinking, it is not too late to change this situation. 1. Materialism versus moral commitment If there is any lesson (in a broader sense) from the current crisis, it is like that: there is a need for collective action – there is a role for government, as the most prominent representatives of the alterglobalists movement have repeatedly emphasized. Politicians and all of the economical agents allowed markets to blindly and freely shape the economy, and in doing so they also shaped us and our society. And from the alterglobalists perspective the way that they have been shaping us is not what the society wanted and what it wants for future. Standard economic theory assumes that individuals are born with fully formed preferences. Many people came to believe in the theory that salary (or more broadly income) reflected social contributions and they concluded that those who received such high income must have been making the most important social contributions. And many people came to value what the market was valuing. The high pay of let’s say bankers indicated that banking was important. How the market has altered the way we think is illustrated by attitudes towards an incentive pay. After the Second World War and till the 1980s there used to be a social contract about the reasonable division of the gains that arise from acting together within the economy. Within American corporations the salary of the executive people used to be forty times of the average worker, a seemingly large number, larger than in Europe and Japan. But then something happened in the 1980s when Margaret Thatcher and Ronald Reagan came into power. Alterglobalists, as the critics of current situations stress that any sense of fairness in compensation was replaced by how much the executives could appropriate for themselves. This change in attitude to fairness and sense of equity has sent strong messages to which the youth respond and in doing so the whole society has been shaped. When the government tax the returns to speculation at much lower rates than the income of those who work hard for an income, not only encourages more young people to go into speculation, but it says, in effect, that as a society we value speculation more highly. Much has been written about the foolishness of the risks that the financial sector undertook, the devastation that the financial institutions have brought to the economy, and the fiscal deficits that have resulted; too little has been written about the underlying ‘moral deficit’ that has been exposed – a deficit that may be larger and even harder to correct. The unrelenting pursuit of profits and the elevation of the pursuit of self-interest may not have created the prosperity that was hoped, but they did help create the moral deficit. 116 2. Economics and lack of moral responsibility There was perhaps a fine line between creative accounting and deceptive accounting – a fine line that the financial sector in the U.S. (but also in many European countries) has crossed time and time again, including a few short years ago, in the WorldCom and Enron scandals. It is not always possible to distinguish between incompetence and deception, but it is not likely that a firm claiming to have a net worth of more than a hundred billion dollars would suddenly find itself in negative territory without knowing that its accounting was deceptive. It is not believable that the mortgage originators and the investment bankers didn’t know that the products they were creating, purchasing, and repackaging were toxic and poisonous (and in Polish case, for example, that forward transactions sold to the enterprises were connected to the very low risk or even they were risk free). The investment bankers would like people to believe that they were deceived by those who sold the mortgages to them. But they were not. They encouraged the mortgage originators to go into the risky subprime market because it was only through the ample supply of mortgages and the transformation of the risky assets into new products that they earned the fees and generated the returns that, through leverage, made them look like financial wizards. If they were deceived, it was because they didn’t want to know. It is possible that a few didn’t know what they were doing, but they are also guilty then, of a different crime, that of misrepresentation, claiming that they knew about risk when clearly they did not (Stiglitz 2010). Exaggerating the virtues of one’s wares or claiming greater competency than the evidence warrants is something people might have expected from many businesses, though the extent was almost surely outsized, just as were the egos and the pay. Financial institutions discovered that there was money at the bottom of the pyramid and did everything they could within the law (and many went beyond the law) to move it toward the top. But instead of asking why the regulators didn’t stop this, societies should have asked what happened to the moral compunctions of those engaged in these practices, pointed alterglobalists. 2. Economics and lack of moral responsibility Economics, maybe unintentionally, provided sustenance to this lack of moral responsibility. A naive reading of Adam Smith might have suggested that he had relieved market participants from having to think about issues of morality. After all, if the pursuit of self-interest leads, as if by an invisible hand, to societal well-being, all that one has to do – all that one should do – is be sure to follow one’s self-interest. And those in the financial sector seemingly did that. But clearly, the pursuit of self-interest (greed) – did not lead to societal well-being, either in this episode or in the earlier scandals involving WorldCom and Enron. The theory of market failure helps to explain why things went so wrong; how it was that the bankers, in the pursuit of their private interests, led to such 117 Do we have to change capitalism – the alterglobalist view disastrous social consequences; and why the pursuit of self-interest by the bankers did not lead to societal well-being, or even the well-being of their shareholders. When there are market failures, such as externalities, the consequences (the marginal benefits and costs) of an action are not fully reflected in prices (received or paid). The failure of one bank has potentially disastrous effects on others; the failure of the banking system, or even the potential failure, has already had huge effects on the economy, on taxpayers, workers, businesses, homeowners. The foreclosure of one mortgage decreases market values of neighboring homes, increasing the probability of their going to foreclosure. The irony of the way the model of individualism (especially American style) worked in practice was that people took credit for successes but showed little sense of accountability or responsibility for the failures or the costs imposed on others (they love to internalize profits and same time externalize costs). When there were recorded profits (it is still questionable if there were real profits or only created by book accounting), the bankers took credit claiming that it was due to their efforts; when there were real losses they were the result of forces beyond their control. These attitudes were reflected in executive compensation schemes, which, in spite of the emphasis on incentives, often had little overall connection between pay and performance: incentive pay is high when performance is good, but when performance is weak, the deficiency is made up by other forms of pay, with another name, like ‘retention pay.’ Those in the industry like to say something like that: we have to pay the worker highly even though performance has been poor, because others might grab him away. One might have expected the banks to want to get rid of those whose performance is poor. But profits are poor not because of inadequate performance but because of events beyond anyone’s control, sound common explanations. But the same thing was true when profits were high. This is one of many examples of cognitive dissonance, of the ability of those in the financial market to make a reasonably good argument on one side but fail to see the full implications (Stiglitz 2010). Much of the talk about accountability seems just a matter of words: in Japanese society a CEO who was responsible for destroying his firm, forcing thousands of workers to be laid off, might commit suicide. In the United States and countries, which have more or less followed this model of capitalism, they are fighting over the size of their bonuses. In today’s financial markets, almost everyone claims innocence. They were all just doing their jobs. And so they were. But their jobs often entailed exploiting others or living off the results of such exploitation. Individualism did not match with individual responsibility. In the long run, society cannot function well if people do not take responsibility for the consequences of their actions. I was just doing my job cannot be a defense neither in politics nor in economics, sounds the strong argument of alterglobalists movement. 118 2. Economics and lack of moral responsibility Externalities and other market failures are not the exception but the rule in modern economies both in developing and developed countries. If that is the case, it has profound implications. There is meaning to individual and corporate responsibility. Firms need to do more than just maximize their market value. And individuals within corporations need to think more about what they do and the impacts on others. They cannot get by, by saying that they are ‘just’ maximizing their incomes. The model of rugged individualism combined with market fundamentalism has altered not just how individuals think of themselves and their preferences but how they relate to each other. In a world of rugged individualism, there is little need for community and no need for trust (in immortal words of Margaret Thatcher – there is such thing like society, there are individuals and families). Government is a hindrance; it is the problem, not the solution. But if externalities and market failures are pervasive, there is a need for collective action, and voluntary arrangements will typically not suffice (simply because there is no ‘enforcement,’ no way to make sure that people behave as they should and usually there is lack of ‘silent heroes’ – people who take the risk and act in a way everybody knows is needed, but nobody wants to take risk and pay costs). But worse, rugged individualism combined with rampant materialism has led to an undermining of trust. Even in a market economy, trust is the grease that makes society function. Society can sometimes get by without trust – through resort to legal enforcement, say, of contracts – but it is a very second-best alternative. In the current crisis, bankers lost our trust, and lost trust in each other. Economic historians have emphasized the role that trust played in the development of trade and banking. The reason why certain communities developed as global merchants and financiers was that the members of the community trusted each other. The big lesson of this crisis is that despite all the changes in the last few centuries our complex financial sector was (and is) still highly dependent on trust. When trust broke down, world financial system froze (Stiglitz 2010). Alterglobalists stress that the financial crisis has brought home, and accelerated, the erosion of trust. The societies of developed countries economies have taken trust for granted, and the result is that it has been weakened. Going forward, if people do not make fundamental changes, they will not be able to rely on trust again. If so, this will fundamentally alter how individuals within these societies treat each other, it will impede such relationships with each other, and it will change how people think about each other. The sense of community will be further eroded, and even the efficiency of economy will be impaired. Securitization, and how it was abused, epitomized this process of how markets can weaken personal relationships and community. The ‘friendly’ relationship within a stable community between the banker and the borrower, in which the banker knew the person who was borrowing money (so if the borrower genuinely had a problem, the banker knew when and how to 119 Do we have to change capitalism – the alterglobalist view restructure the loan), may have been partly a myth. But, still, there was also some truth in it; it was a relationship that was based partly on trust. With securitization, trust has no role; the lender and the borrower have no personal relationship. Everything is anonymous, and all the relevant information on the characteristics of the mortgage (or any other banking product – like let say investment funds units or credit cards) is summarized in statistical data. With those whose lives are being destroyed described as merely data, the only issues in restructuring are what is legal – what is the mortgage servicer allowed to do – and what will maximize the expected return to the owners of the securities. Not only has trust been destroyed between the borrower and lender but it also does not exist among the various other parties: for example, the holder of the securities does not trust the service provider to act in his interests. Given the lack of trust, many contracts restrict the scope for restructuring. Enmeshed in legal tangles, both lenders and borrowers suffer. Only the lawyers win (Stiglitz 2010). Securitization will not go away. It is part of the reality of a modern economy. But implicitly, through the bailouts, governments have subsidized securitization. It should at least create a level playing field – and we may want to discourage it. 3. GDP fetishism Striving to revive the world economy while simultaneously responding to the global climate crisis has raised an important issue: are statistics giving us the right ‘signals’ about what to do? In our performance-oriented world, measurement issues have taken on increased importance: at the end of the day our indicators and methods of aggregating affect what we do. The alterglobalist point of view is clear; if we have poor measures, what we strive to do (say, increase GDP) may actually contribute to a worsening of living standards. We may also be confronted with false choices, seeing trade-offs between output and environmental protection that – from their perspective – do not exist. By contrast, a better measure of economic performance might show that steps taken to improve the environment are good for the economy. There is an increasing discussion among the economists (fueled mainly by the alterglobalist point of view) concerns whether GDP provides a good measure of living standards. In many cases, GDP statistics seem to suggest that the economy is doing far better than most citizens’ own perceptions. Moreover, the focus on GDP creates conflicts. Political leaders are told to maximize it, but citizens also demand that attention be paid to enhancing security, reducing air, water, and noise pollution, all of which might lower GDP growth. The fact that GDP may be a poor measure of well-being, or even of market activity, has, of course, long been recognized. But changes in society and the economy may have heightened the problems, at the same time that advances 120 3. GDP fetishism in economics and statistical techniques may have provided opportunities to improve our metrics. Joseph Stigliz, Nobel Prize winner and one of the prominent representatives of the alterglobalist point of view, named a few commentaries of failures that can be met in the process of measuring the GDP (Report by the Commission… 2009). For example, while GDP is supposed to measure the value of output of goods and services, in one key sector (government) there is typically no way of doing this, so often measurement of the output has been simply done by the inputs. If government spends more – even if inefficiently – output goes up. In the last 60 years, the share of government output in GDP has increased to 40–52% in the United States, France, United Kingdom, and Germany. So, what was a relatively minor problem has now become a major one. Likewise, quality improvements (better cars rather than just more cars), account for much of the increase in GDP nowadays. But assessing quality improvements is difficult. Health care exemplifies this problem. Much of medicine is publicly provided, and much of the advances are in quality. The same problems in making comparisons over time apply to comparisons across countries. The U.S. spends more on health care than any other country (both per capita and as a percentage of income), but gets poorer outcomes. Part of the difference between GDP per capita in the United States and some European countries may thus be a result of the way we measure things. Another marked change in most societies is an increase in inequality. This means that there is increasing disparity between average (mean) income and the median income (that of the ‘typical’ person, whose income lies in the middle of the distribution of all incomes). If a few bankers get much richer, average income can go up, even if most individuals’ incomes are declining. So GDP per capita statistics may not reflect what is happening to most citizens. This realization casts a new light not only on our measures of performance, but also on the inferences that are made. Before the crisis, when U.S. growth (using standard GDP measures) seemed so much stronger than that of Europe, many Europeans argued that Europe should adopt U.S.-style capitalism. Of course, anyone who wanted to could have seen American households’ growing indebtedness, which would have gone a long way toward correcting the false impression of success given by the GDP statistic. Recent methodological advances made possible to assess better what contributes to citizens’ sense of well-being, and to gather the data needed to make such assessments on a regular basis. These studies, for instance, verify and quantify what should be obvious: the loss of a job has a greater impact than can be accounted for just by the loss of income. They also demonstrate the importance of social connectedness (Report by the Commission… 2009). Any good measure of how well the economy is doing must also take account of sustainability. Just as a firm needs to measure the depreciation of its capital, 121 Do we have to change capitalism – the alterglobalist view so, too, our national accounts need to reflect the depletion of natural resources and the degradation of our environment. Additionally, there often seems to be a marked distance between standard measures of important socioeconomic variables like economic growth, inflation, unemployment, etc. and widespread perceptions. The standard measures may suggest, for instance, that there is less inflation or more growth than individuals perceive to be the case, and the gap is so large and so universal that it cannot be explained by reference to money illusion or to human psychology,44 with a clear impact on the way in which public discourse about the conditions of the economy and necessary policies takes place. There may be several explanations for the gap between the statistical measurement of socio-economic phenomena and citizen perception of the same phenomena (Report by the Commission… 2009): • the statistical concepts may be correct, but the measurement process may be imperfect, • when there are large changes in inequality (more generally a change in income distribution) gross domestic product (GDP) or any other aggregate computed per capita may not provide an accurate assessment of the situation in which most people find themselves, • the commonly used statistics may not be capturing some phenomena, which have an increasing impact on the well-being of citizens (e.g. traffic jams may increase GDP as a result of the increased use of gasoline, but obviously not the quality of life), • the way in which statistical figures are reported or used may provide a distorted view of the trends of economic phenomena (e.g. much emphasis is usually put on GDP although net national product or real household income may be more relevant). In February 2008, Nicholas Sarkozy, unsatisfied with the present state of statistical information about the economy and the society, asked Joseph Stiglitz (President of the Commission), Amartya Sen (Advisor) and Jean Paul Fitoussi (Coordinator) to create a Commission, subsequently called The Commission on the Measurement of Economic Performance and Social Progress (CMEPSP). The Commission’s aim has been to identify the limits of GDP as an indicator of economic performance and social progress, including the problems with its measurement; to consider what additional information might be required for the production of more relevant indicators of social progress; to assess the feasibility of alternative measurement tools, and to discuss how to present the statistical information in an appropriate way. On September 14, 2009 (eighteen 44 In some countries this gap has undermined confidence in official statistics (for example, in France and in the United Kingdom only one third of citizens trust official figures, and these countries are not exceptions). 122 3. GDP fetishism months later), the Commission issued its long-awaited report. What are the main messages and recommendations? The report distinguishes between an assessment of current well-being and an assessment of sustainability, whether this can last over time. The current well-being has to do with both economic resources, such as income, and with non-economic aspects of peoples’ life (what they do and what they can do, how they feel, and the natural environment they live in). Whether these levels of well-being can be sustained over time depends on whether stocks of capital that matter for our lives (natural, physical, human, social) are passed on to future generations. The main conclusions of the report are like that: • there is a need to adapt the system of measurement of economic activity to better reflect the structural changes, which have characterized the evolution of modern economies. In effect, the growing share of services and the production of increasingly complex products make the measurement of output and economic performance more difficult than in the past. There are now many products whose quality is complex, multi-dimensional and subject to rapid change. In some countries and some sectors, increasing ‘output’ is more a matter of an increase in the quality of goods produced and consumed than in the quantity. Capturing quality change is a tremendous challenge, yet this is vital to measuring real income and real consumption, some of the key determinants of people’s material well-being. Under-estimating quality improvements is equivalent to over-estimating the rate of inflation, and therefore to under-estimating real income. The opposite is true when quality improvements are overstated, • the measurement system has to shift emphasis from measuring economic production to measuring people’s well-being. And measures of well-being should be put in a context of sustainability. Changing emphasis does not mean dismissing GDP and production measures. They emerged from concerns about market production and employment; they continue to provide answers to many important questions such as monitoring economic activity. But emphasizing well-being is important because there appears to be an increasing gap between the information contained in aggregate GDP data and what counts for common people’s well-being, • emphasis should be put on the household perspective. While it is informative to track the performance of economies as a whole, trends in citizens’ material living standards are better followed through measures of household income and consumption. The household perspective entails taking account of payments between sectors, such as taxes going to government, social benefits coming from government, and interest payments on household loans going to financial corporations. Properly defined, household income and consumption should also reflect in-kind services provided by government, such as subsidized health care and educational services, 123 Do we have to change capitalism – the alterglobalist view • aggregates on income and consumption should be considered jointly with wealth. Income and consumption are crucial for assessing living standards, but in the end they can only be gauged in conjunction with information on wealth. A household that spends its wealth on consumption goods increases its current well-being but at the expense of its future well-being, • more prominence should be given to the distribution of income, consumption and wealth. Average income, consumption and wealth are meaningful statistics, but they do not tell the whole story about living standards. Thus, average measures of income, consumption and wealth should be accompanied by indicators that reflect their distribution. Median consumption (income, wealth) provides a better measure of what is happening to the ‘typical’ individual or household than average consumption (income or wealth). But for many purposes, it is also important to know what is happening at the bottom of the income/wealth distribution (captured in poverty statistics), or at the top, • the measurement system has to include non-market activities and leisure. Many of the services people received from other family members in the past are now purchased on the market. This shift translates into a rise in income as measured in the national accounts and may give a false impression of a change in living standards, while it merely reflects a shift from non-market to market provision of services. There is a need of inclusion of information on how people spend their time that is comparable both over the years and across countries, • the environmental aspects of sustainability deserve a separate follow-up based on a well-chosen set of physical indicators. In particular there is a need for a clear indicator of our proximity to dangerous levels of environmental damage (e.g. climate change or the depletion of fishing stocks.). There is a need for a clear indicator of increases in atmospheric concentrations of greenhouse gases associated with proximity to dangerous levels of climate change (or levels of emissions that might reasonably be expected to lead to such concentrations in the future. Climate change (due to increases in atmospheric concentrations of greenhouse gases) is also special in that it constitutes a truly global issue that cannot be measured with regard to national boundaries. Physical indicators of this kind can only be identified with the help of the scientific community. 4. Sustainable development If there is a consensus today (not only among the economists from the alterglobalists movement but also mainstream people) about what strategies are most likely to promote the sustainable development of the poorest countries in the world (taking into account not only the long-run perspective but also 124 4. Sustainable development environmental problems), it is this: there is no consensus except that the Washington Consensus (WC) did not provide the answer. Its recipes were neither necessary nor sufficient for successful growth, though each of its policies made sense for particular countries at particular times (Stigliz 2008). Whatever its original content and intent, the term WC in the minds of most people around the world (keen in economics and politics but so-called ordinary people as well), has come to refer to development strategies that focus on privatization, liberalization, and macro stability (meaning, mostly, price stability). To such people the WC represents a set of policies predicated upon a strong faith – stronger than warranted either by economic theory or historical experience – in unfettered markets and aimed at reducing, or even minimizing, the role of government. This development strategy stands in marked contrast to the successful strategies pursued in East Asia where the development state took an active role (Stigliz 2008). Of course how the term WC is understood depends on the point of view. John Williamson in his works has arraigned the statement that WC was more than disciplined macroeconomic policy, the use of markets and trade liberalization. But according to Stiglitz (see e.g. Stiglitz 1998) WC has always meant both more and less than Williamson suggested. Williamson does not include in his list of WC’s elements capital market liberalization, which has come to be one of the pillars of the WC as it has come to be applied. His point is reducing public deficits, one of the keys to macro stability. But macro stability itself under the WC as applied focused too narrowly on price stability (Williamson 2004). The biggest failure of the WC – as the alterglobalists claim – was in understanding economic structures within developing countries, in focusing on too narrow a set of objectives, and on too limited a set of instruments. For instance, markets by themselves do not produce efficient outcomes when information is imperfect and markets are incomplete (true in all countries, but especially in developing countries) or when technology is changing as a result of R&D expenditures or learning, or more generally, when there is learning, for instance, about markets. The intellectual foundations of the WC had been badly eroded even before its doctrines became widely accepted. The fundamental theorems of welfare economics provided the rigorous interpretation of Adam Smith’s invisible hand, the conditions under which and the sense in which markets lead to efficient outcomes. Under these theorems, it turned out, markets were efficient only if capital markets were impossibly perfect – at least in the sense that there is no missing risk or intertemporal markets. There could be no externalities (no problems of air or water pollution), no public goods, no issues of learning, and no advances in technology that were the result either of learning or expenditures on R&D. Greenwald and Stiglitz (1986) went further and showed that there also could not be any imperfections of information, changes in 125 Do we have to change capitalism – the alterglobalist view the information structure, or asymmetries of information. These problems are serious in any economy, but are at the heart of development theory. There are important externalities in these dynamic processes, which give rise to an important role for government. The successful East Asian countries recognized this role; the WC policies did not. In short, there is no theoretical underpinning to believe that in early stages of development markets by themselves will lead to efficient outcomes (especially in countries in early stages of development) (Stiglitz 2008).45 Historical experience provided little support to the belief that markets by themselves would lead to rapid development. While there is an active debate about the particular role of each of the industrial policies undertaken by each of the East Asian countries, there is a clear link between the policies and the successes (Wade 2003). The township and village enterprises in China (publicly owned at the local level) were central to China’s success in the 1980s and early 1990s. The individual responsibility system, which was far short of full privatization of land (which market fundamentalists claimed was necessary), was responsible for the enormous increase in agriculture productivity. And it is hard to conceive that Korea or Taiwan would have become the industrial players of today without having undertaken active industrial policies. All of the countries in East Asia had high savings rates, and it is at least plausible that the government policies designed to stimulate savings actually did what they were intended to do. While firms in the rest of the world complain about a shortage of capital, the governments of East Asia provided capital to those firms that were proving their mettle by exporting, especially in technology sectors where there were likely spillovers to the rest of the economy (Greenwald, Stiglitz 2006). If the success of East Asia suggests the desirability of a larger role for government in successful development than was traditionally emphasized in the WC policies, the failures in Sub-Saharan Africa and Latin America have reinforced the doubts about the WC strategies (Stiglitz 2002a). The growth in Latin America during the 1990s, the decade of reform, was just half of what it was in the 1960s and 1970s, the decades marked by the ‘failed’ policies of import substitution. Surely, there were problems with the import substitution strategy and it would have had to evolve, as it did in East Asia, into a strategy based more on exports. It was the debt crisis, however, and not the shortcomings of the development strategy that brought an end to the period of high growth. Success under reform was even more short lived (less than a decade), and the end of that success (beginning in 1997) was directly related to the failures of the reform strategy. The openness of capital markets exposed the countries to the volatility of international capital markets, which had adverse consequences in the global financial crisis of 1997–98. 45 The problem of efficiency of the markets (capital market) would be presented more detailed in the last part: New challenges facing the economic science – did economist really get it so wrong? 126 4. Sustainable development In Africa, the costs of a simple-minded belief in the magic of the market were palpable and huge. For example, policy conditionalities imposed on the region’s countries too often focused much too narrowly on liberalization of agricultural prices without adequate attention to the prerequisites to make such liberalization effective, for example, functioning markets for inputs and outputs, credit availability, and infrastructure (especially roads). The insistence on static comparative advantage foreclosed the kind of dynamic changes that underlay the successes in East Asia (Stiglitz 2008). But there were a further set of problems, illustrating the fallacy of composition, whereby increasing exports of commodities by many countries with similar comparative advantages led to a collapse in their prices. The fact that countries that followed the WC policies grew more slowly than those that did not should, by itself, have been enough to lead countries to abandon these strategies. But the International Monetary Fund (IMF) urged patience; developing countries were told that growth was just around the corner. They were told that if they abandoned the WC policies, all the pain and suffering that they have experienced would be for naught (Stiglitz 2002a). It was the crises, especially in countries like Argentina that had receive an A+ grade from the IMF that finally resulted in global disillusion with the WC. But even before this, there was growing awareness that several of the policies that they had pushed seemed flawed: privatization marred by corruption for instance, and which resulted in monopolies that led to higher prices for consumers. Of course, when such problems occurred, the IMF would say, the problem was not with privatization itself, but with the way it was implemented. But that response was disingenuous: they had urged countries to privatize rapidly, as if to say that even a flawed privatization – and the more rushed the privatization, the more likely was that it would be flawed – was better than a postponed privatization. Moreover, policies have to be designed to be implemented by ordinary mortals, and when country after country faced similar problems in ‘implementation,’ it became clear that the roots of the problem were deeper (Stiglitz 2008). The political agenda was most evident in the WC reliance on market fundamentalism – the belief that markets by themselves lead to economic efficiency, that economic policies should focus on efficiency, and that distributional concerns could and should be taken care of elsewhere in the political process. The policies pursued by the international financial institutions that came to be called WC policies or ‘neoliberalism’ entailed a much more circumscribed role for the state than was embraced by most of the East Asian countries. Of course, governments can make matters worse (government failures etc.). No doubt the WC represented, in part, a reaction to failures of the state in attempting to correct failures of the market. But the pendulum swung too far in the other direction and for too long. The WC policies often assumed the worst about the nature and capability of all governments, and, in its quest to find 127 Do we have to change capitalism – the alterglobalist view a ‘one-size-fits-all’ policy, gave up on trying to improve governments, arguing that it was better simply to rely on markets by themselves. This resulted in a strong bias against basing policy advice on an analysis of what interventions are appropriate in what contexts, or building the institutions or capacity of states to intervene effectively. What is at issue then is not just the size of government, but its role – what activities should it undertake – and the balance between government and the market. It is pretty sure that there is a role for markets (no one questioned that); the question is to what extent do the advocates of WC recognize that there is a role for the state, beyond the minimal role of enforcing contracts and property rights? No doubts, there are government failures, just as there are market failures. But it believes that there are systematic ways to improve the performance of the government, just as there are systematic ways to improve markets. Governments and markets are seen as complementary, with government actually often playing an important role in addressing market failures, helping markets to work better. The WC failed so systematically largely because of its failure to understand development and developing countries; but its failure is also attributable to the fact that the objectives of development reflected in the WC were too narrowly defined: the objective of policy should not have been limited to an increase in GDP – putting aside for the moment the measurement problems associated with that measure – but should have included sustainable increases in standards of living, as well as the promotion of democratic and equitable development (Stiglitz 2008). The issue of equity, in particular, often received short shrift. Is a society in which the vast majority of its citizens are becoming worse off, while a few at the top are doing so well that average incomes are rising, better off than a society in which the vast majority are doing better, even if total GDP is growing more slowly? While there may be disagreements – and those at the very top may well stress that average income is the appropriate measure – the possibility that increases in GDP may not benefit most individuals’ means that we cannot simply ignore issues of distribution. Some economists argued that distribution concerns could be ignored because they believed in trickle-down economics, that somehow everybody would benefit in the way that a rising tide would lift all boats. But the evidence against trickle-down economics is now overwhelming, at least in the sense that an increase in average incomes is not sufficient to raise the incomes of the poor for prolonged periods. Some economists argued that distribution concerns could and should be ignored, because such concerns were outside the province of economics. Economists should focus on efficiency and growth alone; distribution was a matter for politics. The fundamental theorems of welfare economics gave economists some comfort, for those results suggested that one could separate out equity and efficiency concerns, and any desired distribution 128 4. Sustainable development of income could be achieved simply by a redistribution of initial endowments. But advances in economic theory (especially those related to the economics of information) showed that that was simply not true; lump sum redistributions were not generally feasible, efficiency and equity were inextricably interlinked. Ignoring distributional concerns meant that sometimes even improvements in efficiency were compromised. For instance, land reform, which would have reduced the scope for and inefficiencies associated with agency problems in tenancy, would have simultaneously improved equity and efficiency. Sharecropping, a prevalent form of land tenancy in developing countries has resulted in an effective tax rate of 50%, and in some cases 66%, on some of the poorest people. It is ironic that while the IMF and the advocates of the WC often railed against the distortions arising from high tax rates, land reform, which should have been even more important, was seemingly not high on the agenda. While the international financial institutions talked a great deal about ‘getting incentives right,’ they never addressed this incentive problem (Stiglitz 2008). Even worse than the formulation of too narrow a set of objectives was the fact that, too often, the IMF confused means with objectives (especially in case of privatization and liberalization). Sometimes privatization makes sense. But it matters how privatization is done; if done in the wrong way, growth can be reduced and societal welfare lowered. The pursuit of rapid privatization in the post-socialist countries contributed to the enormous increase in inequality, compromising the legitimacy of private rights, at least those acquired in the privatization process, and perhaps even of the market system. Low inflation was seen as an objective in itself; excessively tight monetary policy led to the growth of barter, which undermined market efficiency as equally as inflation. Capital market liberalization did not lead to faster economic growth, but did lead to more instability. As the failures of the WC became increasingly evident especially after the crises, beginning with the Mexican crisis and follow by the East Asian crises, the Russian crisis, and the Argentine crisis – it has evolved to what is sometimes called the Washington Consensus Plus. The advocates of the WC successively tried to modify the prescription. But even as it changed, the underlying problems, based on a flawed understanding of market economics and a too narrow set of objectives persisted (Stiglitz 2008). When these policies failed to produce the satisfactionary results, the diagnosis changed, and it was argued that these policies needed to be supplemented with additional policies: the Washington Consensus Plus. What was added depended on the criticism that was being leveled and on the nature of the failure that was being recognized. When growth failed to materialize, ‘second generation reforms,’ including competition policies to accompany privatizations of natural monopolies, were added. When problems of equity were noted, the Plus Consensus included female education or improved safety nets. 129 Do we have to change capitalism – the alterglobalist view The example of Mexico showed that even if a country got its own fiscal house in order and kept inflation in check, it could have a crisis. The problem, supposedly, was a lack of domestic savings. But when East Asian countries (with the highest rates of savings in the world) faced crisis a new explanation was sought. Now, it was lack of transparency. Weak financial institutions were to blame, but if such weak institutions were found in the United States and other advanced industrial countries (which had banking crises in the late 1980s and early 1990s), what hope did the developing countries have? By this point, the advocates of WC (most of all IMF and U.S. Treasury) advice rang hollow: ex post, they could always find something that was wrong, and add something to the increasingly long laundry list of what countries should do (Stiglitz 2008). When all of these versions of the Washington Consensus Plus also failed to do the trick, a new layer of reforms was added: one had to go beyond projects and policies to the reform of institutions, including public institutions, and their governance. In some ways, this represented a more fundamental change in perspectives, but in other ways it was a continuation of the same mindset. Government had long been viewed as the problem and markets as the solution. The questions should have been: what can be done to improve the efficiency of both markets and the government? What is the right balance between the market and government and how should that balance change over time, as markets improve and the competencies of governments change? Rather than asking these questions, the WC had ignored market failures, viewed government as the problem, assumed that governments could not be reformed, and proposed massive scale backs in government. Belatedly, it recognized the need to improve government, and that many of the countries where development was not proceeding suffered not from too much government but from too little. But there remained a lack of balance. For instance, rather than asking if public pension systems could be strengthened, the Washington Consensus continued to focus its attention on privatization (Stiglitz 2008). When deficiencies in private pension schemes were noted (e.g., their higher administrative costs, problems of adverse selection, the failure to insulate old age pensioners against risks of market volatility or inflation, and the difficulty of preventing fraud), the problems were ignored or attempts were made to address the market failures, but it was simply assumed that it would be easier to make markets work than to make public institutions work. Nor was the link between policies and institutions, or between institutions and society, adequately recognized. The IMF told countries to have good institutions, and examples of good institutions were exhibited, but there was little to say about how to create such institutions. It was easy to instruct countries on good economic policies: simply cut the budget deficit. But an injunction to have honest institutions was much more complicated. There were other important instances of policies interacting with institutions 130 4. Sustainable development in ways that were adverse to economic performance. High interest rate policies in Russia (and the failure to create viable financial institutions to supply credit to new and expanding enterprises) made asset stripping more attractive than wealth creation; and weakened support for the creation of the kind of rule of law that would have facilitated wealth creation (Hoff, Stiglitz 2004). Thus, even as the WC began to expand the list of what was to be done, its perspectives remained too narrow. Broader goals and still more instruments were required. A more fundamental change in mindset was needed. But the criticism now went further. One of the longstanding criticisms of the WC and the IMF was not just the failure to understand economics; it was argued that they failed to take into account adequately politics and political processes, and how they are intertwined with economics. But governance entails political processes, and while the attention newly focused on governance was welcome, these limitations and the imperfections in the international institutions’ own governance itself meant that the IMF and the WC had less to contribute on the subject than one might have hoped. Even when what they said may have had more than a grain of truth, the international economic institutions lacked the credibility required for their messages to have the desired impact (Stiglitz 2002). Above there are described several elements of an emerging consensus, or the broadly shared view about the inadequacies of the WC and its excessive belief in market fundamentalism. But there are a few more named by most prominent representative of the alterglobalist movement Joseph Stiglitz (Stiglitz 2008): • development of a successful sustainable development strategy will have to involve societies in the countries in which it is going to be applied in an important and meaningful way, • ‘one-size-fits-all’ policies are doomed to fail. Policies that work in one country may not work in other ones (compare for example the successful policy adopted in East Asian economies and Latin America countries which at least partly followed instructions of WC), • there are some areas in which economic science has not yet provided sufficient evidence, sufficiently strong theory, or empirical evidence, to result in a broad consensus about what countries should do. There may be a broad consensus against excessive protectionism (with a lot of creditability to the meaning of this expression) that only serves the interests of distributional coalitions, but there is no consensus that rapid liberalization, especially in a country with high unemployment, will lead to faster economic growth. It may only lead to higher unemployment, • a successful development requires not the minimal role assigned to the state by the WC, but a balanced role. The exact role may differ from country to country, • success is to be measured not just by an increase in GDP, but by a broader set of measures, including those that assess environmental and social 131 Do we have to change capitalism – the alterglobalist view sustainability. Greater attention must be paid, too, to issues of distribution, a development strategy that leads to increases in GDP with most citizens not sharing in the fruits of that growth is not a success, and such a development strategy will almost surely not be sustainable over the long run. 5. Conclusions From the alterglobalist point of view the failures in our economic system and the failures of our economic system reflect deeper problems in our society. It is certain (for everybody keen on the field of economics and economic policy) that there will be changes as a result of the crisis. There is no going back to the world before the crisis. But the questions are how deep and fundamental will the changes be? Will they even be in the right direction (at least from their point of view)? In some areas, regulations will be improved almost surely (the excesses of leverage, less confidence in market liberalization, greater role of the government etc.). But in other areas there is remarkably little progress (banking system still makes possible to internalize profits and externalize cost, derivatives that cost taxpayers so much will continue almost unabated, and finance executives will continue to receive out sized bonuses). In each of these areas, something cosmetic will be surely done, but alterglobalists claim it will fall far short of what is needed. In several critical areas, in the midst of the crisis, matters have already become worse. There have been alterations to not only institutions encouraging ever increased concentration in finance, but the very rules of capitalism. Governments indirectly announced that for favored institutions there is to be little or no market discipline. An ersatz capitalism is emerging with unclear rules but with a predictable outcome: future crises; undue risk-taking at the public expense, no matter what the promise of a new regulatory regime; and greater inefficiency. In earlier crises, there was worry about moral hazard, the adverse incentives provided by bailouts; but the magnitude of this crisis has given new meaning to the concept. The rules of the game have changed globally, too. The WC policies and the underlying ideology of market fundamentalism are dead. In the past, there might have been a debate over whether there was a level playing field between developed and less developed countries; now there can be no debate. The poor countries simply can’t back up their enterprises in the way the rich do, and this alters the risks that they can undertake. They have seen the risks of globalization badly managed. But the hopes for reforms in how globalization is managed still seem on the distant horizon. To use the words of Joseph Stiglitz (Stiglitz 2010, pp. 296–297), Will we seize the opportunity to restore our sense of balance between the market and the state, between individualism and the community, between man and nature, between means and ends? We now have the opportunity to create a new financial system that will do what human beings need a financial 132 5. Conclusions system to do; to create a new economic system that will create meaningful jobs, decent work for all those who want it, one in which the divide between the haves and have-nots is narrowing, rather than widening; and, most importantly of all, to create a new society in which each individual is able to fulfill his aspirations and live up to his potential, in which we have created citizens who live up to shared ideals and values, in which we have created a community that treats our planet with the respect that in the long run it will surely demand. These are the opportunities. The real danger now is that we will not seize them. Bibliography De Soto, H., 2000, The Mystery of Capital, Why Capitalism Triumphs in the West and fails Everywhere Else, New York, Basic Books. Greenwald, B., J. Stiglitz, 1986, Externalities in Economics with Imperfect Information and Incomplete Markets, The Quarterly Journal of Economics, May. Greenwald, B., J. Stiglitz, 2006, Helping Infant Economies Grow: Foundations of Trade Policies for Developing Countries, American Economic Review: AEA Papers and Proceedings, no. 96/2, May. Hoff, K., J. Stiglitz, 2004, After the Big Bang? Obstacles to the Emergence of the Rule of Law in Post-Communist Societies, American Economic Review, no. 94/3, June. Prasad, E., K. Rogoff, S. Wei, A. Kose, 2003, Effects on Financial Globalization on Developing Countries: Some Empirical Evidence, IMF Occasional Paper, no. 220. Report by the Commission on the Measurement of Economic Performance and Social Progress, 2009, Paris, www.stiglitz-sen-fitoussi.fr. Stiglitz, J., 1998, More Instruments and Broader Goals, in: The Rebel Within, ed. H.J. Chang, London, Wimbledon Publishing Company. Stiglitz, J., 2002, Globalization and its Discontents, 2002, Mew York, W.W. Norton& Company. Stiglitz, J., 2002(a), Reforming Reform: Towards a New Agenda for Latin America, Santiago de Chile, Prebisch Lecture. Stiglitz, J., N. Serra, 2008, The Washington Consensus Reconsidered. Towards a New Global Governance, Oxford, Oxford University Press. Stiglitz, J., 2010, Freefall. America, Free Markets and the Sinking of the World Economy, New York, W.W. Norton&Company. Wade, R., 2003, Governing the Market: Economic Theory and the Role of Government in East Asia industrialization, Princeton, Princeton University Press. Williamson, J., 2004, A Short History of the Washington Consensus, paper presented at Foundation CIDOB Conference From the Washington Consensus towards a New Global Governance, Barcelona. 133 CHAPTER NINE Piotr Maszczyk46 New challenges facing the economic science – did economists really get it so wrong? In the early years of the 21st century the situation in the field of macroeconomics seemed to be clear. The majority of economists (still there is always a group, which just loves to create rumor) were congratulating themselves over the success of their field. Those successes were both theoretical and practical. On the theoretical side, they thought that they had resolved their internal disputes. Olivier Blanchard declared that the state of macro is good. The battles of yesteryear, he said, were over, and there had been a broad convergence of vision. And in the real world, economists believed they had things under control: the central problem of depression-prevention has been solved, declared Robert Lucas in 2004. Ben Bernanke celebrated the Great Moderation in economic performance over the previous two decades, which he attributed in part to improved economic policy making. These common believes were completely destroyed by Paul Krugman and his article How Did Economists Get It So Wrong? The Nobel Prize winner presented the opinions, which shocked the professional world. In his view only a few economists saw current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the possibility of catastrophic failures in the market economy. During the golden years, financial economists came to believe that markets were inherently 46 This chapter is based on two articles published on websites: http://www.nytimes.com/2009/09/06/ magazine/06Economic-t.html?pagewanted=8&_r=1 and http://modeledbehavior.com/2009/09/11/ john-cochrane-responds-to-paul-krugman-full-text/ 135 New challenges facing the economic science – did economists really get it so wrong? stable – indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened. Meanwhile, macroeconomists were divided in their views. But the main division was between those who insisted that free-market economies never go astray (‘freshwater economists’ as they come from the inland University – mainly Chicago) and those who believed that economies may stray now and then but that any major deviations from the path of prosperity could and would be corrected by the all-powerful institutions like FED or government (‘saltwater economists,’ because this group mainly comes from the U.S. coastal school). Neither side was prepared to cope with an economy that went off the rails. So, Krugman’s attack – as his opposite John H. Cochrane pointed out – had two goals. First, he though financial markets are ‘inefficient,’ fundamentally due to ‘irrational’ investors, and thus prey to excessive volatility which needs government control. Second, he has advocated the huge ‘fiscal stimulus’ provided by multi-trillion dollar deficits. Based on his article (and than the discussion started with the ‘response’ published by Cochrane) it is a very good opportunity to answer these fundamental questions: what happened to the economics profession? And where does it go from here? From Krugman’s perspective the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. The Vision of capitalism as a perfect or nearly perfect system disappeared during the great Depression in the face of mass unemployment, but economists fell back in love with the old, idealized vision of an economy in which rational individuals interact in perfect markets, this time gussied up with complicated equations. The central cause of the profession’s failure was in Krugman’s eyes the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess. As a consequence, they turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets – especially financial markets – that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation. From Krugman’s perspective it is certain that economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off. In practical terms, this will translate into more cautious policy advice – and a reduced willingness to dismantle economic safeguards in the faith that markets will solve all problems. 136 1. Global economic crisis – diverging explanations and questions of efficient markets 1. Global economic crisis – diverging explanations and questions of efficient markets The roots of crisis – as Krugman describes it in his article – can be founded when the financial economists putted away Keynes’s disparaging vision of financial markets as a ‘casino’ and accepted the ‘efficient market’ theory, which asserted that financial markets always get asset prices right given the available information. Meanwhile, many macroeconomists completely rejected Keynes’s framework for understanding economic slumps. Some returned to the view of Schumpeter and other apologists for the Great Depression, viewing recessions as a good thing, part of the economy’s adjustment to change. And even those not willing to go that far argued that any attempt to fight an economic slump would do more harm than good. Even the New Keynesians believed in an active role of the government, have undertaken the notion that investors and consumers are rational and that markets generally get it right. Exceptions to these trends, a few economists challenged the assumption of rational behavior, questioned the belief that financial markets can be trusted were swimming against the tide, unable to make much headway against a pervasive and, in retrospect, foolish complacency. In the early 1970s the discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the ‘efficient-market hypothesis,’ promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth given all publicly available information. And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices. Constantly repeated stock crash (in the 1970s and 1980s), in which indexes plunged for no clear reason, should have raised at least a few doubts about market rationality. The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward – the so-called Capital Asset Pricing Model, or CAPM – is wonderfully elegant. CAPM tells how to choose the right portfolio – even more important from the financial industry’s point of view, it tells how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory’s adepts also received more mundane rewards. Of course, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form. Finance economists rarely asked the 137 New challenges facing the economic science – did economists really get it so wrong? seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices. Finance theorists continued to believe that their models were essentially right, and so did many people making real-world decisions. Not least among these was Alan Greenspan who was then the FED chairman and a long-time supporter of financial deregulation whose rejection of calls to rein in subprime lending or address the ever-inflating housing bubble rested in large part on the belief that modern financial economics had everything under control. And, how meanly describing Krugman, by October 2008 Greenspan was admitting that he was in a state of shocked disbelief, because the whole intellectual edifice had collapsed. In face of recession almost as big as the Great Depression last century the economists faced the questions: what should policy makers do? Unfortunately, macroeconomics, which should have been providing clear guidance about how to address the slumping economy, was in its own state of disarray. In the 1970s the Nobel Prize laureate Robert Lucas argued that recessions were caused by temporary confusion: workers and companies had trouble distinguishing overall changes in the level of prices because of inflation or deflation from changes in their own particular business situation. And Lucas warned that any attempt to fight the business cycle would be counterproductive: activist policies, he argued, would just add to the confusion. By the 1980s, however, even this severely limited acceptance of the idea that recessions are bad things had been rejected by many economists. Instead, the new leaders of the movement, especially Edward Prescott, argued that price fluctuations and changes in demand actually had nothing to do with the business cycle. Rather, the business cycle reflects fluctuations in the rate of technological progress, which are amplified by the rational response of workers, who voluntarily work more when the environment is favorable and less when it is unfavorable. Unemployment is a deliberate decision by workers to take time off. From the Krugman’s point of view this theory seems to be foolish – was the Great Depression really the Great Vacation? But the basic premise of Prescott’s ‘real business cycle’ theory was embedded in ingeniously constructed mathematical models, which were mapped onto real data using sophisticated statistical techniques, and the theory came to dominate the teaching of macroeconomics in many university departments. In 2004, reflecting the theory’s influence, Prescott shared a Nobel with Finn Kydland. Even the self-described New Keynesian economists (almost all saltwater using the Krugman’s etiquettes) weren’t immune to the charms of rational individuals and perfect markets. Although they were willing to deviate from the assumption of perfect markets or perfect rationality, or both, adding enough imperfections to accommodate a more or less Keynesian view of recessions (and of course in the saltwater view, active policy to fight recessions remained 138 1. Global economic crisis – diverging explanations and questions of efficient markets desirable), they tried to keep their deviations from neoclassical orthodoxy as limited as possible. This meant that there was no room in the prevailing models for such things as bubbles and banking-system collapse. The fact that such things continued to happen in the real world – there was a terrible financial and macroeconomic crisis in much of Asia in 1997–98 and a depression-level slump in Argentina in 2002 – was not reflected in the mainstream of New Keynesian thinking. Moreover, there was another interesting point to think about. Even taking into account the pragmatic way of doing their job by saltwater economist (or New Keynesian) you might have thought that the differing worldviews of freshwater and saltwater economists would have put them constantly at loggerheads over economic policy. Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, Krugman believes, is that New Keynesians, unlike the original Keynesians, did not think fiscal policy – changes in government spending or taxes – was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the FED, could provide whatever remedies the economy needed. And as long as macroeconomic policy was left in the hands of the Greenspan’s FED, without Keynesian-type stimulus programs, freshwater economists found little to complain about. They probably did not believe that monetary policy influenced economy but they did not believe it did any harm, either. In economics discussions concerning the grounds and reasons of the crisis it is very often repeated punch line appears – nobody could have predicted. From Krugman’s perspectives it is not the truth. People saying such things with regard to disasters that could have been predicted, should have been predicted and actually were predicted by a few economists who were scoffed at for their pains. As an example Krugman points out the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller of Yale, did identify the bubble and warned of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. How so many economists and policymakers did miss the bubble? In Krugman’s eyes it is the one and only clear explanation. A general belief that bubbles just do not happen. In a 2007 interview, Eugene Fama, the father of the efficient-market hypothesis, declared that the word ‘bubble’ drives me nuts, and went on to explain why we can trust the housing market, housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed. To sum up Krugman’s point of view on the global economic depression. It was the belief in efficient financial markets which blinded many if not most economists to the emergence of the biggest financial bubble in history. And 139 New challenges facing the economic science – did economists really get it so wrong? efficient-market theory played a significant role in inflating that bubble in the first place. Freshwater economists refused to feel guilty. John Cochrane pointed in his article (treated as a response to the Krugman’s attack) that the central empirical prediction of the efficient markets hypothesis is precisely: nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor academics. From his perspective this is probably the best-tested proposition in all the social sciences. Krugman writes as if the volatility of stock prices alone disproves market efficiency and efficient marketers just ignored it al these years. There is nothing about ‘efficiency’ that promises ‘stability,’ pointed Cochrane. ‘Stable’ growth would in fact be a major violation of efficiency. Efficient markets did not need to wait for the memory of 1929 (…) gradually receding, nor did freshwater economists fail to read about the stock market crisis in 1987. Data from the great depression has been included in practically all the tests. It is true and very well documented that asset prices move more than reasonable expectations of future cash flows. This might be because people are prey to bursts of irrational optimism and pessimism. It might also be because people’s willingness to take on risk varies over time, and is sharply lower in bad economic times. As Gene Fama pointed out in 1972, these are observationally equivalent explanations at the superficial level of staring at prices and writing magazine articles. At last the central prediction of free-market economics, as crystallized by Hayek, that no academic, bureaucrat or regulator will ever be able to fully explain market price movements. Nobody knows what fundamental or hold to maturity value is. In this perspective the case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse. Free markets are the worst system ever devised – except for all of the others. If anyone could tell what the price of tomatoes should be, let alone the price of Microsoft stock, communism would have worked, finished his reasoning Cochrane. In his perspective the current crisis has a pure financial nature; it was a classic near-run on banks. The centerpiece of the crash was not the relatively free stock or real estate markets; it was the highly regulated commercial banks. A generation of economists has thought really hard about these kinds of events. Look up Diamond, Rajan, Gorton, Kashyap, Stein, and so on. They have thought about why there is so much short term debt, why banks run, how deposit insurance and credit guarantees help, but how they give incentives for excessive risk taking. Krugman did not have anything interesting to say about FED policy, criticized Cochrane. It did a lot more in 2008 than set the funds rate to zero and then waits for fiscal policy to do its work. Leaving aside the string of bailouts, the FED started term lending to securities dealers. Then, rather than buy treasuries in exchange for reserves, it essentially sold treasuries in exchange for private 140 2. Global economic crisis – fiscal stimulus and the questions of remedies debt. Though the funds rate was near zero, the FED noticed huge commercial paper and securitized debt spreads, and intervened in those markets. There is no ‘the’ interest rate anymore, the FED is managing them all. Recently the FED has started buying massive quantities of mortgage-backed securities and long-term treasury debt. 2. Global economic crisis – fiscal stimulus and the questions of remedies As Krugman states in his article, current recession ended the phase of a false peace over the field of macroeconomics. An extended period during which inflation subdued and recessions were relatively mild brought both saltwater and freshwater economist to common believe that FED had economy under, and even if not it is doing less harm as it possible. Suddenly the narrow, technocratic policies both sides were willing to accept were no longer sufficient – and the need for a broader policy response brought the old conflicts out into the open, fiercer than ever. During previous recessions FED responded by driving interest rates on government debt down and thanks to that lead to an economic recovery (in 1990 it was the decrease from 9 to 3% and in 2001 it was from 6.5 to 1%). And it was the same idea in 2008, FED was driving rates from 5.25% to zero. But it was not enough to end current recession. And the FED can’t push rates below zero, since at near-zero rates investors simply hoard cash rather than lending it out. So by late 2008, with interest rates basically at what macroeconomists call the ‘zero lower bound’ even as the recession continued to deepen, conventional monetary policy had lost all traction. It was the second time America has been up against the zero lower bound, the previous occasion being the Great Depression. And it was precisely the observation that there is a lower bound to interest rates that led Keynes to advocate higher government spending: when monetary policy is ineffective and the private sector can not be persuaded to spend more, the public sector must take its place in supporting the economy. Fiscal stimulus is the Keynesian answer to the kind of depression-type economic situation the whole world is currently in. Such Keynesian thinking underlies the Obama administration’s economic policies, which opened the furious debate about the efficiency of fiscal policy stimulus. It was the hard voice of freshwater economists like john H. Cochrane from Chicago who was outraged at the idea that government spending could mitigate the latest recession. He states that Keynesian economy in the version presented by Krugman requires that people make plans to consume more, invest more, and pay more taxes with the same income. It also presumes that 141 New challenges facing the economic science – did economists really get it so wrong? the government is able to systematically fool people again and again and people do not think about the future in making decisions today. In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending can not have any effect because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered. Is this theorem true? Cochrane states that there is a logical connection from a set of ‘if’ to a set of ‘therefore.’ Economists have spent a generation tossing and turning the Ricardian equivalence theorem, and assessing the likely effects of fiscal stimulus in its light, generalizing the ‘ifs’ and figuring out the likely ‘therefores.’ The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why it is false. Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, estate taxes, how much people care about their children, how many people would like to borrow more to finance today’s consumption and so on. And when you find ‘market failures’ that might justify a multiplier, that analysis quickly suggests direct fixes for the market failures, not their exploitation along the lines Keynes suggested. Most New Keynesian analyses that add frictions don’t produce big multipliers. This is how real thinking about stimulus actually precedes, pointed Cochrane. He neglected the Kruhman’s point that freshwater economists asserted that an increase in government spending cannot, under any circumstances, increase employment. But the Cochrane formulation (imputed to Krugman) that people make plans to consume more, invest more and pay more taxes with the same income only at first glance looks so crazy. Because from the Keynesian point Cochrane is totally misunderstanding how economy works (it is an interesting mark of how deep the division between saltwater and freshwater economist runs if they do not understand such primary points). If people consume less, companies sell fewer goods and services, requiring them to lay off people, who in turn spend even less. This is the famous ‘paradox of thrift.’ This is exactly what we are living through right now. The total money supply does not change, but the economy goes into recession because that money is not circulating. The opposite also holds true. If people consume more, companies aiming to meet that demand hire more workers who then have the income to spend on more products. Indeed it is not just from a Keynesian point of view. Robert Lucas won his Nobel Prize for investigating a class of situations – those with unanticipated nominal money and price level shocks – in which people are in the aggregate confused about what their real incomes are and so plan to spend more (or less) than their incomes turn out to be. Milton Friedman’s monetary transmission 142 3. The future of macroeconomics mechanism rests on people, because their money holdings are elevated (or depressed), trying to spend more (or less) than their incomes. In fact, that is the root of Irving Fisher’s foundational explanation of the quantity theory of money. Knut Wicksell’s definition of the natural interest rate is that at which planned investment is just equal to savings – and so planned spending is equal to income – and in his model business cycles are driven by fluctuations in the market interest rate away from the natural rate that induce wedges between planned spending and income. Milton Friedman of course believed that FED policy rather than changes in government spending should be used to stabilize the economy, but he never asserted that an increase in government spending cannot, under any circumstances, increase employment. In fact, rereading Friedman’s 1970 summary of his ideas, A Theoretical Framework for Monetary Analysis, what’s striking is how Keynesian it seems. The question of unemployment and the eventually willingness of people to work is in the center of the debate about the possible consequences of fiscal stimulus. Like Krugman stated in his article, the current generation of freshwater economists use the arguments that the mass unemployment represents a voluntary reduction in work effort and the recession are actually good for the economy. For example, Casey Mulligan suggests that unemployment is so high because many workers are choosing not to take jobs and workers are choosing to remain unemployed because that improves their odds of receiving mortgage relief. Krugman in his article named such ideas craziness and ask rhetorically if anyone can seriously claim that American economy has lost 6.7 million jobs just because fewer Americans want to work? But if you start from the assumption that people are perfectly rational and markets are perfectly efficient, you have to conclude that unemployment is voluntary and recessions are desirable. 3. The future of macroeconomics The whole Krugman’s article presented the vision that economics got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision – that of a market economy that has many virtues but that is also shot through with flaws and frictions. But there is no necessity to start from scratch. Even during the heyday of perfect-market economics, there was a lot of work done on the ways in which the real economy deviated from the theoretical ideal. What is probably going to happen now – in fact, it is already happening – is that flaws-and-frictions economics will move from the periphery of economic analysis to its center. Krugman in his article pointed out the school of thought known as behavioral finance. Practitioners of this approach emphasize two things. First, many real143 New challenges facing the economic science – did economists really get it so wrong? -world investors bear little resemblance to the cool calculators of efficientmarket theory: they are all too subject to herd behavior, to bouts of irrational exuberance and unwarranted panic. Second, even those who try to base their decisions on cool calculation often find that they can not, that problems of trust, credibility and limited collateral force them to run with the herd. Behavioral finance, drawing on the broader movement known as behavioral economics, tries to answer that question by relating the apparent irrationality of investors to known biases in human cognition, like the tendency to care more about small losses than small gains or the tendency to extrapolate too readily from small samples (e.g., assuming that because home prices rose in the past few years, they will keep on rising). Krugman argued that until the crisis, efficient-market advocates like Eugene Fama dismissed the evidence produced on behalf of behavioral finance as a collection of curiosity items of no real importance. That’s a much harder position to maintain now that the collapse of a vast bubble – a bubble correctly diagnosed by behavioral economists like Robert Shiller who related it to past episodes of irrational exuberance – has brought the world economy to its knees. Probably the most influential paper in this vein was a 1997 publication by Shleifer and Vishny, which amounted to a formalization of the old line that the market can stay irrational longer than you can stay solvent. As they pointed out, arbitrageurs – the people who are supposed to buy low and sell high – need capital to do their jobs. And a severe plunge in asset prices, even if it makes no sense in terms of fundamentals, tends to deplete that capital. As a result, the smart money is forced out of the market, and prices may go into a downward spiral. But, as freshwater economists as the advocates of the free market stress, the behavioral view gives us a new and stronger argument against regulation and control. Regulators are just as human and irrational as market participants. If bankers are, in Krugman’s words, ‘idiots,’ then so must be the typical treasury secretary, FED chairman, and regulatory staff. They act alone or in committees, where behavioral biases are much better documented than in market settings. They are still easily captured by industries, and face horrendously distorted incentives. In the field of macroeconomics Krugman stated that recent events have pretty decisively refuted the idea that recessions are an optimal response to fluctuations in the rate of technological progress; a more or less Keynesian view is the only plausible game in town. Yet standard New Keynesian models left no room for a crisis like the world’s economy is struggling with, because those models generally accepted the efficient-market view of the financial sector (there were some exceptions – e.g. Bernanke and Gertler work, or Kiyotaki and Moor model examined the influence of real estates assets market on the real economy). To sum up Krugman’s statements, firstly he thinks that economists have to face up to the inconvenient reality that financial markets fall far short of 144 3. The future of macroeconomics perfection, that they are subject to extraordinary delusions and the madness of crowds. Secondly, they have to admit that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Thirdly, they will have to do their best to incorporate the realities of finance into macroeconomics. But Macroeconomists have done it years ago, argued Cochrane. Pretty much all freshwater economists have been doing for 30 years is introducing flaws, frictions and new behaviors, especially new models of attitudes to risk, and comparing the resulting models, quantitatively, to data. The long literature on financial crises and banking, which Krugman does not mention, has been doing exactly this bidding for the same time. When economics incorporates flaws and frictions, the result will not be to rehabilitate an old theory of ‘pure’ Keynes. The New Keynesians did just what Krugman asked, putting Keynes inspired price-stickiness into logically coherent models, ended up with something that looked a lot more like monetarism or even something more radical than monetarism. A science that moves forward almost never ends up back where it started. And as the biggest surprise Cochrane treated Krugman’s attack on mathematics in economics. Cause what is the alternative? Does Krugman really think economists can make progress on his agenda for economic and financial research – understanding frictions, imperfect markets, complex human behavior, and institutional rigidities – by reverting to a literary style of exposition, and abandoning the attempt to compare theories quantitatively against data? In Cochrane perspective the problem is that economists do not have enough maths. Math in economics serves to keep the logic straight, to make sure that the ‘then’ really does follow the ‘if,’ which so frequently does not if you just write prose. The challenge is how hard it is to write down explicit artificial economies with these ingredients, actually solve them, in order to see what makes them tick. No matter if you agree with Krugman or Cochrane (or in broader sense with freshwater or saltwater economists, or with apologists of free market or Keynesians), it will be a long time, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. 145