Definition & Reality in the General Theory of Political Economy

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Title: Definition & Reality in the General Theory of Political Economy
Author: Cool, Thomas
Language: English
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Definition & Reality
in the
General Theory of Political Economy

Thomas Colignatus

Dutch University Press

Samuel van Houten Genootschap

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2nd edition, January 2005
(The first edition was in March & June 2000)

Colignatus is the preferred name of Thomas Cool in science.

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Prologue

The basic idea of this book is that Keynes’s _General Theory_ is
generalised even further by including endogenous government in the
model, so that we arrive at a truly general Political Economy. The
world had the Great Depression 1930-1940 and has the Great Stagflation
1970-today and by including ‘stagnation in economic policy making’ in
our analysis we find a better explanation. The general theory also
advises a democracy to create an Economic Supreme Court as a separate
constitutional power, next to the Legislative, Executive and Judicial
branches.

This book is primarily directed at my fellow economists and it
primarily gives theory and stylized facts. The colleagues will
specifically have to understand the ‘Definition & Reality methodology’
before they will appreciate that my analysis is scientifically
warranted. Much work remains to be done in practical research. And much
work remains to be done by the other professions.

Since the current imbalance of powers has many victims, it may be
hoped, none the less, that the parliaments of our democratic nations
investigate the issue too, so that there is more hope for improvement
in their living conditions. Parliaments should do as Alfred Marshall
(1890, 1947:3) wrote:

“Now at least we are setting ourselves seriously to inquire whether it
is necessary that there should be any so-called ‘lower-classes’ at all:
that is, whether there need be large numbers of people doomed from
their birth to hard work in order to provide for others the requisites
of a refined and cultured life; while they themselves are prevented by
their poverty and toil from having any share or part in that life.”

Books are more stimulating and more enjoyable to read if they are
guided by questions and if they cause questions themselves. This book
has been written in the style that it provides answers and thus it must
be feared to be a dull read. It is too late to change that style.
However, some questions are: (1) How is it possible that Europe has an
unemployment of about 10% for more than three decades now, and the USA
the mirror image of poverty ? (2) Can we really trust our governments ?

With this book ends a project that basically started with the Fall of
the Berlin Wall in 1989. My hope is that this book contributes to the
fall of some other walls, i.e. the intangible mental ones, consisting
of perceptions and conventions - but equally confining.

Contents in Brief

Book I Introduction 11

Book II Trias Politica and Economic Supreme Court 16

Book III Economics ‘as usual’ 36

Book IV Presentations for the general public 60

Book V Methodology: Definition & Reality 69

Book VI Structural models 87

Book VII Social Choice 158

Book VIII Supportive notions 186

Book IX Reduced form 198

Book X Conclusions 216

Appendices 266

The symbol ° is used to indicate market clearing equilibrium (and
possibly expectational). The symbol * or E[.]is used for expectations
and expectational equilibrium (and possibly market clearing). The
symbol °* is used for both, and · for the one or the other (and
possibly both).

Contents

Book I Introduction 11

1. Order of presentation 11

2. The general theory 11

3. Methodology 14

Book II Trias Politica and Economic Supreme Court 16

4. The Trias Politica 16

5. The economic record of the 20th century 18

6. An Economic Supreme Court 24

7. Position of the Court in economic theory 26

8. The record of economics itself 26

9. Economics ‘as usual’ and its inadequacy 30

10. Four empirical cases 32

11. The moral imperative 33

Book III Economics ‘as usual’ 36

12. Introduction 36

Stylized history 38

Structure of the argument 41

The difference that it means 42

13. Unemployment via taxes and minimum wage 43

The earnings distribution 44

Analysing the minimum wage 44

The Tax Void 47

Cause of the Tax Void 48

Development of the Tax Void 51

Marginal tax rate & VAT 53

Marginal tax rate & dynamics 54

Spillover and domino effects 56

Diagnosis and Therapy 56

Stagflation resolved 57

14. The 1974 Duisenberg disaster 59

Book IV Presentations for the general public 60

15. Unemployment solved ! 60

16. Enable Russia to help itself 64

Parallel 64

Risk not chance 65

Internal not external 65

Conclusion 66

17. Will the West repeat Versailles ? 66

Book V Methodology: Definition & Reality 69

18. How to check ? 69

19. Dealing economically with concepts 70

Maximising information power 70

Pythagoras and the circle 73

Falsification 76

Determinism and free will 78

From stylized fact to definition 82

Relating to Hicks 1983 83

20. Structural and reduced form 84

21. Direct application to the Economic Supreme Court 85

22. Methodological summary 85

Book VI Structural models 87

23. A textbook macro-economic model 87

The IS-LM model 87

The production function 89

Dynamics versus statics 90

Phillipscurve 90

Macro-economic interactions 91

24. Heterogeneity and nonlinear taxation 92

Heterogeneity versus homogeneity 92

Nonlinear versus proportional taxation 93

Some literature 93

25. Summary of current views 94

A simple view 94

A complex view 96

Efficiency wages intermezzo 96

A more sophisticated view 97

Confusions 98

26. Heterogeneous labour 99

Dromedary supply 99

Dutch income distribution data 100

Definitions and formulas 102

Amendment to the textbook model on the Phillipscurve 106

27. Subsistence 106

Definitions 107

Economic literature 109

Types of indexation 109

Formal development 110

28. Phillipscurve 115

Concepts 115

A homogeneous Phillipscurve 118

On expectations 121

Heterogeneous Phillipscurves 122

More factors that cause a shift 122

Crowding out 123

Poverty 124

The submarket Phillipscurves 125

Shifting back 125

29. Tax basics 126

Taxes and premiums 126

Common structure 127

Nonlinear tax function 128

Exemption 129

The marginal rate 140

Balanced growth 143

Off balanced growth 144

30. Dynamic curvature of the tax wedge 145

Introduction 145

Formulas 145

Graphs 147

31. Differential impact of the minimum wage on exposed and sheltered
sectors 149

Introduction 149

Model 151

Graphs 152

Tables 154

Conclusion 155

32. Dynamic optimality 155

The Phillipscurve revisited 155

Investment, growth and productivity 156

Book VII Social Choice 158

33. Introduction 158

34. The solution to Arrow’s difficulty in social choice 159

Introduction 159

Basic concepts 162

Restatement of Arrow’s Theorem 165

A note on the name of APDM 167

A lemma 167

Rejection of the Arrow Moral Claim (AMC) 168

Rejection of the Arrow Reasonableness Claim (ARC) 168

Selection of the culprit axiom. 169

Examples of consistent constitutions 170

A reappraisal of the literature 170

Conclusion 172

Addendum: Sen’s restatement in “Development as freedom” 172

Addendum: Mas-colell, Whinston and Green, “Microeconomic Theory”
175

35. Without time, no morality 175

Introduction 175

Control of natural forces in the social process 176

Three traditional methods 177

Borda Fixed point 178

Relation to Saari’s work 179

Pareto 182

A note on cheating 182

Conclusion 183

36. Some notes on ethics 183

Book VIII Supportive notions 186

37. On the nature and significance of a free lunch 186

Some quotes 186

Consumers surplus 187

Economic growth 188

Conclusion 192

38. Proper definitions for uncertainty and risk 192

Uncertainty 192

Risk 193

Example 195

Wrong use in economics 1921-2005 196

Book IX Reduced form 198

39. The possibility of full employment in the welfare state 198

Introduction 198

Stylized facts 198

Concepts 199

The theorem 201

Graphical presentation 205

40. The possibility of co-ordination 206

Stylized facts 206

Concepts 207

The special theorem 211

The general theorem 213

On the interaction of the reduced form theorems 214

More on Paul Krugman 256

The Dutch tragedy of the murder of Pim Fortuyn in 2002 256

On the European Enlargement 259

Advice to vote NO on the current proposals for a European Constitution
260

A note on my own position 261

Appendix: After 20 years of mass unemployment: Why we might wish for a
parliamentary inquiry 262

46. Final conclusion 263

Epilogue 264

Appendices 266

On the definition of economics 266

Biographical note on Montesquieu 270

Price inflation and wage growth in Holland 1950-2002 272

Income distribution in Holland 1950 and 1988 273

Program used in the analysis on exposed and sheltered sectors 275

A note on Hayek 276

A note on Barrow’s “Impossibility” 278

A constitutional amendment for an Economic Supreme Court 279

A parallel argument on the Central Bank 281

About the US Council of Economic Advisers 282

From the “Employment Act of 1946” 282

Martin Feldstein on the US Council of Economic Advisers 283

Commenting on this 288

Presentation for the National Press in Washington 1993 289

Clinton administration EITC plans for 2000 293

Summaries of additional papers 298

A note on the New Economy (2000) 299

On the 2005 edition of this book 300

Autobiographical note 303

What is new in this analysis ? 305

Abstract 306

Literature 311

Index 323

Book I
Introduction

1. Order of presentation

The basic idea of this book is that Keynes’s _General Theory_ is
generalised even further by including endogenous government in the
model so that we arrive at a truly general Political Economy. The
argument can be presented in a top-down fashion, for example by
repeating the IS-LM model before the amendments are introduced. This
order appears to be uninviting and therefor the argument is presented
in a bottom-up fashion. We better discuss the amendments before we look
at the consequences for theory as a whole. We start with the new
economic synthesis and the argument for the Economic Supreme Court,
since these motivate the book.

2. The general theory

Political Economy is the science of the management of the state. More
in general, ‘economics’ is Greekish for ‘management theory’.

[1] Marshall already explained that ‘economics’ is wider than
‘political economy’, see his “Principles of economics” (1947:43). The
proper definitions are:

· Economics ‘in a narrow sense’ puts the _approach_, methods and tools,
of the discipline central, and looks at a variety of subjects.

· Political Economy puts the _subject_, the management of the state,
central.

· Economics ‘in a broad sense’ joins the ‘narrow sense’ and Political
Economy.

One way to view these distinctions is to visualize a matrix with the
sciences in the rows and the subjects in the columns. The common
economist may to some extent neglect the inputs of the other
disciplines, but the political economist must draw on the resources of
philosophy, history, law, sociology, politicology, social psychology,
biology, physics and so on.
[2] Political Economy is, just by definition, the study that tries to
integrate all human knowledge about the management of the state.
Political Economy is, in that respect, the proper continuation of
ancient philosophy on that subject matter.

Confusions easily arise when these definitions are not understood. [3]

The reasons to adopt these definitions are rather mundane. The King -
and the ruling elite - can derive their wealth (a) from exploitation or
(b) from general productivity growth. The latter is more advantageous
in the longer run. [4] Productivity can be increased in basically two
ways: by technology or by management. For example, computers can add to
our wealth, and we must have technology to be able to have computers.
But a room full of computers does not present much value if we don’t
manage their use. So technology and management are the two sides of the
coin of human wealth. Though no study should neglect either side, there
of course is advantage in some specialisation of those studies. The
engineers take one side, the economists the other.

Psychologists and artists might object to that view, and argue that
proper training in enjoyment and in particular the arts could teach
people to enjoy life so much more, requiring neither additional
engineering nor economics. In a sense, this viewpoint would seem to be
correct. In another sense, it apparently isn’t sufficient. Human beings
get used to levels of wealth, and require more wealth. It would be
economics again to study why people are not happy eating bananas and
watching sunsets. And dealing with issues like this, is management
again.

Also, when writing this in 2000, and again 2004, there are some rumours
about the ‘end of the state’ and the ‘loss of power of existing
nation-states’. This clarifies that the definition of ‘Political
Economy’ subsequently requires a definition of the ‘state’. I will not
try to give that here.
[5] For the purposes of this book it suffices to take the existing
nation-states, and international governmental bodies, and we can
reconsider that assumption when they all drop their constitutions.

Then: The economic process can be understood much better if economic
policy making itself is included as one of the factors, and then is
studied from the Public Choice perspective. The basic proposition of
this book hence is that we can extend the current ‘neoclassical
synthesis’ by including endogenous government in the model, so that we
arrive at a truly general Political Economy.

This extension causes the subsequent proposition that it would be
advisable for a democratic society to create an Economic Supreme Court
as a separate power in the constitution next to ‘Trias Politica’ of the
Legislative, Executive and Judicial branches.

It is useful to recall that economics does not restrict its attention
to ‘income’ only, but also considers rights and duties. Coase’s theorem
is a good result in an older tradition. Sen (1999)’s “Development as
freedom” is a welcome refresher. Beckerman (1999) explains that when
economic growth causes our grandchildren to be wealthier than us
anyhow, that we should rather focus on bequeathing a good system of
justice rather than try for even more growth. So, it is quite natural
in Political Economy to also consider the law.

The basic argument is the following. Governments already have economic
planning bureau’s - the US for example have the Council of Economic
Advisers to the President. [6] Current forecasts are conditional on the
assumption that the government will do as planned and promised. Such
forecasts often fail, and can be forecasted to fail if one takes an
independent position. Proper forecasting requires that the economic
adviser not only has a scientific attitude, but also a scientific
position, and is able to tell and indeed tells the public that plans or
promises will fail if there is scientific reason for thinking so. Given
the experience of the 20th century, it appears that strong
constitutional safeguards are required to provide for this public
function. Hence an Economic Supreme Court.

Keynes (1936) already formulated a ‘general theory’ for political
economy. Keynes subsumed the ‘classical’ approach as a special case.
[7]

Keynes’s theory is rich in many respects and poor in other. On the poor
side: Keynes’s book is not exact on many issues, and proper models like
the IS-LM model were only developed by Hicks, Meade and others.
Samuelson (1947) presented the first integration of both the
competitive model and the utility maximising calculus, only then giving
body to the notion of ‘classical’. [8] However, on the rich side:
Keynes’s book was and still is a source of inspiration for new research
angles. Note that Samuelson coined the phrase ‘neoclassical synthesis’
for ‘his’ conceptual integration of classical processes at the micro
level and Keynesian processes at the macro level. This synthesis
endures till today, as e.g. Colignatus (1990a), Blanchard (1999) and
Krugman (1999) acknowledge. It is important to note, though, that
Samuelson’s phrase is a bit awkward, since Keynes himself already
proposed such synthesis - he namely did not abandon micro-economics. It
would be wrong to associate Keynes only with the macro-economic leg of
the synthesis. Thus the neoclassical synthesis is actually the
Keynesian synthesis itself. But we may as well use the phrase
‘neoclassical synthesis’, if only to acknowledge the role of others.
[9]

Keynes remains vitally present, not only for reasons of polical economy
but also in the standard macro-economic core. A student who considers
recent textbooks on economics, such as Mankiw (1992 and 1998) or
Dornbusch & Fischer (1994), notes that the core of macro-economics
still derives from Keynes (1936) and from the interpretation of his
theory by the IS-LM model developed by Hicks (1937) and others. The
ongoing discussion since 1936 can only be understood by properly
including these original theoretical roots. Krugman gives a useful
refresher in his “The return of depression economics” (1999). Flanning
& Mahony (1998, 2000) provide a recommendable modern summary companion
to _The General Theory_ that is a testimony of its relevance. The
theoretical extension with the Phillipscurve in its relation to
unemployment and inflation belongs to this tradition. Also practical
economic modelling, such as the models Athena and MIMIC of the Dutch
Central Planning Bureau rely on that macro-economic core, see CPB
(1990) and Graafland and De Mooij (1998).

There are also good reasons to remain modest about the novelty of the
‘new synthesis’ proposed in these pages. Keynes had an open eye to the
policy making process and social philosophy. Similarly, Public Choice
theorists like Buchanan and Tullock have not suggested that other
factors like the macro-economy itself were not important - they only
emphasised the importance of Public Choice. In that sense the presently
proposed extension with institutional economics, information and Public
Choice is no real extension.

In addition, the three pillars of the Trias Politica are not fully
independent already. There are rather numerous dependencies instead. A
modern nation has decentralised much power, and created hundreds of
‘independent organisations’ - so that some speak about ‘myrias
politica’ instead of ‘trias politica’.

However, from the very definition of ‘political economy’ it follows
that the function of analysing, theorising and forecasting the
management of the state is a part of management itself, and this
function indeed can be in danger of the other three branches.

A nation that will adapt its constitution to create an Economic Supreme
Court will still feel that it takes a historical step. Similarly,
economists would feel the change of perspective. It would be a
different world, for example, if the US Council of Economic Advisers to
the President would honestly state that they ‘would rather veto the
Budget’ if they really would think so; and if they would become subject
to criticism from the profession if they wouldn’t start behaving like
this. So, speaking about a new synthesis is of major significance. And
it can be shown to be crucial.

3. Methodology

Methodology appears to be important in this book. Sometimes, paradigm
shifts are as much a matter of methodology as a matter of content.

One example is Keynes. As an economist, Keynes emphasised the economic
content of his analysis: notably his findings on the peculiar role of
money in the economy. His observation is firstly that money is both a
medium of exchange and a store of value, and secondly that storage
value depends upon expected value: and then his analysis on
expectations takes off. In retrospect the force of Keynes’s analysis is
a bit less ‘economics’ than he thought, and has more to do with the
handling of time than with money per se. Samuelson (1947, 1983:117) and
Grandmont (1983) showed that the analysis can be reproduced if money is
entered in the utility functions. What remains is the issue of time.
From a methodological point of view, Keynes’s theory is general in that
it extends economic equilibrium with the notion that market
non-clearing _disequilibrium _such as unemployment could be a state of
expectational _equilibrium _too (a different concept of equilibrium).
And money need not be the only cause, witness for example the
difficulty of forecasting sales in order to set production.
[10]
[11]
[12]

Another example of the relevance of methodology appears to be Samuelson
(1947). Samuelson emphasises his interest in a general theory (that
word again) of economic theories, and clarifies that such a theory (i)
should apply to various circumstances and (ii) be meaningful (as
opposed to being a tautology). Samuelson clearly presents his argument
as a methodological one. [13]

Originally, the draft of this book started out with methodology, but
this discussion now has been moved downwards, to a place where one will
better appreciate its argument and the need for it.

Book II
Trias Politica and Economic Supreme Court

4. The Trias Politica

Montesquieu published his _De l’Esprit des Lois_ in 1748. An English
translation can be found on the internet, and a short biographical
note, taken from there, has been included in an appendix. Though his
book discusses many issues, it remained famous for the theory of the
separation of powers, i.e. of the Legislative, Executive and Judicial
branches of government. The American phrase is ‘checks and balances’. A
key passage in Book XI shows that Montesquieu also refers to the
existing case of England - so that his role is not one of originator
but one of keen observer and developer of theory:

“One nation there is also in the world that has for the direct end of
its constitution political liberty. We shall presently examine the
principles on which this liberty is founded; if they are sound, liberty
will appear in its highest perfection.

To discover political liberty in a constitution, no great labour is
requisite. If we are capable of seeing it where it exists, it is soon
found, and we need not go far in search of it.

6. Of the Constitution of England. In every government there are three
sorts of power: the legislative; the executive in respect to things
dependent on the law of nations; and the executive in regard to matters
that depend on the civil law.

By virtue of the first, the prince or magistrate enacts temporary or
perpetual laws, and amends or abrogates those that have been already
enacted. By the second, he makes peace or war, sends or receives
embassies, establishes the public security, and provides against
invasions. By the third, he punishes criminals, or determines the
disputes that arise between individuals. The latter we shall call the
judiciary power, and the other simply the executive power of the state.

The political liberty of the subject is a tranquillity of mind arising
from the opinion each person has of his safety. In order to have this
liberty, it is requisite the government be so constituted as one man
need not be afraid of another.

When the legislative and executive powers are united in the same
person, or in the same body of magistrates, there can be no liberty;
because apprehensions may arise, lest the same monarch or senate should
enact tyrannical laws, to execute them in a tyrannical manner.

Again, there is no liberty, if the judiciary power be not separated
from the legislative and executive. Were it joined with the
legislative, the life and liberty of the subject would be exposed to
arbitrary control; for the judge would be then the legislator.

Were it joined to the executive power, the judge might behave with
violence and oppression.

There would be an end of everything, were the same man or the same
body, whether of the nobles or of the people, to exercise those three
powers, that of enacting laws, that of executing the public
resolutions, and of trying the causes of individuals.”

It is useful to recall Montesquieu’s definition of political liberty:

“We must have continually present to our minds the difference between
independence and liberty. Liberty is a right of doing whatever the laws
permit, and if a citizen could do what they forbid he would be no
longer possessed of liberty, because all his fellow-citizens would have
the same power.”

Thus, of key importance: A person with few means can take less
advantage of his liberties than a person with more means. A person with
insufficient means might be regarded as not free at all. This brings us
to the economic amendment to Montesquieu’s heritage.

There appears to be a clear link between Montesquieu and Adam Smith. In
his preface to his edition of Smith (1776; 1974), Skinner explains that
Smith used the historic method to provide him with empirical input
(rather than econometrics). Quite fittingly, Skinner writes:

“(…) it was Montesquieu rather than Voltaire who provided the most
important impetus to their studies. Montesquieu was widely regarded as
the ‘greatest genius of the present age’ and his _Esprit des Lois_ came
to be enjoy a considerable vogue in the circle of Smith’s friends. But
while Montesquieu’s work provided an important stimulus, the Historians
in general, and Smith in particular, went well beyond the teaching of
the master. In the words of one of their number: ‘The great Montesquieu
pointed out the road. He was the Lord Bacon of this brand of
philosophy. Dr Smith is the Newton.’” (p30)

The limitations of the Trias Politica with regards to economics are a
well-known theme. Marshall’s “Principles of economics” opens with the
painful story of poverty - as Mankiw unfortunately waits till p421.

David M. Kennedy (1999:245), “Freedom from Fear; The American people in
Depression and War”, quotes Roosevelt in a special message to the US
Congress on June 8 1934:

“(…) ‘the interdependence of members of families upon each other and of
the families within a small community upon each other’ provided
fullfillment and security. But those simple frontier conditions now had
disappeared. ‘The complexities of great communities and of organized
industry makes less real these simple means of security. Therefor, we
are compelled to employ the active interest of the Nation as a whole
through government in order to encourage a greater security for each
individual who composes it.’ The federal government was established
under the Constitution, he recollected, ‘to promote the general
welfare,’ and it was now government’s ‘plain duty to provide for that
security upon which welfare depends’. (…)”

5. The economic record of the 20th century

Unemployment and poverty can be seen as indicators for the quality of
the management of the state. They are social phenomena, and thus depend
upon the rules that society defines. When they exist, then apparently
something is wrong with the management.

The economic record of this century may be judged with mixed feelings.
Much has been achieved, but much has gone wrong too:

1. Two World Wars.

2. The Great Depression 1930 - 1940.

3. The Great Stagflation 1970 - the present (2005). [14]

4. Disputable ways for decolonisation and development
co-operation.

5. The economic disaster in Russia and Eastern Europe after the
Fall of the Berlin Wall.

6. The environment.

Of this record, the wars are the focal points of attention.

Wars are disasters for the common citizen. Perhaps wars need to be
fought for political reasons, but, an economist can express some doubt.
In fact, Keynes wrote his General Theory with an eye to the threat of
war:

“War has several causes. Dictators and others such, to whom war offers,
in expectation at least, a pleasurable excitement, find it easy to work
on the natural bellicosity of their peoples. But, over and above this,
facilitating their task of fanning the popular flame, are the economic
causes of war, namely the pressure of population and the competitive
struggle for markets. It is the second factor, which probably played a
predominant part in the nineteenth century, and might again, that is
germane to this discussion.”

_John Maynard Keynes,_ “The General Theory of Employment, Interest and
Money”, 1936:381-382

Skidelsky even makes a strong case that it took the War for people to
start listening to Keynes:

“In his biography of Keynes, Sir Roy Harrod reports a widely acclaimed
speech delivered by his subject to the House of Lords in 1946, the year
of his death. ‘But Keynes had been talking in this style ... for some
twenty-seven years. Why had his words not been listened to .... ?’
(...) Unemployment as a problem in economic theory may have been
sufficient to produce a revolution in the discipline; unemployment was
not a sufficient problem to society to produce a revolution in
political ideas. If it was not the prolonged experience of mass
unemployment that finally broke the hold of nineteenth-century ideas,
what was it ? A strong case can be made out for war. ‘Normal’ life
could coexist with unemployment; it could not with modern war.”

_Robert Skidelsky,_ “The reception of the Keynesian revolution”, in
Milo Keynes, “Essays on John Maynard Keynes”, CUP 1975:89 & 102-103

Kennedy (1999) makes clear that ‘Keynesian’ elements like maintaining
aggregate demand were prominent elements in even Herbert Hoover’s
policies. Similarly, deliberate inflation was considered by Roosevelt
e.g. to help farmers reduce their debt burden. Nevertheless, Kennedy
has to write: “In the ninth year of the Great Depression and the sixth
year of Roosevelt’s New Deal [i.e. 1938 /TC], with more than ten
million workers still unemployed, America had still not found a formula
for economic recovery.” (p362) There was contact between Roosevelt and
Keynes, but with little effect - Roosevelt apparently regarded Keynes
pejoratively as an academic theorist. Then:

“Deprived of adequate public or private means of revival, the economy
sputtered on, not reaching the output levels of 1937 until the fateful
year of 1941, when the threat of war, not enlightened New Deal
policies, compelled government expenditures at levels previously
unimaginable.” (p360)

The policy stagnation around 1938 is the more surprising, since Kennedy
reports Roosevelt saying on a Fireside Chat at that time (April 14
1938): “History proves that dictatorships do not grow out of strong and
successful governments, but out of weak and helpless ones.” (p362)

Keynes is an amazing person also on the following. Skidelsky makes
another important point about Keynes’s role in the aftermath of the
First World War in turning people’s attention from geopolitical power
to economic growth:

“None of this is to deny that _The Economic Consequences of the Peace_
was a very influential book. Of the dozens of accounts of the Treaty
which appeared in the 1920s it is the only one which has not sunk
without a trace. It captured a mood. It said with great authority,
flashing advocacy and moral indignation what ‘educated’ opinion wanted
said. It also had an influence at a deeper level. Wickham Steed was
right: it was a revolt of economics against politics. The war had been
fought in the name of the nation, state, emperor. These, Keynes argued,
were false gods, from whom he sought to divert allegiance towards
economic tasks. It was a message calculated to appeal to the nation of
Cobden and Bright, once it had recovered of its intoxication with
military victories. It helped form the outlook of a new generation. The
nineteen-twenties saw a new breed of economist-politician, who talked
about the gold standard and the balance of trade as fluently as pre-war
politicians had talked about the Two-Power standard and the balance of
power. (…) The idea that the creation of opulence was the main task of
rulers was born in 1919 though it came of age only after the Second
World War.” Skidelsky (1983:399). [15]

Reading this, one would tend to think that there still is a risk when
politicians get involved with the economy.

The Trias Politica setting is usefully limited to the nation-state.
However, if we were to limit our attention to the nation-state, could
we really neglect the external conditions ? One would think not. A
crucial chapter in the theory of the nation-state concerns the external
relations: trade and war by tradition, and then, in our age: the risks
of world population growth and of environmental disaster, i.e. risks
that may spill over across the border. Wise managers would not close
their eyes to external risks. Hence, though this book concentrates on
the situation in the Western democracies, we also regard the
non-democracies in the developing world.

Projections for the future indicate such external risks:

“The Global Crisis scenario (...) explores the risks and dangers of a
neglect of, and late response to regional and global challenges (...)
the world may end up in the throes of widespread distress, an
eco-crisis, which can only be corrected at high cost. The policy
message conveyed by this scenario is abundantly clear. Dismissing this
scenario as unduly gloomy and pessimistic is in our view, absurd; such
a statement would be tantamount to a complete denial of large segments
of twentieth-century history.”

_Centraal Planbureau,_ “Scanning the future”, SDU 1992:211

World population is forecasted in 1999 to rise to 9 billion around
2050, with a forecast error of 1.5 billion lower or higher. The central
forecast already is a reduction from a forecast of 9.5 billion as the
result of AIDS. This disease not only kills, but also reduces the
quality of life for the surviving. Other diseases may well develop. Or,
for AIDS itself, given the huge number of infected, a mutation could
develop that can be transferred by flies or mosquitos too - that
already transfer diseases. Another problem is that when policy succeeds
in improving a situation, then such new room tends to be taken up for
growth again. So it would be some kind of a miracle if the world would
hit the ‘low’ 7.5 billion target with a healthy, well fed, educated and
peaceful population.

UNDP administrator Speth correctly states:

“Fifty years after the adoption of the Universal Declaration of Human
Rights, one third of the world’s people are enslaved by a poverty so
complete that it denies them fundamental rights.” (UNDP 1999 internet
site)

This quote usefully recalls to memory that Montesquieu’s liberty has
been extended in this century with more rights, so that there is an
even stronger intellectual case to test whether the system of Trias
Politica serves the demands made on it.

Amartya Sen’s “Development as freedom” (1999) is along this line of
reasoning.

The hypothesis of self-interest clarifies that Western nations are less
interested in the development issue. Surely, if the Democratic State
knew that economic policies were feasible that would make external
development Pareto improving rather than wasteful, then it would deem
it wise to pursue such a course. And part of the argument in this book
is that such knowledge does not get the attention that it deserves. On
the other hand, we should presume the lack of that attention, and the
lack of sufficient knowledge. But we can still argue that the current
world development situation should provide the West with some worry
anyhow.

For Western democracies, current situations in the developing world
might be regarded as replays of their own past, and as forecasts for
their own future - if times of distress were to return again. A 1996
UN-WIDER statement was:

“Thus, man-made crises have become a serious, perhaps the most serious,
threat to human security in the present world.” [16]

“Over the last ten years, the number of humanitarian crises has
escalated from an average of 20-25 a year to about 65-70, while the
number of people affected has risen more than proportionately. The
International Red Cross estimates that the number of persons involved
is increasing by about ten million a year. As a result, scores of
people have been left dead, maimed, starving, displaced, homeless and
hopeless. Afghanistan, Bosnia-Herzegovina, Burundi, Cambodia, Central
America, Haiti, Liberia, Sierra Leone, Rwanda and Transcaucasia are the
countries or regions where the most acute crises have occurred during
the last two decades. In turn, Guyana, Kenya, Surinam and Zaire are
nations where negative trends in the factors under analysis make many
fear that social explosions may take place in the not too distant
future, unless corrective measures are introduced urgently.” (idem)

E. Wayne Nafziger (1998), of UN-WIDER, reports in the Financial Times:

“Many people believe that humanitarian disasters are ethnically
determined, arising from differences of language, race, tribe or
national origin between disputants. These differences, it is thought,
are so deeply rooted that they are not amenable to economic and
political reform: violence cannot be avoided. That is too pessimistic a
conclusion. Our research focuses on the contribution to humanitarian
crises of two factors: national income and the role of the government.
Both provide some reasons for modest optimism, or at least subjects for
action. (…) An analysis of the root causes of humanitarian crises
indicates that the mechanism for preventing them are primarily
macro-economic.”

Then, there are Russia and Eastern Europe after the Fall of the Berlin
Wall in 1989. The risks of turmoil in Russia, while nuclear weapons are
abundantly about, were already evident in 1989, and indeed we have seen
an attempted coup against Gorbachev and later the bombing of the Duma
parliament building. Eastern Europe had the criminal actions of
Milosevic. The risks with respect to Russia still exist. Both in 1989
and today in 2004 a reasonable expectation was and is that Eastern
developments would and will be positive. But the crucial issue does not
concern the average, but the _risk_. Who understands the economics of
unemployment will see that Western economic policy is deficient on this
point - a topic that we shall return to.

In the middle of 1999 the UNDP also published a report on Eastern
Europe. The conclusion is that there is much more misery than commonly
recognised, and that most misery is needless and also a result of wrong
decisions by Western governments. In an interview with director
Kruiderink, a key question and answer is:

Q: “According to some experts it went wrong precisely since the
economic reforms did not go far enough.” A: “Nonsense. The ruin would
only have been greater. No, precisely the reform of the state should
have been the main target. Some people actually said that ten years
ago, but they were not listened to. They were considered to be
_softies_, since they wanted to maintain parts of the communist system.
You currently see economists of the Worldbank and IMF slowly change
their minds too.” [17]

What is crucial is that the methods, by which such dissenting ‘softies’
were silenced, were unscientific. Crucial policy preparations were left
to the fric and fray of politics and bureaucrats, unworthy of a decent
democracy.

There is Robert Barro’s research in the relationship between democracy
and growth. An early report is in Barro (1996) [18] but he has been
working on it since. His results suggest that it first takes a certain
level of income before democracy has a chance. This reminds one of the
willingness of Westerners to accept dictatorships in developing
countries as long as economic welfare is increasing. Four comments can
be made: The present discussion is targetted at existing democracies,
and Barro’s finding then is only relevant as a warning of what could
happen if the risk of, say, an eco-crisis would materialise. Secondly,
Barro seems to imply that current democracies are finished, and that
there is no next stage. But we can advance. Thirdly, once the concept
of an Economic Supreme Court is clear, then one could imagine that a
dictatorship on the way to a democracy (notably China) could first
install such a Court - and the rule of law - before it moves towards
elections. Finally, we should read Sen (1999a) as an answer to the
Barro analysis, since it could rather be that democracy futhers
development and growth.

Above uses plain human survival to judge on the economic record, it
focusses on war, humantarian disasters, overpopulation, diseases,
environmental deterioration. It is sobering to regard the more standard
economic outcome. Table 1 reviews the unemployment in the European
Union for 2003, reassembling the data after the enlargement of May 1
2004.

Table 1. Unemployment in the European Union in 2003

Eurostat [19]

EU (after enlargment)

EU 15

Total population

451 million

378 million

Unemployed

19.0 million

14.2 million

Idem,
% labour force (age 15+)
%
%
%
9.1 %

8.1 %

Participation [20]

72.0 %

72.4 %

The unemployment figure excludes many welfare state benefit recipients
who could work when judged from other standards. For example, there is
the well-known case of ‘disability’ with a major fraction of hidden
unemployment, see OECD (2003). A hypothesis in public choice theory is
that policy makers in the past solved part of their problem with
unemployment by allowing an increase in these other welfare programmes.
The recent focus in the policy debate is upon increasing participation
again, shifting people from such arrangements back into the labour
force. This debate however runs into the problem of unemployment again.
Disability, sickness, early retirement and welfare relief might be
reduced (by reducing problems in the bureaucracy, solving
principal-agent problems, and by adjusting definitions, reducing
entitlements), yet it might well cause higher unemployment again and
thus only shift the problem. A major insight thus is that unemployment
remains the root problem for macro-economic policy making. It is proper
that we pose the question: why is it that the EU doesn’t achieve more
employment ? This question can best be answered by taking a long run
point of view - which is not the standard economic point of view.

We can conclude this chapter as follows. The economic record of the
last century is mixed, and human suffering was large. For the future:
there still are serious risks. Bad economic conditions don’t
necessarily result into wars. During the Great Depression the US
remained a democracy and didn’t resort to fascism. Though it came close
! [21] Nevertheless, there can be situations in which certain
politicians can rise to power by exploiting social, religious and
racial sentiments - which sentiments actually draw on economic distress
and uncertainty. Such is actually the rule, and stable democracy is
rather the exception. Though the probability of such developments might
be limited, in the currently affluent West, their costs would be great,
and hence the risk may be sufficiently large to try to _do_ something
about it. If the system already fails now, what may happen if
circumstances would turn out to be far less favourable ?

Since Western societies since the Second World War already have much
experience with standard approaches to enhance economic security, and
are apparently failing to a large degree, it becomes time to look for a
more fundamental approach. We may look into the very process of
economic policy making itself.

6. An Economic Supreme Court

Since the problem is found to be equal across nations and across time,
we may look for common factors. The basic factor that we can identify
is the Trias Politica structure of Western democracies. The present
checks and balances are imperfect. This structure appears to allow too
much leeway for forces that are detrimental to the economic well-being
of the population at large, their economic security and their
possibilities for the pursuit of happiness. The structure of economic
policy making allows politicians, bureaucrats and special interest
groups too much room to distort the contribution of economic
scientists.

The conceptual scheme of the Trias Politica was a useful ladder to
climb out of the situation of feodality and absolute kings. But a
ladder is not a goal in itself. Democracy is a living concept and can
develop further. If we find that the Trias Politica fail with regards
to our needs, then we should adapt it.

In the past there have been two steps towards more independence and
more checks and balances in the management of the economy. First there
was the independent Central Bank, and then the separate Council of
Economic Advisers to the government (or other planning body). Indeed,
the situation after the Second World War has been much improved:
instead of a Great Depression we only got a Great Stagflation.

Okun (1983), “The economist and Presidential leadership”, provides an
recommendable account of current practice. Two quotes are particularly
relevant, one that observes current partiality and one that advises
impartiality:

“Given these constraints, members of the Council of Economic Advisers
are clearly recognized as the President’s men. If they speak publicly,
they will be identified as spokesmen for administrative positions.”

“One wishes for a more effective way of influencing public and
congressional opinion in the areas of professional consensus. There is
a role to be played by a Supreme Court in the profession, although a
less important one than that actually fulfilled by the Council and the
Bureau of the Budget in recent years.” (p580)

We are advised to go one step further than the current situation, and
create a scientific Economic Supreme Court safeguarded within the
Constitution as an equal partner next to the three of the Trias
Politica. Its role will be limited, but crucial.

The argument is not that politicians could not be qualified in
economics. The argument is the balance of power. Having an Economic
Supreme Court increases democracy, since it improves the quality of the
checks and balances. It caters to the civic right of good government
and to the right to know.

The crucial considerations are:

· The first point is _theory dependence_. The State will decide on its
policy while using an economic model. Hence policy is directly
dependent upon the state of economic theory. Who is going to decide
what the current state of theory is ?

· The second point concerns _self-reference_ (reflexiveness). The model
contains a submodel of State instruments. Clarity requires that policy
itself is clearly formulated and put into the model too (with error
terms to allow for possible discretion).

· The third point is _conflictive self-reference_. One can conceive the
situation that the government announces a policy while the true
scientific forecast shows that the policy is untenable and will be
repealed later. Hence there is an internal source of conflict - the
worst kind, not a dysfunctional person, but a logical knot.

· Finally, there is a ‘general conflict of interests’. Governments have
more objectives, and any power group might want to exert its influence
anyway.

It follows from this that the Constitution should warrant for the
Economic Supreme Court:

· It would be possible for the Court to use a model with an endogenous
government. The Court would scientifically forecast government actions,
instead of _conditionally_. The conditional forecast assumption that
government promises will be kept and government assumptions realised,
will be dropped.

· As the Court will have a scientific base, there can be publications
and discussions with different analyses, and these would not by
themselves mean a breach of confidentiality.

· The Court cannot exist without some power.

It would suffice for the Court to have the power to veto the national
budget if the information that the Executive presents or uses for the
budget is scientifically incorrect (in the judgement of the Court). The
information and statistics only. The Court will focus on the statement
on the deficit and the national debt, since all errors accumulate in
those figures - though it can call any number or piece of economic
information into question. Parliament of course keeps the power to
decide on the budget and on policy. President and Parliament would lose
the power to make misleading statements as judged by the Court.

An appendix contains a draft constitutional amendment as an example, to
start thinking about it. The appendices also contain a description of
the current US Council of Economic Advisers, and the difference should
be clear - e.g. where the CEA appears to have no scientific status.

With an Economic Supreme Court in place, a downside is that a nation
could get stuck in a specific economic theory. A Court could believe in
Monetarism while reality would require something differently. Indeed,
Keynes himself addressed his _General Theory_ to his fellow economists,
who were as conservative as politicians in rejecting his proposals
about fighting the Great Depression. To answer this: Such stagnation in
policy making can happen nowadays too, but the situation with a Court
is much more transparant. Also, the very job of the Court requires it
to pay attention to the data, and this tends to make for eclectic
views.

7. Position of the Court in economic theory

It is useful to indicate in more abstract terms what this book does.
Unemployment is not taken as a natural disaster like an earthquake, but
regarded as the result of policy. The central questions in the
political economy of employment are: _can _one solve unemployment and
poverty, does one _know_ how, and does one_ want_ to ?

Next to the_ budget set_ and _preferences,_ it appears useful to
distinguish_ information._ Government policy making is not guided by
prices as markets are. Perceptions play an special role. For example,
when policy makers associate tax policy with income distribution
policy, and in that manner overlook inefficiencies such as the tax
void, then policies are blocked that would otherwise benefit everyone.

Colignatus (1990a) forecasted a revival of institutional economics. We
see this happening in the literature indeed. This current book belongs
to that development. An Economic Surpreme Court, or the lack of it, is
a topic in institutional economics, and thus has a natural position in
the proposed new synthesis. [22]

There have been precursors to this approach indeed. Galbraith
(1998:199) correctly quotes Michael Kalecki (“Political aspects of full
employment”):

“The assumption that a Government will maintain full employment if only
it knows how to do it is fallacious.”

8. The record of economics itself

Economics is not a finished science. Hicks (1983) even rejects the
notion of ‘science’ itself, and writes a chapter with the title ‘A
discipline not a science’. (See also below.) He quotes Keynes:

“The Theory of Economics does not furnish a body of settled conclusions
immediately applicable to policy. It is a method rather than a
doctrine, a technique of thinking, which helps its possessor to draw
correct conclusions.”

A joke is that there are as many theories as economists, and five for
Keynes. Krugman (1994ab, 1996a) describes eloquently how Western
economies came from full employment and a period of great expectations
to a period with unemployment and inflation and a productivity
slowdown, and as a result diminished expectations. He is even more
eloquent in describing the different fashions in economics and economic
policy making. He gives a brilliant discussion of Keynesians,
Monetarists, Supply-siders, Business-cyclists, Post-Keynesians,
Strategic Policy Adepts. Krugman also makes an apt distinction between
serious economists and the policy entrepreneurs who abuse economics for
schemes of their own. [23]

The discussion by Galbraith (1998) is also very useful to understand
the history of economic schools in the last decades. I discuss this
book in the final chapters.

There also is ample reason to be humble about econometric testing of
theories or identifying regularities (see Hendry (1995)), and then we
haven’t started yet on the quality of national statistical data. [24]

If we regard the role of economic theory itself, then we cannot
overlook the error that economists made with respect to Arrow’s Theorem
in the theory of Social Choice.

First of all, there has been a stagnation in theory development:

“Tullock sees public choice as a subject in which there was a burst of
interest from the 1950s to the 1970s, but which has now ‘died out’
(p39). The cause of death was the set of unremittingly negative
conclusions that issued from the analysis of the Condorcet and Arrow
paradoxes.” Sugden (1999).

Secondly, it turns out that economists and Arrow himself gave a wrong
interpretation to the mathematics. Below we will present a novel
analysis with respect to the Arrow problem, and show that economists
have run astray indeed. This gives another reason to be humble.

But, our discussion also provides clarity that social choice can be
based on reasonable and morally attractive axioms. And thus there is a
logical basis for a Court too.

Evaluating in general:

· Looking at this circus, it would be wrong to be only entertained. The
proper point to see - the real upshot of Krugman’s books - is that the
current government structure has little protection against this circus,
the fads and fashions, the David Stockmans: and that this protection
would be larger with a well selected Court. Note that the word ‘court’
has been chosen judicially: the job of this body is to make a judicious
choice, a wise selection of all competing theories and approaches.

· It is useful to realise that the academia basically write for the
journals, i.e. each other, and do not necessarily have the focus of
analysing or predicting the national economy. Van Bergeijk c.s. (1997)
point to these different focusses and the ‘dangers’ thereof. [25] The
academic job also is to generate and test new ideas, not only the
implementation of accepted theory.

· Another aspect of the distinction between the academia and practical
policy advice is that only the first have the luxury of saying that
they ‘don’t know it’. In policy advice this luxury basically lacks, and
a decision has to be supported with the best information available.
Much academic criticism on economic policy advice is overdone, since it
does not take this condition into account.

· Also, economics has come far, and many economic models show
similarities. So there is a body of ‘existing economics’ or ‘accepted
theory’ and a rather firm scientific base. Let me indicate as such: the
textbooks of Dornbusch & Fischer (1994), Mankiw (1992), Blanchard &
Fischer (1989), Mueller (1989), research like Bruno & Sachs (1985),
Layard, Nickell & Jackman (1991), Phelps (1994), and the practical work
such as of the Dutch Central Planning Bureau (1990) (in which I
participated) and Gelauff (1992). [26] [27] As Montesquieu for his
Trias Politica referred to the existing example of England, we can
point to Holland, where the Dutch Central Planning Bureau has earned
itself a strong position, even to the extent that political parties
have their programmes evaluated before elections. One can be severely
critical of that CPB, precisely since it is no real Economic Supreme
Court, but the current achievement is there, and is an argument for
‘promotion’.

If we regard the arguments for a court again, in the light of this
evaluation of the record of economics itself, then:

· The issue is not quite the difference between unfinished science and
finished science. Even if economics were to be like engineering with
some finished science - like Keynes’s famous dentistry, where it would
be easy to switch from one economist to another - then still there are
always decisions to be made. How to interprete the data ? Is factor X
now crucial or not ? Even if a science is finished, then its
application to reality still is an art, and there are differences in
the artists. One should realise that choices are made nowadays too,
albeit hidden and not in the open, and with less scientific scrutiny as
is advisable. Currently we have the President and Parliament deciding
what will be the ‘information’ on which policy is based: and only too
often they select that kind of presentation that suit their goals
rather than the truth. The only suggestion here is to make procedures
such that the result better serves democracy.

· It is important to see that we are dealing with a natural monopoly
here. When the government has to establish its budget and thereby wants
to rely on science, then there has to be an instance at which it is
decided what the current state of science is. Even if one would
‘privatise’ forecasting, and have universities compete in bids for the
contract, then there still is the decision which university to take for
this year. By definition there is a monopolistic situation for that
decision maker at that moment.You cannot compete that away. My analysis
and advice is to embed that authority in the Constitution, and provide
warrants that the critical decisions are taken in scientific manner.

· Thus crucially: If the government on the one hand would desire to use
the results of scientific advice for its budget process, and on the
other hand would not opt for an Economic Supreme Court, then its
_definitions _would be logically inconsistent, and it would thereby
tend to create a cause for dishonesty and improper manoeuvreing and
thereby corrupt its processes. [28]

· We should realise that also law is no ‘finished business’. Our
ancestors have opted for an independent judiciary, even though there is
no unanimity about formulations and interpretations. But precisely
since there is no unanimity, we need an institute to make a decision -
a court.

· It will also be useful here to recall one of the key aspects of being
a scientist: namely the responsibility to make up one’s own mind. The
scientist is in this respect as a judge. He or she has to balance all
pro’s and contra’s, to review theories and facts, to replay all
opinions of the colleagues, and then make a decision as to what he or
she believes is the right thing to think. For example, to let one’s
opinion to be swayed by the opinions of others is unscientific. Now, in
the light of the enormous complexity of an economy, and the additional
complexity of human made theories about the economy, many academics
have the liberty to choose not to ‘believe’ anything - except the
logical consistency of the paper that they read or write. But in policy
advice, this luxury, as said, is lacking, and much more scrutiny of
what one really believes, in terms of probable effects and such, is
required.

9. Economics ‘as usual’ and its inadequacy

Economists can be aware of the problems posed here; but then they tend
to look for solutions _within_ the given framework of the Trias
Politica:

“There may be a communication problem. Using the words of Cairncross,
again: ‘Policymakers as a rule are slightly deaf: there is too much
noise’. In other words, there is a need to raise the ‘signal-to-noise’
ratio. One cannot overemphasize the importance of the packaging — the
simplicity and saleability of ideas and the need to pursue these in
clear and non-technical language using simple diagrams, etc. Moreover,
often the more important contributions of economic advisers are in the
clarification of the most basic and simple (simple only for us,
professionals) concepts (...)” Bruno (1990:276)

The suggestion to my fellow economists is contrary: Thinking within the
framework of the Trias Politica rather is a waste of time. It is like
working from within astrology to arrive at astronomy.

Above discussion is at the constitutional level. It is about the Trias
Politica, the Great Depression and Stagflation, wars, and a suggestion
of a constitutional amendment. Alternatively, there also is ‘economics
as usual’, about prices and wages, growth and such. Part of the
analysis can be presented in terms of ‘economics as usual’ - and then
of course much of the political drama is lost. Part of the ‘usual’
argument can be indicated graphically.

Figure 1: Isoquants of national income

Figure 1 shows how national income is produced. Capital and labour
combine in a production function and give national income. Capital is
aggregated in dollars, labour in personyears.

[29]

Let labour supply be _LS _and the unemployment rate be _u._ In the
unemployment regime 0 only _LS_ (1 -_ u_)_ _work, producing a national
income of _Y0 _in wages and profits. The slope of the tangent gives the
price ratio of wages and rents. In regime 1 _LS_ work, producing _Y1_.
The rise of national income from regime 0 to 1 is the increase in
efficiency from going from the lower to the higher isoquant. The graph
clarifies about the improvement in efficiency that: (a) more people
work, (b) total income is higher, (c) _average _wage costs are lower,
indicating lower pressure on prices, (d) hence, when there is
unemployment, then there is a possible improvement, that benefits some
while it needn’t hurt others.

The story of course doesn’t stop with Figure 1, and is a bit more
difficult. Some points need to be developed - just indicative, not
extensive:

1. We have to show that (current) unemployment is inefficient
indeed, and that it is not caused by technology or globalisation or
labour market inflexibility (which would cause it to be a form of
_efficient unemployment_).

2. Wages may fall _on average, _but the story for each individual
is different. We have to deal with heterogeneous labour. And we have to
develop the impact on inflation.

3. An econometric problem is that observations are based on
observations of _LS_ (1 -_ u_),_ _i.e. on the inefficient area, so that
extrapolations towards the true efficiency frontier are difficult,
especially when labour is heterogenous.

4. Policy makers tend to see the decision process as a clash of
preferences. When a tax reduction is proposed, to tackle unemployment,
then this is translated in their minds into terms of the (re-)
distribution of income - and then it is quickly opposed. So we have to
deal with this source of misunderstanding too.

5. Though above uses a Bergson-Samuelson social welfare function,
many economists are hesitant about that approach and refer to Arrow’s
theorem. This matter then needs clarification too.

Indeed, I might present much of the argument along these ‘economics as
usual’ lines.

But doing that makes part of the problem go away. We no longer see the
dead of the two World Wars, the hungry of the Great Depression, the
ruined lives of the Great Stagflation. We no longer see the devastation
in Russia and many of the Eastern European Countries in the first
decade after the Fall of the Berlin Wall. Closing our eyes to these
issues, would be closing our eyes to the evidence for the need for an
Economic Supreme Court.

The critical observation is: If economics would not confront the
serious problems of mankind, it would lose it relevance to democratic
policy making, and would rather become disinformation and a veil for
anti-democratic policy making. It would become an accomplice in
economic policy stagnation.

10. Four empirical cases

If economics is a science, then it must regard _facts_ as _sacred_.

Many economists don’t quite understand this. When they see some
unpleasant facts, they run, and start studying something else. Or they
live in the corridors of power, and - like politicians - massage the
facts, and make those fit the mold of the times. But running from a
scary fact shows only a partial understanding of their importance. The
proper attitude is to stare at the facts till they don’t go away and
till they aren’t scary anymore, and then adjust theory to fit them.

Sometimes it is said that ‘facts’ don’t say much, but that it is the
theory that makes them tick. People have lived for ages with the
‘facts’ that the moon is 2D round and shows stages of illumination, but
it took them almost as long to accept 3D roundness of heavenly bodies
as a theory. Admittedly, it is hard to impossible to pinpoint a ‘fact’
without also invoking theoretical concepts. But it would be wrong to
switch to the view that ‘everything is theory’. Facts do exist, they
can bite, and economists can be scared by them.

It is scary to economists that economic disaster can be related to the
role of economics and economists.

At a crucial moment in his life J.M. Keynes was what we nowadays would
be calling a ‘whistleblower’. As a civil servant and senior Treasury
representative he served at the Versailles negotiations after the First
World War. At a certain moment he resigned, and wrote _The Economic
Consequences of the Peace _(1919)_._ Many people thought that he should
have kept silent given his position as (ex-) civil servant, and perhaps
this played a role in his never becoming a full professor. I don’t have
the intention to resolve this issue. But a valid question is: Would it
not have been better if we had had Economic Supreme Courts at that
time, that because of their scientific agenda would have put Keynes’s
analysis up for discussion, that would have given him more protection,
and that would have forced the other branches to answer to some
questions ?

Another example is Keynes’s _General Theory_ in 1936. Note that Hicks’s
simplification of IS-LM was available in 1937. Then the same questions.

The _General Theory_ itself contains the famous lines: “Practical men,
who believe themselves to be quite exempt from any intellectual
influences, are usually the slaves of some defunct economist. Madmen in
authority, who hear voices in the air, are distilling their frenzy from
some academic scribbler of a few years back.” (p383) He continues: “(…)
there are not many who are influenced by new theories after they are
twenty-five or thirty years of age, so that the ideas which civil
servants and politicians and even agitators apply to current events are
not likely to be the newest.” Perhaps Keynes would have supported the
idea of an Economic Supreme Court that keeps its knowledge up to date.

A third example is Jan Tinbergen’s 1936 model of the Netherlands (vide
Barten (1988), with p48 highly amusing). The same questions.

The fourth example involves my own person at the Dutch Central Planning
Bureau (CPB) around 1989-1991. This book already wins the argument
without mentioning my own experience, but it would not be correct not
to mention it. This book presents an analysis that has been suppressed
by that bureau with abuse of power - see also my biographical appendix.
Then the same questions.

Again, as above, there must be a warning about stagnation. My question
“Would it not have been better if we had had Economic Supreme Courts at
that time ?” is, admittedly, quite rhetoric, and may tend to sweep away
deeper questions. It may suggest ideal Courts that always remain
impartial and always come to the rescue. But also a Court can get stuck
on misconceptions. Keynes and Tinbergen illustrate the point themselves
by the famous criticism of Keynes (1939) of Tinbergen’s method. Two of
the leading economists of their times did not agree ! Indeed, this is
a powerful argument to make the concept of a Court doubtful. (And they
did not disagree on policy - more public works - but rather on
methodology.)

Interestingly, Frank Sulloway’s (1996) “Born to rebel” argues, roughly
put, that first-borns tend to be more conservative and that later-borns
are more open to new scientific findings. Van den Berg (2004) calls
this finding into question. But an Economic Supreme Court packed with
conservatives could be a recipe for stagnation anyway.
[30]

To be sure: my question of ‘would it not have been better if…’ is not
intended to be rhetoric, and I grant that a Court at times will be slow
to take up a challenge.

There however is a proper analogy: In the same way, occasionally, a
fireman is caught causing fires himself. But this does not cause us to
abolish the whole fire-department. As said, the appendix contains an
example constitutional amendment that tries to find the middle ground,
something that is workable and a huge improvement compared to the
current situation.

11. The moral imperative

The modern economist entertains a sharp distinction between science and
values. This indeed is a proper attitude, and also a crucial instance
of the division of labour. It is up to Parliament and the President to
set the course and make the value judgements - and once the ship’s
course has been set, economists will build the ship, rig the sails and
do whatever necessary to get there.

[31]

It is interesting to observe however that economists regularly express
values. It is well-known that Marshall and Tinbergen were drawn to the
subject out of a desire to understand the causes of poverty and ‘do’
something about it. Less well known may be this quote of Pigou:

“I would add one word for any student beginning economic study who may
be discouraged by the severity of the effort which the study, as he
will find it exemplified here, seems to require of him. The complicated
analyses which economists endeavour to carry through are not mere
gymnastic. They are instruments for the bettering of human life. The
misery and squalor that surround us, the injurious luxury of some
wealthy families, the terrible uncertainty overshadowing many families
of the poor---these are evils too plain to be ignored. By the knowledge
that our science seeks it is possible that they may be restrained. Out
of darkness light! To search for it is the task, to find it perhaps the
prize, which the “dismal science of Political Economy” offers to those
who face its discipline.” --- A. C. Pigou [32]

Keynes wrote the _General Theory_ not only motivated by the beauty of
economic theory itself but also against the backdrop of the Great
Depression and the threat of communism and facism, and war. He even
presented the GT somewhat in the fashion of ‘either you accept my
theory or there will be a world revolution’:

“The authoritarian state systems of to-day seem to solve the problem of
unemployment at the expense of efficiency and freedom. It is certain
that the world will not much longer tolerate the unemployment which,
apart from brief intervals of excitement, is associated - and, in my
opinion, inevitably associated - with present-day capitalistic
individualism. But it may be possible by a right analysis of the
problem to cure the disease whilst preserving efficiency and freedom.”
- GT:381

What do we make of these value judgements ? Do these economists cross
the line ? Do they wander in the perk reserved for politics ?

The answer is no. They only emphasise that society may be well willing
to do something decent about unemployment and poverty, if only people
had the knowledge. If the knowledge is lacking, then society faces a
tough choice, and people in power will tend to look after themselves
first. But with the knowledge, the situation is entirely different, and
even those in power will be quite ready to help create the new
prosperity. By doing so, they may also become popular, and gain or
retain power. Note that it is not obvious or self-evident that the
powerful will allow such change, but they might be persuaded to it.

Of course, in a sense, it could be considered a political act, when one
provides crucial knowledge that changes a situation. But properly seen,
this is just the _definition _of a scientist: to provide knowledge.
Scientists can be knowledge (power) brokers - see also Throgmorton
(1991). If one does not like this role of scientists, then throw out
Montesquieu too.

In the same manner the economist can, with his or her knowledge,
elucidate the moral problems of society. People may not be aware of
certain choices that they implicitly make, and they will be grateful -
though not necessarily happy at the first instance when responsibility
dawns on them - when these choices are pointed out. The economist then
again is only helpful in clarification. Though of course it is often
wise to only try to clarify matters if one can predict that this will
cause a change - otherwise much discussion and sweat will have been for
nothing.

But clearly, the economist has to be protected by the Constitution to
be able to perform his or her task of clarification, since new or
seemingly contrary ideas always run the risk of misunderstanding and
disproportional reaction.

My analysis in 1990 was, vide Colignatus (1990a), and the first edition
of this book in 2000 stated:

“In my analysis the moral imperative for the Western nations since the
Fall of the Berlin Wall is to help the Russian and Eastern European
peoples to recover from the brutal communist oppression that they have
suffered. The best way to help is to allow trade. But the West is
afraid for cheap products, and thus its own unemployment. And hence
there are barriers to trade again. But the true cause of unemployment
is not external, but internal to the West, internal in our system of
economic policy making. It is the West’s own stupidity that causes hurt
to others.”

The second edition of this book in 2005 witnesses the Enlargement of
the European Union on May 1 2004. This is a great step in the right
direction. There are still obstacles, however, if not internally to the
EU then externally to the other nations.

The argument thus has not changed fundamentally.

Hence, the moral imperative for Western nations is to reconsider the
Trias Politica structure of economic policy making. [33]

Book III
Economics ‘as usual’

12. Introduction

In ‘economics as usual’ we neglect the World Wars and concentrate on
the current problem of stagflation. This book then also provides a
novel explanation in this area - novel in the sense that it bundles the
articles that have been written since 1989.

In the years after World War II, Western societies created systems of
social security - the ‘Welfare State’ - and for a while it seemed as if
they could do so without serious economic consequences. From a
macro-economic point of view, they hoped to enjoy growth, full
employment and low inflation. These indeed happened in the golden years
1950-1970. However, there arose the problem of stagflation around 1970,
i.e. the combination of high unemployment, high inflation and
stagnating growth. Around 1980, unemployment and inflation reached
double digit values. Other economic indicators in the red were budget
deficits, high interest rates, and the crowding out of private
investments. Adjustment to these problems has been difficult and slow.
The economic performance around 2004 is a major improvement from the
worst episode, but the progress seems to be stagnating. The ongoing
discussion in policy making circles during all these years is how the
Welfare State arrangements are related to these economic problems, and
what the proper policy reaction should be.

Welfare state economics differs from ‘traditional’ macro-economics in
that there are more arrangements that protect individuals from
insecurity and that entitle them to benefits. Welfare state economics
however does not differ from ‘traditional’ macro-economics in the
respect that the basic laws of economics cannot be changed. Generous as
arrangements can be, people fundamentally still react to incentives.
Welfare state arrangements tend to reduce the base of the economy of
those participating in the workforce and they increase the burden on
those. The welfare state also tends to generate more unemployment and
inflation. While unemployment would ‘traditionally’ cause people to
lose their income and thus to be more cautious with their wage demands,
in the welfare state they receive an unemployment benefit and may
continue tot insist on high wages. These points can readily be verified
from comparing the results of the EU and US economies, where the EU is
more of a welfare state and where the US has more traditional features.

Not surprisingly, there has been much debate about the sustainability
of the welfare state. The US economy clearly is more dynamic and in
many respects also more successful and innovative than the European
economy. In this debate, a wide range of issues is discussed, from
trade to investments, technology, monetary policy, migration, and so
on. All these features indeed are very important for a balanced
economic judgement. A common conclusion remains that employment plays a
key role, as is for example witnessed by the OECD (1994) “Jobs Study”,
the OECD Economic Studies 31 (2000), OECD (2003), to name a few. This
conclusion actually is not so surprising, since the very definition of
the welfare state suggests that it tries to protect people from the
uncertainties of the job market rather than anything else.

Many people accept these days that Western economies have a problem
with jobs with a low level of productivity and thus a low level of
market-earned income. The United States tolerate more poverty while
Europe sets its minimum wage much higher so that Europa has more
unemployment. This problem with low productivity jobs finds various
explanations, notably those of technology, globalisation and labour
market inflexibility - or ‘welfare state sclerosis’. Policies based on
these explanations have been enacted for some time now. For quite some
time, in fact; while little is being achieved. It is proper that we
pose the question: why is it that we don’t achieve much ? [34]

The novel analysis presented in these pages finds the problem and
answer in _taxes_.

[35] As noted, benefits have to be financed, and the tax arrangements
have a key impact on incentives and costs. We will focus on the
influence of taxes that runs via the labour market, both directly by
‘labour taxes’ and indirectly by ‘consumption taxes’ that also affect
the cost of labour. The emphasis in our study is on dynamics where
interactions have more time to take hold. The idea of this present
study is that by proper management of tax dynamics, the economy could
become more efficient, in both the EU and US alike, so that ultimately
the drawbacks of a welfare state can find a better balance with its
advantages.

Obviously, when this analysis is new, then it has not been recognised
before, and then it has likely been missing in policy. And policy that
was based on a wrong analysis, is likely to have been the cause of the
very problem that it wanted to solve.

The emphasis on taxes does not mean that technology, international
trade and labour market inflexibilities are irrelevant. It does not
mean that we can throw away the current macro-economic models. On the
contrary: the emphasis on taxes is only an amendment to the current
models. The tax analysis would be meaningless without these current
models. I myself participated in the construction of the CPB (1990)
Athena model, a sectoral model of the Dutch economy with 7000
variables, and I would be the last one to suggest that only taxes
matter !

Though the amendment sounds simple, there still are grounds to cover.
Unemployment obviously has a much longer history than the current
problem. Also, the Western track record on unemployment can only be
understood when the record on inflation is taken into account too. A
wrong diagnosis of the cause of unemployment would also have its
effects via the anti-inflation policy of the monetary authorities.

Stylized history

Consider the empirical evidence since 1950. This track record coincides
with decades:

· The 1950s had low unemployment and low inflation, and high real
growth.

· The 1960s had the threat of unemployment, and governments
accommodating inflation in order to actually prevent it.

· The 1970s nevertheless had mass unemployment bursting into the open,
and governments accommodating high and accelerating inflation to battle
it. Growth is volatile.

· The 1980s had governments come down hard on inflation, while they
accept high levels of unemployment and stagnating growth as the price
for stability.

· The 1990s-till-now: There are different reactions on both sides of
the Atlantic. Europe appears reluctant to dress down the welfare state,
accepts high minimum wages and more unemployment that is partly hidden
in Welfare State programmes. The USA appears willing to accept more
poverty. (This difference in regional reactions started already
earlier, but is clearest in this period.)

One sees a certain “trade-off” between unemployment and inflation.
Figure 2 reviews the official data for the United States and Figure 3
for the Netherlands for 1950-2001. [36] For both countries, the
official values for the 1950s and 2000s are in the same lower left and
favourable region, but they have been far outside of it during the
years in-between. [37] Since the official statistics in the 2000s have
returned to the favourable lower left region, the natural question to
ask is whether stagflation has been defeated. Figure 4 reviews the
situation in the Netherlands, where the official values have been
extended with those on the labour force ‘not working’. [38] One can
suspect that Welfare State programmes can hide unemployment.

In macro-economics, the relation between unemployment and inflation is
expressed in the _Phillipscurve_. Next to the standard (wage-)
Phillipscurve there is the (price-) Phillipscurve that gives the
relationship between unemployment and (consumer) prices (and that
relies upon a dependence of prices on wage-costs). A more extensive
(participation-) Phillipscurve links the development of wages and
prices to unemployment or ‘not-working in general’. Understanding the
relationships of the curves is subtle: it is not just the inclusion of
the numbers, but rather the effect on the market. Notably, when
‘disability’ means a reduction of the workforce, the remaining workers
face less competition and might raise their wage demands (see Figure
4).

Figure 2. The unemployment - inflation space 1950-2001, United States

Figure 3. The unemployment - inflation space 1950-2001, Holland

Figure 4. The Netherlands, ‘official unemployment’ (drawn) and ‘not
working’ (dashed)

Above rough division in decades suggests, as said, some ‘trade-off’.
There is a discussion among economists whether such a ‘trade-off’
really exists, and in particular for the short run, but, with this
division in decades, it cannot be denied that there are some systematic
choices involved. Our object of study, stagflation, can be rephrased by
observing that the Phillipscurve apparently has shifted to a higher and
unfavourable position.

The authors Okun (1981), Hebden (1983), Blanchard & Fischer (1989),
Friedman (1991), Phelps (1994) help to put the Phillipscurve in
perspective. Extensive empirical work has been done by the Central
Planning Bureau (1992a&b).

Okun (1981) emphasises the stability of the US Phillipscurve over the
1954-1969 period, but accepts that wages and prices thereafter are less
flexible in the short run, due to ‘implicit contracts’ and ‘invisible
handshakes’. Referring to Friedman and Phelps he notes: “In the sense
that all economists must recognize that adverse shift of the short-run
Phillips curve, they have all become accelerationists now (to reverse
Friedman’s celebrated concession to Keynes).” (p239). Rather than
getting lost in finding proper functional formats, Okun concentrates on
formulating various elements that are important for policy making,
indicating that a whole range of instruments must be used. The minimum
wage gets short mention, but is not considered in relation to the
Phillipscurve.

Hebden (1983) gives a recommendable review of econometric issues and
empirical work (till that time) on the Phillipscurve, including (a) the
original article by Phillips, (b) papers that remain close to his
format, and (c) papers that include trade union influence and price
expectations. Hebden notes:

“Models that seek to explain the causes of the inflation that has been
experienced in the recent past, and hold out the possibility of helping
economists to predict and maybe control inflation in the future, are
sought after eagerly by economists and politicians. Many models have
been produced and a fair degree of unanimity has been found as to the
mechanics of the relatively mild inflation experienced in Britain in
the 1950s and 1960s. But when inflation accelerated, in this country as
in most of the industralised world, in the mid-1970s, those models were
unable to cope; and though almost a decade of ‘hyperinflation’ has
passed since then, no model that adequately explains its causes has yet
been found.” (p158)

Blanchard & Fischer (1989) note:

“The Keynesian framework, embodied in the “neoclassical synthesis”,
which dominated the field until the mid-1970s, is in theoretical
crisis, searching for microfoundations; no new theory has emerged to
dominate the field, and the time is one of explorations in several
directions with the unity of the field apparent mainly in the set of
questions being studied.” (p27).

On the Phillipscurve they note:

“The contemporaneous correlation between innovations in wage inflation
and GNP is, however, positive and significant: it is this correlation
that underlies the Phillips curve, which plays a central role in
theories of the business cycle that allow aggregate demand disturbances
to affect output.” (p19). [39]

Their discussion is critical and enlightening, but does not involve the
role of the minimum wage. On p551 they discuss the high European
unemployment, but then refer to the Layard & Nickell 1986 & 1987 model,
concluding, a bit non-committingly:

“The Layard-Nickell model provides an example of how to relate the
theories developed in this book to the data. It suggests a complex set
of causes for high unemployment in which both demand and supply factors
play a role and the labor market’s own dynamics explain the persistence
of high unemployment with nearly stable inflation.” (p555).

Our analysis will allow a stronger conclusion. From the 1950s till the
beginning of the 1990s the common view among economists and policy
makers tended to be that the unemployment in the trade-off was
“general” unemployment. This is not quite true for all economists, but
many made this simplifying assumption. Nowadays we tend to link
unemployment to lowly productive labour. For us it may be obvious, but
compared to the earlier view of many it is a change of perspective that
the once-thought-to-be “general” unemployment now turns up as a rather
specific type. To make this change specific: we will hold that the
unemployment in the trade-off has _always_ been related to the
distribution of productivity across labour.

Structure of the argument

The crucial insight is that the people who can demand pay rises need
not be the people who run the risk of unemployment thereof. High
productivity workers run less risk of unemployment and can more easily
demand pay rises, while low productivity workers run the larger risk of
unemployment. High productivity workers are more versatile and are able
to shift the risk of unemployment to the lower income groups. When jobs
are scarce, the high productivity workers even crowd out others from
the labour market. [40]

The policy rule on taxes is: don’t tax low productivity labour. Why ?
To keep it employed so that more productive labour will meet more
competition and will not demand inflationary pay rises. In Europe,
taxes on low productive labour are still high, causing a high minimum
wage that causes unemployment. These taxes could be abolished, and
without costs, since these workers are unemployed anyway. Similarly,
marginal tax rates are less a problem than often said. The proposed
alternative policy provides an improvement on both unemployment and
inflation, exactly the kind of policy measure required for in the
current situation.

This analysis is not common knowledge. It is missing in the economic
journals, it is missing for example in Borjas’s (1996) much used
textbook for undergraduates. Borjas (1996:441) states: “The minimum
wage, however, affects mainly less-skilled young workers, so it is
difficult to attribute much of the unemployment problem to minimum wage
legislation.” [41] For policy makers, the OECD (1998) reports: “The
cross-country evidence suggests that the minimum wage has no
significant impact on overall adult employment.” though OECD (2000) is
more guarded, see chapter 44. We will show however that a minimum wage
can have huge ‘multipliers’.

The difference that it means

It is useful to clarify the difference between currect macro-economic
policy in Western nations and what macro-economic policy can be
according to this book.

Current macro-economic policy:

· accepts unemployment as a consequence of low inflation and reduced
deficits

· sees the likely cause of unemployment in technology, globalisation
and labour market inflexibility

· focusses on aggregates and averages

· discusses the distribution of wages mainly in terms of income (in-)
equality.

The new macro-economic policy:

· sees a way to combine low inflation and balanced budgets with full
employment

· sees the cause of current unemployment in the system of taxation

· focuses on distributions

· discusses the distribution of wages in its relation to productivity
and unemployment.

Table 2 tabulates the differences.

Table 2: Differences between current and possible policy

_Current policy_

_Possible policy_

_low inflation & low deficit_

accepts unemployment

full employment

_cause of unemployment_

technology, globalisation and labour market inflexibility

system of taxation

_method_

aggregates & averages

distributions

_distribution of wages_

income equality

productivity & unemployment

The new analysis means that we get a different perspective on the
existing models.

For example, a current argument in Holland on labour market
inflexibilities is that the replacement rate is too low. There would be
a so-called poverty trap. People in a benefit situation would have
little incentives to accept a job offer, since they would earn hardly
more. This is regarded as a supply issue, and since one cannot raise
wages (which would increase unemployment), the only solution seems to
be the reduction of benefits. This was actually the statement of the
Dutch Minister of Social Affairs at the presentation of the Dutch
National Budget in September 1999. Even the small Socialist Party (SP)
accepts this view, vide its January 2000 internet site. The Minister
and the oppostion party however are misguided and badly advised. In the
proper analysis the problem is crucially different. If there would be
sufficient jobs then there already are regulations that people can be
fined for not accepting a job offer. This fine creates an incentive of
30% in a warning stage and eventually 100% by full withdrawal of the
benefit. So the problem is rather that there are insufficient job
offers - with sounds more like a demand problem. By manipulating taxes,
it is possible to reduce gross wage costs - and increase demand - while
still allowing for a decent net income.

Another point of attention is the word ‘unemployment’. Holland in 1999
features an ‘official unemployment rate’ of about 3.2 %. It seems as if
unemployment is no problem for Holland. As an economist I however
cannot accept the sausage that the Statistical Office (in this case the
Dutch CPB and CBS) here present. (1) Dutch ‘official disability’ is
about 10% of the true labour force, (2) people older than 55 years are
often excluded from the ‘official labour force’ too, (3) many people
work part-time since they cannot find a full-time job, (4) many women
will not work outdoors since childcare is too expensive because of the
wrong wages, (5) etcetera. Many economists classify these issues under
the denominator of ‘participation’, and then agree that Holland has a
participation problem. However, in proper economic terms it is
unemployment: people who would want jobs but cannot find them. I urge
the statisticians to remain servient to economic science, as they claim
they are, rather than servient to politics and disinformation.

13. Unemployment via taxes and minimum wage

Let us see in stylized fashion how it went wrong in 1950-2005. Our
discussion uses Holland as the example to clarify the general OECD
situation. The discussion will also use simplifying assumptions and few
footnotes, to keep the text transparant. These defects will be remedied
in the subsequent chapters.

Key aspects are:

· heterogeneous labour, and the use of an earnings distribution

· the minimum wage and unemployment

· decomposition of the minimum wage in subsistence and tax burden

· analysis of the Tax Void

· differential indexation

· dynamic marginal tax rates

· consequences for the macro model: spillover and domino effects.

Figure 5: Earnings distribution

The earnings distribution

Figure 5 gives an earnings distribution of a standard lognormal shape.
The figure approximates the situation in Holland 2002, though without
parttimers. With each level of income there is a number of
‘personsyears’ of people who earn that level. The earnings distribution
can be used to compute how large unemployment will be below the minimum
wage. Figure 6 gives the situation for the Dutch minimum wage of about
€ 18.3 thousand. Since Dutch unemployment is about 25% of a potential
labour force of 8 million people, the graph conforms to the facts. [42]

Figure 6: Unemployment below the minimum wage

Analysing the minimum wage

We wonder how the minimum wage comes about. We see two terms in the
minimum wage, as can be seen in equation (13.1a) and its explanation:

_M_ = minimum wage [43]

_B_ = subsistence [44]

_T _= arbitrary tax function

_Bentham _= Bentham tax function [45]

_y_ = an arbitrary level of income

_r_ = marginal rate

_x_ = exemption

(13.1a) _M = B + T_[_M_]

_ _

(13.1b) _Bentham_[_y_]_ = r _(_y - x_)_ _for _y > x,_

_ = _0 for _y
x_

_ _

(13.1c) _Net_[_y_]_ = y - T_[_y_]

The minimum wage provides subsistence and thus consists of that net
minimum and the taxes at that minimum, which is expressed by (13.1a).
Since net income must be larger than _B, _this means for the Bentham
function:

_y - r (y - x) B _& equality at _M __ M = _(_B - r x_)_ /
_(1_ - r_)_ _

Malthus has subsistence _B _enforced by nature. Under current rules of
(European) welfare states, _B _can be higher, since people who cannot
earn subsistence _B_ are entitled to a benefit of that level. [46]
Table 3 gives the Dutch example.

Table 3: Tax wedge at subsistence (single person)

_Dutch legal minimum wage _2002 (per annum)

€

Gross minimum wage in the official statute

15,638

Net, after deduction of taxes incl. premiums for the employee (single
person)

12,516

Gross minimum wage: gross + premiums for the employer

18,265

All taxes incl. premiums (though exclusive of VAT etc.)

5,749

Tax as a percentage of gross minimum wage

31.5
%
%
%
%
%
Tax as a percentage of net income

45.9 %

The Dutch situation is depicted in Figure 7, the _tax plot_. The
horizontal axis gives income _y_, the vertical axis the tax _t_. The
tax line _T_[y] gives the Dutch tax brackets. Net income is given by
the difference between the tax and the 45-degrees line (_t = y_).
Subsistence causes the line _y - B_ parallel to the 45-degrees line.
This line cuts off a part of net income. The intersection of the
subsistence and tax lines gives _y - B = T_[y], and this solves into
the minimum wage _y_ = _M_. You must earn at least _M_ to satisfy the
minimum net income requirement _B._

Figure 7: Tax plot

Figure 8 clarifies that the minimum wage means that there are no full
time wage earners below _M, _so that tax and net income are only
relevant above it.

Figure 8: Tax plot revisited

Figure 9 gives gives the same result but then as a _net income plot_.
The horizontal axis gives income, the vertical axis net income. The tax
is given by the difference between net income and the 45-degrees line.
Subsistence now is a horizontal line at _B. _The intersection of the_
B_-line and the net income line gives the minimum wage _M._ You must
earn at least _M_ to satisfy the minimum net income requirement _B_.

Figure 9: Net income plot

The Tax Void

Let us now combine the earnings distribution and the tax plot.

Note that the tax figures have shaded areas only above the minimum
wage. The tax appears effective _at _and _above_ the minimum wage, but
not _below_ it. Though taxes are defined below the minimum wage, there
are no taxes collected, since people are unemployed below the minimum
wage. The clear area from net minimum_ _till the gross minimum wage _M_
can be called the Tax Void.

The difference between net and gross is called the tax wedge, and it is
generally seen as a vertical jump. There is a change of perspective
now, in that we see it also as a _range,_ particularly relevant for the
minimum wage.

In the Tax Void the tax code has only a paper function (in terms of tax
collection). The tax code helps to drive up the minimum wage, but it
does not collect any revenue. Abolishing taxes in this area therefor
does not cost anything too. Note that abolishing the tax void would
mean that exemption would be chosen at subsistence.

Figure 10: Tax Void Unemployment

Part of unemployment below the minimum wage is still above subsistence.
If taxes would be abolished in that section, then the affected people
could still earn a living wage, and need no income support. This kind
of unemployment can be called the Tax Void Unemployment. Figure 10
gives a plot of that section (shaded) for Holland.

For the record: the Dutch minimum wage only holds for fulltimers, and
not for parttimers. Holland has a lot of parttime work (for that
reason). We have eliminated parttimers from the present analysis.

Cause of the Tax Void

How has the tax void come about ? Since abolishing the tax void does
not cost anything, and would generate a lot of employment, why don’t we
abolish it ? Why do we continue the present absurd situation of mass
unemployment ?

It appears that the situation has come about gradually, by a mechanism
that is difficult to observe directly. It involves the co-ordination of
tax policy with social policy, specifically the indexation of taxes and
subsistence.

First note that OECD countries adjust their taxes for inflation, see
OECD (1986). Tax exemption in 2002 will often be close to the
inflation-adjusted real value of 1950. On the other hand, research in
social psychology shows that subsistence tends to rise with the general
level of income, the growth of which consists of inflation and real
growth (or real net income). So there is “differential indexation”. In
the 1950s exemption was pretty close to subsistence, so that there was
no void to speak of. Since then, exemption has lagged behind the
standard of living. When tax exemption lags behind net subsistence,
then there is a multiplier effect on gross subsistence, with an
accelerated increase of the tax void. This process also explains the
‘squeezing of income differentials’ in OECD countries.

Holland is the example again. In 1951, exemption for a single person
household was € 354 and for a couple without childern € 463. At that
time there was no official minimum wage, but it can be taken at that
value. The price level in 2002 (1951=1) is 6.25 and the wage index 2002
is 25.59. This allows us to construct Table 4.

Table 4: Development of tax exemption in Holland

Euro’s

1951

1997

2002

Inflation index (%)

100

545

625

Wage index (%)

100

2082

2559

Exemption, single person

354

3223

8025

Idem, price adjusted

354

1930

2211

Idem, wage adjusted

354

7369

9060

Exemption, couple without children

463

6445

*13116

Idem, price adjusted

463

2524

2892

Idem, wage adjusted

463

9638

11850

* Dutch readers can find the computation in Colignatus & Hulst (2003)

Till 1997, official exemption € 3223 lagged strongly behind the wage
adjusted 1951 value € 7369. In recent years the gap has been reduced,
but the 2002 official exemption of € 8025 still lags more than € 1000
behind the wage adjusted 1951 value. Most important, it lags € 4500
behind the (single person) net minimum wage of € 12500.

Taxes

If we index tax parameters on inflation only, then this affects
exemption _x_ in the Bentham tax function, and thus _x_ should be
included in the function call.

_P_ = price index

_x_[_0_]_ _= exemption at the
base year

_xi_ = real exemption index

(13.2a) _x = x_[0] _xi P _(and here _xi_ = 1)

_ _

(13.1b’) _Bentham_[_y, x_]_ _

_ _

(13.2b) _Bentham_[_y, x_[0]_ P_]_ = r _(_y - x_[0]_ P_)

We also write the tax function as _T_[_y, x_] and net income as
_Net_[_y, x_]_._

Subsistence

The indexation of subsistence differs from other incomes. When wages
follow, on average, an index _wi_, the real subsistence index _rsi
_commonly follows the net average wage, i.e. the wage after taxes.

_W _= the average wage (nominal)

_W_[_0_] = the average wage in
the base year

_wi_ = wage index = _W / W_[0]

_rwi_ = real wage index = _wi / P_

_B_[0] = subsistence in the base year

_h_ = _B_[0]_ / W_[_0_]

_rsi_ = real subsistence index

_rnai_ = real net average wage index

(13.3a) _W = W_[_0_]_ wi = W_[_0_]_ rwi P_

(13.3b) Subsistence _= B = B_[0]_ rsi P_

_ _

(13.3c) _rsi = rnai =

Net_[_W_]_ / P / Net_[_W_[_0_]]

(13.3d)

Deduction of the real net average income index

We choose the base year so that _x_[0]_ = B_[0]_. _Let _W_[_0_] be the
average wage in the base year, and let _h = B_[0]_ / W_[_0_] be the
base year ratio with subsistence. Then the index of real (net)
subsistence _rsi_ is set to the index of the real net average wage
_rnai_, and is (proving (13.3d)):

with _B_[0]_ = W_[_0_]_ h:_

(13.3d)

For example, if base subsistence is half the base year average wage,
_B_[_0_]_ = ½ W_[0]_ _then _h =0.5._ When _r = 0.5 _then _rsi_ _=
0.33 + 0.67 rwi._

With _h _and _B_[0]_ _given, the causal chain is {_rwi, r_}_ rsi B
M_ _ u._ [47]

When all incomes grow as fast

Before we continue it is useful, however, to first clarify a formal
property for the Bentham tax function.

Property (13.3e): For the Bentham tax function: There is equal growth
of gross and net income, if and only if exemption is indexed on either.

Note: The distinction between (13.3d) and (13.3e) is that the former
indexes _x_[0] on _P_ only, and the latter indexes _x_[0] and _B_[0] on
_wi = P rwi_.

Corrollary: Under (13.3e): If the income distribution remains the same
(all incomes grow with the same rate) then also the average income,_ y
= W _grows at the same rate, and then also the net income distribution
remains the same, and then the ratio of net average to subsistence
remains the same too. Note: Western nations thus could wisely index
subsistence and exemption on gross average income.

Note: These relations seem obvious enough, but actually proving it
turned out to be a bit tedious.

Proof: Denote _y_[+1] = (1+_gr_)_ y _= _g y_ for growth rate _gr_, and
Net[_y_[+1]] = _n _Net[_y_] (both _g_ and _n _one period indices).

Net income with the Bentham tax is Net[_y_[+1]] = _g y - r (g y - X)_
with _X_ the new exemption. This should be equal to_ n _Net[_y_] = _n
(y - r (y - x))_. Thus _n _is defined by:

_g y - r (g y - X) = n (y - r (y - x))_

() Take _z = g = n. _Then _z y - r z y + r X_ = _z (y - r y + r x)
_and this gives _X = z x._

( _g_) Take _X = g x. _Then _g y - r(g y - g x)) =_ _n (y - r (y - x)),
_so that _ n = g._

( _n_) Take _X = n x. _Then

_g y - r(g y - n x)) =_ _n (y - r (y - x))_

_g y - r g y + r n x =_ _n y - n r y + n r x_

_g y - r g y = n y - n r y_

_g (1 - r) y = n (1 - r) y _

_g = n_

Q.E.D.

Development of the Tax Void

These formulas call for a graphical illustration. We only need data on
_rwi, r_ and_ h_ for a stylized display. We will take _r = h =_ 50%.
Then we need data on _rwi_, and we can use our example of Holland.

Graphical presentation of the Dutch data

Appendix Table 20 gives the required data on the Dutch economy. Dutch
1951 exemption can be taken as 1951 subsistence. Before we use the data
for the formula, let us first see what they mean. Figure 11 and Figure
12 on inflation _P _and real income growth _rwi = wi / P _ show that
the data fit above classification of subperiods for inflation and real
income growth behaviour.

Figure 11: Continued inflation, stagnating real wage

Holland, _1951 = 1_

Figure 12: Inflation plotted against the real wage

Holland, _1951 = 1_

Using the data for our analysis

We now use the data for our analysis. There are four combinations of
gross/net and real/nominal. This results into Figure 13. ‘Subsistence’
is always measured as a net term, and ‘minimum wage’ as a gross term.
For Holland, we find that real subsistence has risen about 4-fold since
1951, and the nominal minimum wage more than 30-fold. The computed
nominal minimum wage relates well to the factual 2002 minimum wage. Not
only inflation accounts for the rise, but also an increased tax burden
(that encounters inflation again).

Figure 13: Different indices at the minimum [48]

Holland, _1951 = 1_

It was the slow rise of subsistence _B_ and the lagging of exemption
_x _in the 1950-1975 period that caused a multiplied rise of _M_,
creating the Tax Void. Also, since the earnings distribution is
nonlinear (lognormal), there was an even sharper nonlinear increase in
unemployment.

Figure 13 shows that the real values stagnate since about 1980, and
that the development since then is determined by inflation. Since
inflation does not occur in the _rsi _index, the real situation is
stable. For example, the gross-to-net ratio at the minimum since 1980
is quite constant.

Note too that this in a sense presents a difficulty. The problem with
the minimum wage was caused before 1980, and policy makers wanting a
solution in 2002 will rather look at the last decennium rather than to
the 1950-1975 period.

Marginal tax rate & VAT

While the above considers exemption _x,_ the analysis can be extended
with an analysis on the marginal tax rate _r._

Many economists hold that a high marginal tax rate is a disincentive
for labour effort. They frequently propose a change from the income tax
to the Value Added Tax (VAT). If we assume the same total tax revenue
then the VAT might allow for a lower marginal tax rate, for the reason
that the VAT has no exemption. At least, that is commonly conjectured.

Above analysis already exposes one flaw to the argument ‘in favor of
the VAT’. Having no exemption means a higher minimum wage ! So, those
tax theorists who propose a shift from income tax to VAT tend to
neglect an important part of labour market economics. Note that a
higher VAT on luxuy cars does not affect the subsistence worker who
cannot afford these, and hence there is some truth in the statement
that a VAT sometimes can be preferred. However, once we have solved
unemployment by proper labour market policies, the discussion about
income tax or VAT could be done in terms of fiscal properties only, and
it might quickly appear that a low VAT of say 5% suffices. [49]

Secondly, it is said that a VAT taxes profits too and thus seems to
allow a general reduction of the price of labour. But it raises costs
disproportionally for the lowly productive (who generally work with
less capital).

Figure 14 shows the development of the relative revenue shares of Dutch
income tax and VAT for a selection of years (i.e. 1975, 1980, 1985,
1990, 1997 and 2003). The Dutch minimum wage problem has worsened also
by this development.

Figure 14: Revenue shares of income tax and VAT

Marginal tax rate & dynamics

I agree with the basic idea about the disincentive effects of marginal
tax rates. Namely, economic theory assumes maximising agents, and the
condition for a maximum can normally be expressed in terms of
marginals. However, the marginal must be computed correctly. Above
marginal rate _r_ is only a static rate, that applies to a specific
regime, for example a specific period. However, tax rates are adjusted
from year to year. A dynamic situation requires a dynamic analysis.

Let _y = y - y_[_-_1]_._ Then the proper (dynamic) marginal tax rate
is _DMR = T / y_. For the Bentham function:

Generally the dynamic marginal is lower than the static marginal. In
fact, when tax parameters are indexed in a certain way, then the tax
can have the same growth rate as income, and then the dynamic marginal
rate equals the average tax rate. This holds for individuals and for
the macro data if all individuals are on a balanced growth path. Let
the balanced growth rate be _bgr:_

(13.4)

The following is a small example of how a dynamic marginal rate can
equal a normal average. Let exemption be $10000, and let the statutory
marginal rate thereafter be 50%. Someone earning $50000 pays the tax of
$20000, on average 40%. Let all incomes grow 5%, and exemption be
indexed on national income. Then exemption becomes $10500, income
$52500, tax $21000, again 40%. Thus on the (dynamic) “marginal dollar”
this person doesn’t pay 50% but 40%.

For the Bentham tax function we can derive a simple expression for
individual growth. We are most interested in expected developments. Let
personal income grow by rate _,_ so that _y_[_+_1]_ = _(1 +_ _)_ y,_
and let exemption be expected to be adjusted by rate __, so that
_x_[_+_1]_ =_ (1 +_ _)_ x._ Then we find:

Let us regard the dynamic marginal rate for a Dutchman in 2002 who
considers an increase in work effort for 2003 (and beyond), and let us
assume a regime of sound economics. In the ideal case, exemption in the
base year is put at subsistence, in this case € 12.5 thousand. Ideally,
subsistence rises with income, and not just real net average incomes.
This ideal implies that exemption is adjusted not just for inflation,
but for the nominal growth of income. Let us assume this ideal, and let
us assume that national nominal growth is 4%, for example consisting of
2% inflation and 2% real growth. Let us then regard the situation of a
single economic agent. He knows that next year exemption will be
adjusted with 4%. He has to judge whether it is worthwhile to him to
invest or to increase labour effort, so that his income will rise. If
his personal income rises with 4%, then his dynamic marginal will be
equal to his present average tax rate. If his personal income rises by
8%, then his dynamic marginal will differ; it will depend upon his
actual income level, but anyway will be less than the statutory
marginal rate of 50%. Figure 15 gives the plot of the dynamic marginal
for those two rates, for various levels of income. The 4% line here
also gives the average tax level.

Figure 15: The dynamic marginal rate

_Individual income grows at 4% or 8%, while national income grows at 4%
and the statutory marginal rate is 50%_

Empirical analysis often shows marginal rates to be less relevant - and
average tax rates to be more important - than ‘common theory’ claims.
This analysis on the dynamic marginal provides a useful part of the
explanation.

Spillover and domino effects

Above analysis concerns minimum wage unemployment. The next question is
how this relates to other kinds of unemployment.

It is useful to observe that the analysis in these pages is new.
Concepts like the tax void, differential indexation and dynamic
marginal tax rates, and the insights on their interaction, are really
new, and have been concocted by me in a search for new scientific
results. That means that governments have not incorporated these
concepts in their policy making (even though the occasional civil
servant may have been aware of some phenomena). Policy making up to now
has been based upon a different analysis, and, alas, by being different
from the right analysis, the governmental analysis is a wrong one. This
is not without consequence. By analogy, when a patient gets a medicine
based on a wrong diagnosis then the illness may get worse rather than
diminish. In the present case, the tax void unemployment has important
spillover or domino effects on unemployment above the minimum wage, and
the channel of transmission is the misguided policy reaction up to now.

For example, in the 1970s governments tried to stimulate the economy by
incurring big deficits, but they ended up with inflation. In the 1980s
and 1990s governments opt for low inflation, and they end up with high
real rates of interests and mass unemployment in Europe and poverty in
the United States.

For example, Dutch economic policy is based on a general restraint on
wages. This policy has fueled Dutch exports and reduced Dutch imports.
The general restraint in fact subsidises exports, and Holland runs an
external surplus for quite some years now. The internal imbalance is
reflected in an external imbalance. The proper policy reaction however
would be a wage cost policy targetted at the minimum.

Diagnosis and Therapy

Please note that the present review only gives a diagnosis, and that it
is a different affair to find the proper therapy. The first is
necessary step before the second can be considered.

In the course of some years I have experienced that discussing therapy
is useless when people do not even understand the diagnosis. Policy
makers tend to be focussed on therapy - but judge this from a wrong
diagnosis. For example, in The Hague in 1992 (at a social-democratic
political rally when I was no longer a member of his party) mr. Wim
Kok, the Dutch Prime Minister of 2000, occasional chairman of the
European Union and the social-democratic ‘respected elder’ to mr.-s
Clinton, Blair, Schröder and Jospin, and a person who did some basic
econometrics in his younger years, laughed loudly when I suggested to
raise Dutch tax exemption from the then € 3 thousand to € 10 thousand.
He must have thought of staggering costs, and it didn’t help when I
said that it need not cost anything.

A major remark about therapy is that to undo the damage of the last
four decades, it is not necessary to take four new decades. Return to
optimality can be much faster.

The alternative and new policy would be to abolish taxes in the tax
void and to allow people to earn their own - decent and untaxed -
living. This alternative policy reminds of an old rule. The Dutch
economist Cohen Stuart proposed in 1889 (cited in Hofstra (1975)) to
put tax exemption at the level of subsistence. To drive the point home
he drafted the following analogy:

“A bridge must carry its own weight before it can carry a load.”

In 2005 there is the additional argument that abolishing void taxes
will not cost anything, while nations will save benefit payments due to
more employment.

Note that the ideas of Cohen Stuart’s ‘bridge’ and the tax void are not
very complex in themselves. In 1991 I explained them to a 12 year old
kid and he commented: “A child can understand that.” Still, the EU and
its score of modern governments sin against these concepts.

If unemployment is inefficient, then by definition there is a Pareto
optimising solution, that will not cost anything. Most economists don’t
believe in cheap solutions. Much of the debate hence focusses on
‘efficient unemployment’, where the sad state is caused for example by
globalisation, technology or ‘welfare state scelerosis’ (with poverty
traps). But, clearly, the tax void exists, it is a cheap way out, and
the other arguments will turn out to be ghosts, which they already can
be shown to be.

Note though that some period of transition may be required. Policy
makers will be hesitant, advisedly, about an overhaul of the tax
system. Note, then, that the tax system defines our notion of a
subsidy. A wrongly levied tax, in this case the tax void, can be
compensated for by a wage cost subsidy. [50] Abolishing the tax void is
more sensible in the long run, but since this can only be done
gradually, then some general subsidy directed at lowly productive jobs
would speed up short term adjustment. The rule would be that those
subsidies are reduced when tax exemption rises towards subsistence.

Stagflation resolved

More employment.... Does that not fuel inflation ? The pieces of the
puzzle fall into their places when the tax void is related to the
unemployment & inflation problem. The steady rise of the tax void
explains the track record of unemployment and inflation. The 1950s have
been characterized by relatively low taxes on low income earners, and
this allowed for full employment and low inflation. From the 1960s
onwards the lagging tax exemption started causing problems with
unemployment. The tax policy since at least 1965 enhanced the imbalance
of the internal bargaining positions of labour instead of
counter-balancing it. Hence inflation was persistent, and high levels
of unemployment were required to achieve price stability.

As said, governments suffer from a co-ordination problem. How
governments reacted in the past depended upon the view of the day.
Since the proper solution was not known, the problem did not go away.
The differential indexation of tax exemption and the social minimum did
not draw attention to itself. Each year adds only a slight effect which
is hard to see. But over the years the void has accumulated, and with
huge consequences. And the problem will remain with us in the future
unless policy changes.

The co-ordination problem persists, currently. Governments currently
regard minimum wage unemployment as just one type of unemployment, and
not even the most important type. Current policy is based upon other
explanations for unemployment, notably those of technology,
globalisation and flexibility. The policy reaction based on these views
is to reduce taxes for higher incomes, so that they are encouraged to
work, invest and spend more, and so that labour market flexibility
might be increased. However, the ineffectiveness of current policy can
be explained by the fact that these views are not entirely logical. The
arguments of technology, globalisation and flexibility run up against
contradictions:

· Technology is a source of wealth, and it boosts the productivity of
the lowly productive jobs, making the problem of poverty and
unemployment less serious than it would otherwise have been.

· “Globalisation” is a scare word for “trade”. Trade however is another
source of wealth, and it too has been with us for ages. Rising wealth
in distant countries means rising wages over there, and trade itself
thus puts limits to foreign competition. Japan over the last 60 years
is a prime example of this phenomenon, but every rich nation has had
the same experience.

· The “flexibility” or “welfare state sclerosis” argument can only
explain that the US has poverty and Europe unemployment, but it does
not explain that there is a problem with low productivity jobs in the
first place. The poverty trap as said does not exist.

Thus to be sure: the real policy target is low inflation, and policy
makers only discuss technology, globalisation and sclerosis/flexibility
in a second line of the argument. This second line is essentially a
cop-out, since it does not concern the real issue - and a discussion
can be very tiring if people behave like that.

At the same time, the wrong policies work counterproductively. The
reduction of taxes for the higher incomes obviously is financed by a
reduction of provisions for the lower incomes, aggravating the minimum
wage and poverty problems.

In my analysis, the present situation bears another surprise. We
diagnose current unemployment as inefficient. Be sure that you see what
inefficiency means: it means that there is a solution that is
beneficial to some and that does not hurt others. Having a bright idea
always means a “win-win” situation or a free lunch. In the present case
there is the move to full employment under price stability. The present
unemployed will find jobs. The higher productivity group will have a
theoretically larger risk of unemployment, but in practice this risk
will be modest as in the 1950s. The real gain for the higher income
earners will come from the services that will be provided by the jobs
of the presently unemployed. So you do not need to reduce taxes for the
higher paid, since they already will have a real gain at current
income.

This was it, in a nutshell. Now I beg your understanding. My analysis
is more complex than can be stated in these few lines. Both tax policy
and social policy are quite complex themselves, and this certainly
holds for their interaction with inflation and unemployment. For
example, you may ask why I haven’t discussed income redistribution
effects. Actually, this is because the alternative policy could be
neutral to the income distribution. The reason for this is that the
analysis focusses only on the link between wage costs and productivity.
But you might want to hear more about this. Also, you might ask whether
above explanation covers all possible cases of unemployment and
inflation. Of course it doesn’t. The analysis does help to clarify that
other types of unemployment need other types of policy, such as
education and so on. But you might want to hear more on that too. These
are just examples of issues, and there are many more issues that need
to be dealt with. Which space forbids. However, given that my model
_amends_ existing economic models, much of the required explaining is
‘existing economics’.

This novel explanation is in the tradition of Keynes and Tinbergen
while it fits in with mainstream economics. When economists check and
confirm these findings, our economies are likely to enjoy more growth
with full employment and low inflation.

14. The 1974 Duisenberg disaster

While the above uses a stylized example of Holland, there is a short
and enlightening story about actual Dutch politics, far remote from
econometric regressions. Quotes are here in my translation, Dutch
readers can also read Colignatus (1994b:28).

In Dutch politics, parties have to form coalitions to be able to
govern, and the Biesheuvel 1971 cabinet came about by a coalition
agreement that contained the following plan:

“Increase of tax exemption (in the direction of equality exemption for
married couples with one child towards the minimum wage (….))”

The explanation of this idea to parliament was (MvT 1971/72):

“(…) it doesn’t require more adstruction that current exemption is too
low. Its size doesn’t satisfy the fundamental notion of a threshold,
the exemption of taxation of part of income, that is reasonably
required for financing the necessary means of existence as seen in
contemporary social views.”

This plan didn’t succeed, the government broke down prematurely. There
came about a new leftist government under leadership of Den Uyl, and
his Minister of Finance was Wim Duisenberg, the president of the
European Central Bank in 2000. This cabinet however rejected above
concept. The 1974 argument was:

“De government (…) explained that the social minimum had been raised in
the preceding years in such extent that it could be considered to
provide means to pay taxes.”

The latter statement is rather shocking. Subsistence is by definition a
net concept, and the politicians don’t stick to that definition. The
statement also means that someone who falls in the tax void is forced
into a benefit situation. [51]

What is alarming too, is that Duisenberg was not alarmed, didn’t veto
this nonsense.

After this ‘Duisenberg disaster’, the issue disappeared from people’s
mind, it got transformed into an annual debate on indexation and the
topic of discussion became the level of benefits for the needy. In 2005
Holland still suffers the consequences.

Book IV
Presentations for the general public

In March / April 1996 I put two presentations for the general public in
the Economics Working Papers archive at the Washington University at
St. Louis. In August 1998 there was a third paper. [52] These papers
are directed to a general audience, and to teachers and students. Since
this current book basically addresses economists and uses quantitative
methods, I doubted whether I should include these texts here, also
since there is some overlap that can be distracting. There however are
two good arguments to include them with little adaptation: (i) Once a
fellow economist is starting to grow convinced of the value of my
analysis, then he or she will face the same problem of explaining it to
others. These texts then can be of use. (ii) The historical date of
these texts underlines the co-ordination problem. Even when a good
summary was available, and even when the moral imperative facing
Western nations was clearly formulated, our failing systems of economic
policy making limped along, and caused misery upon misery for many of
its citizens.

15. Unemployment solved !

_A breakthrough in economic theory_

Since the early 1970s Western economies have been plagued by mass
unemployment and the threat of inflation. Over the years since then
various economists have proposed various possible solutions, but never
quite convincing ones. Now there is a novel analysis that means a
breakthrough in economic theory. The present author is quite certain
that the “missing link in the model” has been found. If true, this
analysis offers guidelines for full employment under price stability,
just as Western economies enjoyed in the 1950s. The main point is:
don’t tax lowly productive labour. Why ? To keep it competitive so that
more productive labour will not demand inflationary pay rises. Though
this new analysis is only in the stage of presentation and introduction
at the scientific fora, there is no reason to withhold the present
rough sketch for a general public.

It is well-recognised these years that Western economies have a problem
with jobs with a low level of productivity and thus a low level of
market-earned income. The United States tolerate more poverty - the
working poor - while Europe sets its minimum wage much higher so that
Europa has more unemployment.

This problem with low productivity jobs finds various explanations,
notably those of technology, globalisation, and inflexibility - the
latter ornate for “welfare state sclerosis”. Policies based on these
latter explanations have been enacted for some time now. For quite some
time, in fact; while little is being achieved. It is proper that we
pose the question: why is it that we don’t achieve much ?

Unemployment obviously has a much longer history than the current
problem. Also, the Western track record on unemployment can only be
understood when the record on inflation is taken into account too.
Economic science has much to say on the complex relationship between
inflation and unemployment. Now, we are forced to be brief here. We
will concentrate on what is new and on why it is new.

We set out with the empirical evidence since 1950. This track record
can be divided in meaningful decades:

· The 1950s had low unemployment and low inflation.

· The 1960s had the threat of unemployment, and governments
accommodating inflation in order to actually prevent it.

· The 1970s nevertheless had mass unemployment bursting into the open,
and governments accommodating high and accelerating inflation to battle
it.

· The 1980s-till-now had governments come down hard on inflation, and
accepting high levels of unemployment as the price for stability.

One sees a certain “trade-off” between unemployment and inflation. From
the 1950s till the end of the 1980s the common view among economists
and policy makers was that the unemployment in the trade-off was
“general” unemployment. Nowadays we tend to link unemployment to lowly
productive labour. For us it may be obvious, but compared to the
earlier view it is revolutionary that the once-thought-to-be “general”
unemployment now turns up as a rather specific type. To make the
revolution specific: we will hold that the unemployment in the
trade-off has _always_ been related to the distribution of productivity
across labour.

Now obviously, when this is new, then it has not been recognised
before, and then it has likely been missing in policy. And policy that
was based on a wrong analysis, is likely to have been the cause of the
very problem that it wanted to solve.

Let us see how it went wrong. Regard the legal minimum wage and note
that people are not allowed to work below that minimum. Note too that
there_ hence_ will be no earnings that can be taxed in that range. We
can call this range the “tax void” or “tax vacuum”. However, tax
statutes are defined in that range anyhow. Tax statutes in that void
are actually used to define the gross minimum wage. In Europe, the high
gross wage will cause unemployment and its related benefit burden. In
the US, the void is reduced a bit by accepting poverty. In common
economic terms: tax policy and social-economic policy are badly
co-ordinated.

How this has come about is a story of a more technical nature. First
note that OECD countries adjust their taxes for inflation. Tax
exemption in 1996 will often be close to the inflation-adjusted real
value of 1950. On the other hand, research in social psychology shows
that subsistence tends to rise with the general level of income, the
growth of which consists of inflation and real growth. So there is
“differential indexation”. In the 1950s exemption was pretty close to
subsistence, so that there was no void to speak of. Since then,
exemption has lagged behind the standard of living. The
inflation-adjusted subsistence of 1950 may be only a third of 1996
subsistence. When tax exemption lags behind net subsistence, then there
is a multiplier effect on gross subsistence, with a fast increase of
the tax void.

The alternative and new policy would be to scratch taxes in that void
and to allow people to earn their own - decent and untaxed - living.
This alternative policy reminds of an old rule. The Dutch economist
Cohen Stuart proposed in 1889 to put tax exemption at the level of
subsistence. To drive the point home he drafted the following analogy:
“A bridge must carry its own weight before it can carry a load.” In
1996 there is the additional argument that abolishing void taxes will
not cost anything, and that nations will save benefit payments due to
more employment.

More employment.... Does that not fuel inflation ? The pieces of the
puzzle fall into their places when the tax void is related to the
unemployment & inflation problem. The steady rise of the void explains
the track record of unemployment and inflation. The 1950s have been
characterized by relatively low taxes on low income earners, and this
allowed for full employment and low inflation. From the 1960s onwards
the lagging tax exemption started causing problems with unemployment.
The tax policy since at least 1965 enhanced the imbalance of the
internal bargaining positions of labour instead of counter-balancing
it. Hence inflation was persistent, and high levels of unemployment
were required to achieve price stability.

How governments reacted depended upon the view of the day. Since the
proper solution was not known, the problem did not go away. The
differential indexation of tax exemption and the social minimum did not
draw attention to itself. Each year adds only a slight gap which is
hard to see. But over the years the gap has accumulated, and with huge
consequences. And the problem will remain with us in the future unless
policy changes.

Current policy is based upon other explanations. Notably those of
technology, globalisation and flexibility. The ineffectiveness of
current policy can be explained by the fact that these views are not
entirely logical. The arguments of technology, globalisation and
flexibility run up against contradictions. Technology is a source of
wealth, and it boosts the productivity of the lowly productive jobs,
making the problem of poverty and unemployment less serious than it
would otherwise have been. “Globalisation” is a scare word for “trade”.
Trade however is another source of wealth, and it too has been with us
for ages. Rising wealth in distant countries means rising wages over
there, and trade itself thus puts limits to foreign competition. Japan
over the last 40 years is a prime example of this phenomenon, but every
rich nation has had the same experience. Finally the “flexibility” or
“welfare state sclerosis” argument can only explain that the US has
poverty and Europe unemployment, but it does not explain that there is
a problem with low productivity jobs in the first place.

The present situation bears another surprise. We diagnose current
unemployment as inefficient. Be sure that you see what inefficiency
means: it means that there is a solution that is beneficial to some and
that does not hurt others. Having a bright idea always means a
“win-win” situation or a free lunch. In this case it is the move to
full employment under price stability. The present unemployed will find
jobs. The higher productivity group will have a theoretically larger
risk of unemployment, but in practice this risk will be modest as in
the 1950s. Their real gain will come from the services that will be
provided by the jobs of the present unemployed.

Policy makers will be hesitant about an overhaul of the tax system.
Note, then, that the tax system defines our notion of a subsidy. A
wrongly levied tax, in this case the tax void, can be compensated for
by a wage cost subsidy. Abolishing the tax void is more sensible in the
long run, but when this can only be done gradually, then some general
subsidy directed at lowly productive jobs would speed up short term
adjustment. If only those subsidies are reduced when tax exemption
rises towards subsistence.

This was it, in a nutshell. Now I beg your understanding. My analysis
is more complex than can be stated in these few lines. Both tax policy
and social policy are quite complex themselves, and this certainly
holds for their interaction with inflation and unemployment. For
example, you may ask why I haven’t discussed income redistribution
effects. Actually, this is because the alternative policy could be
neutral to the income distribution. The reason for this is that the
analysis focusses only on the link between wage costs and productivity.
But you might want to hear more about this. Also, you might ask whether
above explanation covers all possible cases of unemployment and
inflation. Of course it doesn’t. The analysis does help to clarify that
other types of unemployment need other types of policy, such as
education and so on. But you might want to hear more on that too. These
are just examples of issues, and there are many more issues that need
to be dealt with. Which space forbids. However, given that my model
amends existing economic models, much of the required explaining is
‘common economics’.

There remains one major point. That tax exemption is low, is defended
by OECD governments with the argument that it keeps marginal rates
down. And the attractiveness of low marginal rates is that they spur
economic activity. My finding however is that the latter claim is only
true when the marginal rate has been defined properly. Thus I agree
with the claim, but it must concern the proper marginal tax rate. There
is a difference between the proper rate, which is dynamic, and the rate
used by OECD governments, which is the static and statutory rate.
Dynamic analysis shows that the proper marginal rate will be close to
the average rate. This part of my analysis is important for economic
growth. Having less unemployment will mean lower average taxes, and
thus lower proper marginal rates, and thus more incentives for
sustainable growth. For many of my fellow economists it is this part of
my analysis that will come as the greatest surprise of all. However,
this is not an issue that can be settled in this review, and here I
definitively have to refer to my extensive analysis.

This novel explanation is in the tradition of Keynes and Tinbergen
while it fits in with mainstream economics. When my fellow economist
check and confirm these findings, our economies are likely to enter
into a new high growth path with full employment and low inflation.

Allow me to add the personal note that I am overjoyed by these
findings.

(March 1996)

16. Enable Russia to help itself

World developments in the 1990s show a worrysome parallel to the 1930s
with the Great Depression. Present-day Russia reminds of the pre-war
Weimar republic, where a devastated economy and weak democracy allowed
Hitler to take power. Western nations in the 1990s hinder trade with
Russia and the Eastern nations for fear of unemployment at home, as
they did in the 1930s with Germany. If trade were stimulated instead of
hindered, Russia could regain economic and political stability by
itself. The moral problem is not external and does not concern whether
Russia would need financial aid. The moral problem is internal, and
concerns whether Western political leaders are willing to face their
own errors that cause the present mass unemployment at home.

Russia is shrouded in a veil of doom. A nation once proud about its
achievements, is now, as so many feel, humiliated in the face of
history. A loss of empire, a collapse of economic security, some coup
attempts in both Kremlin and Duma, a rising reign of violence by a
mafia in the main cities and by full-blown fighting at the geographical
fringes, and a political arena that smells more of fear than of
confidence. Like the Weimar republic in pre-war Germany, Russia has
been subjected to the rules of chaos, and yet again the odds are risky
- and risky for the world at large.

Something needs to be done. Something smart, something humane,
something effective and efficient, and something courageous. Therefor,
something which is not likely to happen quickly. However, there is one
single possibility that is very much worth of our attention. It is
something what we actually could do. And what - given the risks of this
moment - we should do

It is _trade_ that will help Russia and the Eastern nations to
recapture economic security and thereby regain political stability.
And, since it is our fear of unemployment that motivates us to block
that trade, Western nations should tackle unemployment at home
directly.

Parallel

Our comparison of present-day Russia with pre-war Germany is no
coincidence. World developments in the 1990s show a worrysome parallel
to the 1930s. The 1930s suffered from the Great Depression. In the
1990s the world is again plagued by mass unemployment. Again there is a
major region that is economically devastated and that desperately needs
access to the world market, and yet again the other wealthier nations
hinder that entry, while concentrating shortsightedly on their own
problems at home, and neglecting the consequences of neglect. The West
might want to reduce the risk of a Russian disaster, but not at the
cost of jobs at home. Trade barriers are there to keep cheap Eastern
products from “flooding” its home market. Europe throws in huge
subsidies for its agricultural exports. Western tariffs or quality
requirements are pitted against Eastern exchange rates, in a war on
trade whatever its consequences on economic and political stability.

The West is dugging in and seems to repress the recognition that
history is repeating itself. Again the world finds itself in a
deadlock, and yet again chaos feeds on it.

But we should remember the trade war of the 1930s and the rise to power
of Adolf Hitler ! In the 1930s the same mechanism of trade,
unemployment and political instability applied. In this period it was
Germany that was the weak nation. The Versailles Treaty of 1919 that
ended World War I put Germany under a huge reparations bill. The world
forgot that the war had been started by an autocratic Kaiser and that
Germany now had a new, fidging democracy. To pay that bill, this weak
democracy was obliged to cut imports and to spur exports. The
reparations bill worked like a foreign tariff that took away funds that
could have been invested otherwise. By the end of the 1920s Germany
defaulted on its international debt - and thereby indirectly caused the
Wall Street Crash of 1929. Thereafter, all nations scrambled for the
life-boats. Nations feared for their home markets and employment, and
defended themselves by exchange rates and tariffs. In their fear they
made things only worse. The German economy collapsed, and on the
teutonic waves of resentment its weak democracy toppled and Hitler took
power.

Let us now compare: Is the Russian democracy anything other than new
and fidging ? Have its generals not tried to seize power ? Have its
tanks not roared against its very own Parliament building ? Has its
economy not dropped by a third? Or conversely, have all its nuclear
weapons and uranium stores been savely secured ? Have the Western
nations done their utmost in opening their markets ?

Risk not chance

Of course, there is a glimmer of hope. The Russian capacity for
suffering is impressive. Few nations could sustain this suffering and
national disgrace without lapsing into resentment, cruelty and violence
on a much larger scale than we actually see in Russia. The West has
provided some funds and done something more. The world is not at war
and may not be at war for some time. The probability that things go
right is large, and there is only a small chance that things go wrong.

But please consider: If the only glimmer of hope is that _the world is
not at war,_ then the situation is quite depressing. Hope is not the
point, and neither likelihood nor expectation. The point is risk. Risk
comes from the arithmetic of loss multiplied by chance. Thus: risk =
loss * chance. If things go wrong in Russia then the consequences will
be huge, and a small chance _times _a huge loss gives _a risk too
large_.

Internal not external

The West should open its eyes and see the economic logic. Eastern
nations need to take part in the international economy and thus need
modern Western equipment. To buy the latter goods they need the proper
currency. Either someone _gives_ them that foreign currency, the
dollars, yen or marks, or they have to _earn_ it themselves by
exporting. To simply give them credit, on the scale required, is
absurd. Therefor it is access to Western markets that is essential for
those nations and for political stability. Indeed, if they had access,
and if the flow of trade were to start, then the World Bank and IMF
could extend credits and thereby fuel the process towards stability.

At the same time, economic science tells us that it is not trade that
has caused present Western unemployment. Marking trade down as the
culprit, and using trade barriers to solve a situation that trade has
not caused, only makes things worse.

The moral problem is internal and not external. The cause of
present-day unemployment in Western economies is internal management
and not external trade. There is a failure within the internal
co-ordination of macro-economic policy, a failure by our very own
governments. Western nations could tackle their unemployment problem at
home - if only our political leaders were willing to take a hard look
at their own internal policies.

The historic parallel also concerns the current lack of attention for
the internal question. Policy makers that concentrate on an external
trade war neglect the internal opportunities. There is the following
sobering story about the economist John Maynard Keynes. From the early
1930s Keynes advanced his solutions to the Great Depression, and this
culminated in his 1936 book that changed macro-economics. Policymakers
could have reacted already in the early 1930s, ... but only did so
after World War II had already begun.

Conclusion

We might ask: Do we care about the peoples of Russia and the Eastern
nations ? And should we act with economic sense ? However, those
questions are imprecise. The real question is whether our leaders care
so much that they will reschedule their busy agenda’s and really look
into a problem that they cause themselves.

There is every reason to believe that political leaders are quite deaf
on this. So pray that there will not be a new world war. So shout to
your political leaders: Stop that trade war !

Do something about external trade tariffs and internal unemployment.
Enable Russia to help itself.

(March 1996)

17. Will the West repeat Versailles ?

Asia and the Eastern European nations are in a state of economic
turmoil. An important element for improvement is that Western nations
open their markets to more trade. This is in fact what the West could
have done after the fall of the Berlin Wall. But petty shortsightedness
of the governing elites in the West blocks this kind of solution. The
situation reminds one of the Versailles peace conference after World
War I that fostered a lot of resentment and helped cause World War II.
The basis conclusion is that sound economic advice is not listened to.
The best advice on how to steer out of the current world macro-economic
mess is that every parliament installs a committee to enquire into the
process of economic advice. They could study the books by Paul Krugman,
and possibly also my analysis on unemployment and my suggestion for an
Economic Supreme Court.

Western nations show an inadequate reaction towards the Eastern nations
since the fall of the Berlin Wall, and this inadequate reaction is
repeated with respect to the current economic throes of Asia. The West
displays disinterest in the hardship and actual physical pain inflicted
on millions of our fellow human beings, and a neglect of the long run
effects of this egotistic behaviour. Part of this inadequate reaction
however is also caused by wrong applications of economic theory, so
that true compassion that is out there doesn’t get the chance to show
itself. One lesson is that Western nations are advised to restructure
their policy making process so that governments are better served with
proper economic advice.

The negligent way that the Western nations treat the other nations
reminds one of the Versailles peace conference after World War I.
Historians agree about the sad Western attitude at the Versailles
conference. The Western Allies humilated Germany and subjected that
country to decennia of economic hardship, purposely crippling its
economy. These events caused a huge resentment in Germany, and this
fostered the rise of Adolf Hitler. Also, Germany’s defaults on its
financial obligations were a major cause for the 1929 Crash and the
subsequent Great Depression. This episode is another example that two
wrongs don’t necessarily make a right, and it also shows how wrongs can
backlash at the wrong-do-er.

The lesson of Versailles is that opponents can often best be allowed to
grow into a relationship of companionship and economic competition and
co-operation for the betterment of all. Rather than subdue them or take
advantage of temporary weaknesses, they could be helped so that they
could help us. This lesson should now be applied to the current
situations of Asia and Russia.

It is useful to recall that Western nations were not without proper
advice at the time of Versailles. They were warned, and by nobody less
than J.M. Keynes. As Paul Krugman recently stated about Keynes: “After
that war he became famous as the author of _The Economic Consequences
of the Peace_, an eloquent condemnation of the vindictive terms imposed
on the defeated Germans; his concern was vindicated by the rise of
Adolf Hitler, and the memory of his warnings helped convince a
victorious America to aid, not punish, its prostrate enemies after
World War II.”

Indeed, after World War II the Allies helped Germany and Japan to
reorganise their countries and to prosper again. While the average
citizen may be deluded by sentiments of nationalism, religion or
ideology, it normally is a governing elite that abuses those sentiments
for purposes of its own grandeur - and once a decent government is in
place, there often appears little reason to blame that average citizen
for the errors of its country. In the same way post-communist Russia
deserves our sympathy, and the same holds for Asia with its different
history.

But why has the West forgotten this valuable lesson ? Why do Western
governments neglect Nobel Prize winner Jan Tinbergen’s work on the
Optimal Economic Order, and why do we again have a show of petty
egotism and shortsightedness ?

The reason is that the West is not immune to the same ‘governing elite’
processes that can be at the detriment of common welfare. The governing
elites and bureacracies in the West have agenda’s of their own, and
though they are restrained by democratic rules, these rules are not as
strong as they could be. Our systems of checks and balances are a
product of history, and not necessarily of the quality required.
Politicians and bureaucrats often still can lie and get away with it.
The United States e.g. had David Stockman on the budget deficit, and it
took too long before that matter was settled. In general, sound
economic advice still is obstructed by political processes, and
policies and the electorate itself then grow misguided in their
choices.

To better understand the failure of Western democracies on the issue of
economic advice, one can best start by reading Paul Krugman’s books
“The Age of Diminished Expectations” (1990), “Peddling prosperity”
(1994), “Pop Internationalism” (1996), and “The accidental theorist”
(1997). For example, when Krugman discusses US majority leader Armey’s
book “The Freedom Revolution”, he states: “Armey is no fool. He cannot
be unaware that he is fudging his numbers. Possibly he regards a small
fib as justifiable in the service of a higher truth. Or possibly he has
managed to achieve a state of doublethink, in which the distinction
between what is politically convenient to believe and the objective
facts no longer exists [sic]. The end result is the same: His book is
an effort to obscure the stark realities (…)” (1997:60). Similarly, one
can read in the American Economic Review that the US Council of
Economic Advisers is rather proud of its achievements in the last
decades, but we should be aware that this council is a bureaucratic
body, and it hasn’t the independent position that could have protected
the US economy from the events and errors as are related by Krugman in
his “Peddling prosperty” saga or shown by the record of mass
unemployment.

Let us now regard what the West could have done with regards to Russia
after the fall of the Berlin Wall and the first free elections there -
and what could be done now also with respect to Asia. I take my own
1996 paper “Enable Russia to help itself”, and quote from its summary:
“Western nations in the 1990s hinder trade with Russia and the Eastern
nations for fear of unemployment at home, as they did in the 1930s with
Germany. If trade were stimulated instead of hindered, Russia could
regain economic and political stability by itself. The moral problem is
not external and does not concern whether Russia would need financial
aid. The moral problem is internal, and concerns whether Western
political leaders are willing to face their own errors that cause the
present mass unemployment at home.”

Clearly, with this being the state of affairs, one can imagine the
strength of the forces that prevent a proper discussion of these
issues. Western companies embrace tariff barriers to cheap imports -
and raise their own prices. Bureaucrats embrace barriers since these
give a sense of control, and these also justify the very existence of
this bureaucracy. Labour unions will fight unemployment at home with
whatever misguided argument it takes. Governments embrace economic
tales about ‘globalisation’ and ‘competition from cheap labour
countries’ since these distract attention from home grown errors, and
these goverments neglect economists who tell them that ‘globalisation’
and ‘competition from cheap labour countries’ are rather like fairy
tales indeed. Krugman again uses the term ‘globaloney’ - and have you
heard your President or Prime Minister adopting that critical attitude
too ?

The best economic advice for the current situation is as follows - and
I urge upon my fellow economists to adopt and spread that advice too_:
Every parliament could install a committee that will enquire into the
process of economic advice._ This committee could study Krugman’s books
and my suggestions for a solution of mass unemployment and for an
Economic Surpreme Court amendment to the national constitution(s).
Nothing less will do. Note, by the way, that when countries start
installing these committees, the markets will be quick to anticipate
the directions of their conclusions, and economic recovery would
already set in.

We all know Lincoln’s words: “You can fool all of the people some of
the time, and you can fool some of the people all of the time, but you
cannot fool all of the people all of the time.” Let us act upon it, or
show Lincoln wrong. (August 1998)

Notes in 1999: (1) A 1999 UNDP report describes the Eastern European
situation as disastrous, and calls for a quick joining up to the EU (De
Volkskrant October 16 1999). It is courageous that an international
body speaks up like this - and it indicates the seriousness of the
situation. (2) The journalist Peter Michielsen in NRC-Handelsblad
October 30 1999 rightly calls attention to the original borders between
the empires of Rome and Byzantium. The Eastern European countries that
are doing relatively well belong to the Roman area, the others to
Byzantium. He mentions that this cultural distinction has also been
noted by Andreas Oplatka of the Neue Zürcher Zeitung 1994, who again
refers to George Kennan in 1945. I was a bit surprised by this, hadn’t
thought about it in this way. (3) These points however nicely fit what
I have been argueing for ten years now. Enabling people to help
themselves starts with taking account of the local conditions; and
overall the barriers to trade should go.

Book V
Methodology: Definition & Reality

18. How to check ?

At the Dutch Central Planning Bureau, I helped making the Athena model
(CPB (1990)) with its 7000 variables. I had this model at my computer
and could let it do tricks like an obedient dog. But a proposal to an
exercise effectively like the above was rejected by the directorate,
and nowadays I am no longer in the position to make such proposals. The
desktop computer that I have now, in 2004, might have more power than
the 1990 mainframe, but I don’t have the data, the programs, and the
possibility of discussion with colleagues. I have Word for Windows,
_Mathematica_, some crucial books, an occasional visit to the Dutch
Royal Library, and the internet (at low speed). Moreover, I have to
make a living, in a different kind of job, and my time constraints thus
are severe. This explains why I am forced to a logical argument - and
this explains again why I emphasise logic anyhow.

Thus, crucially: it is up to the fellow economists to check my
findings. They / you should actually do this anyhow, since a critical
perspective always is best. For example: What are the data on the
minimum wages in the other OECD countries ? OK, the OECD internet site
shows that 1997 statutory minimum wage is 39% of median wages incl.
overtime in the USA, 60% in France, 30% in Japan, etcetera, quite
sizable
[53] - but what about the tax void, the development, the indexation,
the discouraged workers below the minimum, etcetera ?

[54] What about the shifts of the Phillipscurves in this light ? What
about the effects of the dynamic marginal rate ? How are these topics
in _all_ nations ? And what would happen, if all nations gain
confidence about growth policies again, and they fire up each other and
move all to a new higher growth path ? Clearly, the research agenda is
huge.

The situation since 1989-1991 has been a bit like this: Me stating that
unemployment has been solved (analytically) and inviting the fellow
colleagues to check it - and nothing further happening. This book
should make a difference in that I collect the various articles that I
have been able to write since then. When others see the whole route
then they will also better see the crucial junction where to take the
other turn.

This may also concern the novel contribution to methodology below. [55]

19. Dealing economically with concepts

Maximising information power

Methodology may be seen as _‘economics applied to science’_. The
_methodology of economics_ is the fixed point in that construct - even
economic methodology in the traditional form as presented by Tintner
(1968).

The ‘basic economic problem in science’ is - in my perception or
definition - that some set of concepts can better deal with the data
than another set. New ideas are like manna from the sky, but the manna
must be collected, stored, compared to the older findings, etcetera,
and an optimum must be found, using scarce resources over alternative
ends. This ‘basic economic problem in science’ thus is quite different
from the ‘mundane (non-basic) economics’ that, say, 5% more truth can
be traded against 10% more effort and cost.

The mind has the economic problem of dealing effectively and
efficiently with (i) old concepts, (ii) new information and (iii) the
construction of new concepts. The name of the game is to have concepts
or definitions fit reality as usefully as possible. The definitions
must be chosen as strong as possible, so that uncertainty can be
shifted to observation (and the problems with observation).

The human mind seems to be occupied with reduction of cognitive
dissonance - or, at least, that is a fruitful way to look at that mind.
Here I follow Aronson (1992a&b), who provides a definition of cognitive
dissonance, and data and tests that lend empirical support for it. It
appears that a commonly used method of reduction of cognitive
dissonance consists of the rejection of new information to the
advantage of older views. Frequently the messenger is blamed for the
bad message, and even, after the messenger has been punished, the bad
news is neglected since it came from an unreliable source - namely a
person who had to be punished (while it is forgotten that, if the news
is considered irrelevant, then there was no base for punishment). Man
is a rather prejudiced creature, and thus not so effective and
efficient at information handling - but man has to handle new
information.

Barrow (1998:4) [56] provides us with a useful quote:

“This unifying inclination of ours is a by-product of an important
aspect of our intelligence. Indeed, it is one of the defining
characteristics of our level of self-reflective intelligence. It allows
us to organize knowledge into categories: to know vast numbers of thing
by knowing rules and laws which apply in an infinite number of
circumstances. We do not need to remember what the sum of every
possible pair of numbers is: we need know only the principle of
addition. The ability to seek and find common factors behind
superficially dissimilar things is a prerequisite for memory and for
learning from experience (rather than merely by experience). (…)

All human experience is associated with some form of editing of the
full account of reality (‘we cannot bear too much reality’). Our senses
prune the amount of information on offer. Our eyes are sensitive to a
very narrow range of frequencies of light, our ears to a particular
domain of sound levels and frequencies. If we gathered every last
quantum of information about the world that impinged upon our senses
they would be overwhelmed. Scarce genetic resources would be lopsidedly
concentrated in information-gatherers at the expense of organs which
could exploit a smaller quantity of information in order to escape from
predators or to prey on sources of food. Complete environmental
information would be like having a one-to-one scale map. For a map to
be useful it must encapsulate and summarize the most important aspects
of the terrain: it must compress information into abbreviated forms.
Brains must be able to perform these abbreviations. This also requires
an environment that is simple enough and displays enough order, to make
this encapsulation possible over some dimensions of time and space.

Our minds do not merely gather information; they edit it and seek
particular types of correlation. They have become efficient at
extracting patterns in collections of information. When a pattern is
recognized it enables the whole picture to be replaced by a briefer
summary form which can be retrieved when required. These inclinations
are helpful to us and expand our mental powers. We can retrieve the
partial picture at other times and in different circumstances, imagine
variations to it, extrapolate it, or just forget it. Often, great
scientific achievements will be examples of one extraordinary
individual’s ability to reduce a complex mass of information to a
single pattern. Nor does this inclination to abbreviate stop at the
door of the laboratory. Beyond the scientific realm we might understand
our penchant for religious and mystical explanations of experience as
another application of this faculty for editing reality down fo a few
single principles which make it seem under control. All this gives rise
to dichotomies. Our greatest scientific achievements spring from the
most insightful and elegant reductions of the superficial complexities
of Nature to reveal their underlying simplicities, while our greatest
blunders often arise from the oversimplification of aspects of reality
that subsequently prove to be far more complex than we realized.”

This human property should be used in economics to explain actual
events. Colignatus (1996d) for example applies Aronson’s findings in
social psychology to economics, trying to indicate the actual ‘forces’.
Another application is the very analysis in this book, for example
where we stated earlier:

“If the government on the one hand would desire to use the results of
scientific advice for its budget process, and on the other hand would
not opt for an Economic Supreme Court, then its _definitions _would be
logically inconsistent, and it would thereby tend to create a cause for
dishonesty and improper manoeuvreing and thereby corrupt its
processes.” (above)

While the above relies on structural models, the property can also be
modeled in the reduced form. Chapter 40 uses information indicator _I_
{0, 1}.

Another application is to the methodology of science. Methodology
should harness this human property, and clarify when it is useful and
when it is misleading.

Science aspires at a more unbiased approach. This unbiased approach
also means the deliberate creation of cognitive dissonance, by creating
new concepts and by looking hard at the evidence till it doesn’t go
away anymore.

The evolution of knowledge can be described in terms of an ever
increasing power in the concepts used.

The introduction of a new definition is not simple. The questions
always are: does the definition cover the facts as we know them, does
the definition not introduce hidden aspects that cause confusion and
prevent advancement ? If a new definition wins out, it is, apparently,
only so because it is believed to have passed the test. Though, we
should be critical of this assumption. Only if the environment is
‘critical’, then we might presume a ‘survival of the fittest’ for
concepts. (And all this is reminiscent of Dawkins’s ‘memes’.)

Definitions can be devious in quite vulgar ways. In the English
economics literature, ‘perfect competition’ is defined as the situation
when no agent can affect the price, i.e. all agents are price takers.
The Dutch word for this case is ‘full competition’. The English
definition forces English economists to use the word ‘imperfection’ for
all other cases. Even quite reasonable cases, in the normal state of
human life, when agents have market power but balance at some social
optimum, would be ‘imperfect’. Also a natural monopoly would be an
imperfection - even if one could not conceive the situation differently
since the monopoly is a natural one. It would be better if the English
economists would adopt the Dutch definition, so that the words
‘perfect’ and ‘imperfect’ could be used in their proper sense depending
upon circumstance. This is just a vulgar example of how definitions can
lead one astray.

The competition of alternative concepts can be quite sophisticated
however. Let us illustrate this with three examples. The most
illuminating example may well be Pythagoras’s theorem and its relation
to the circle. This problem concerns mathematics, so that the
discussion is less taxed by semantics and empirical matters - though
there is of course the theory about empirical space. The second example
of ‘falsification’ is surely in the realm of empirics. The third
example concerns the distinction between determinism and volition.

Pythagoras and the circle

Regard a triangle with perpendicular sides _a _and _b _and hypotenuse
_c. _There are two points of view:

1. Pythagoras proved [57] that the square of the hypotenuse
equals the sum of squares of the perpendicular sides, i.e. that _a2 +
b2 = c2_

2. For the circle, it is taken as the defining quality of the
circle, and thus accepted without proof, that the points are at equal
distances from the origin. In other words, a circle with radius _c _is
defined as the collection of points (_a, b_) at a distance of _c _from
the center. Thus _a2 + b2 = c2 _by definition.

The two points of view are presented in Figure 16. The definition of
the circle can be taken for granted, since it is just a definition. On
the other hand, it will be very useful to discuss the proof of the
Pythagoras theorem, since then we see the_ need_ for a proof.

Let us take the square with sides _z = a + b _and surface _z * z = z2
= _(_a + b_)_2. _ Within this square we can see four triangles with
straight sides _a _and _b _and hypotenuse _c, _as has been done in
Figure 16 in the square on the left.

In the square, another tilted square has been drawn, with sides _c _and
thus a surface of _c2_. There are four surrounding triangles, each
triangle has a surface of ½ _a*b. _The surface of the large square is
equal to the surface of the tilted square and the four triangles.

Figure 16: Pythagoras and the circle

Thus:

· From the big square itself: _z2 = _(_a + b_)_2_

· From the tilted square and the triangles: _z2 = c2 + 4 ab/2._

Elimination of _z _then gives _a2 + b2 = c2. _

This proof has been taken from DeLong (1971), and he remarks that
Pythagoras proved it differently.

How do we explain that one and the same equation can have two
interpretations that are so widely different, one with the need for
complicated proof and the other with direct acceptance by definition ?

There may be other explanations, but I think the following will do
fine. Note that the definition of the circle relies on the notion of
‘distance’. There are two points of view again, so that point 2 above
actually splits in two parts:

2A) Basically the (Euclidian) distance between two points can be
measured by a straight line section. That is rather simple, and makes
for a readily acceptable definition of a circle.

2B) However, in a system of co-ordinates, that distance can be
reinterpreted in a representation in terms of the co-ordinates. There
are two possibilities again. Either the distance can be defined as
simply the formula _dist_[{_x, y_}, {_a, b_}]
((_x -_ _a_)_2 + _(_y - b_)_2 _) with {_x, y_} the origin - above {x,
y} = {0, 0} - or it can be defined geometrically as the hypotenuse of
the differences of the co-ordinates. If either definition is accepted,
then one can use Pythagoras’s theorem to derive the other.

The essential difference between (2A) and (2B) is that (2A) is
elementary and poor in concepts and results, while (2B) is complexer
and rich in concepts and results. Viewpoint (2A) only allows us to use
measuring rods between arbitrary points and little else. We are allowed
to sweep the rod around the center, and thereby draw the circle, but
then it somehow stops. Viewpoint (2B) allows us to do much more. A line
between two points is interpreted in terms of a system of co-ordinates,
and that opens the scope for new results.

We find that the opposition of (1) against (2) is rather messy, and (2)
actually hides two suppositions. The ease of (2) depends directly upon
the ease of (2A), while (1) actually compares with (2B) that is
complexer. The phrase “In other words” in (2) above thus was
misleading, and actually represents the introduction of another
assumption.

With this clarified, we also note that (2) is stronger than (1), and
that it was possible to seduce the human mind to accept (2) rather
easily. There has been a progression in concepts, resulting in stronger
definitions.

Note that behind all this there is a notion of empirical space. In (1)
there is a hidden assumption of a flat space. In (2B) the assumption is
made explicit, and then open to amendments (curved surfaces, or
abstract spaces). The movement of (1) to (2) thus is, partly, (a) the
advancement in concepts by means of the definition of distance (and the
circle as a collection of equal distance points), (b) the introduction
of the separate step of observation - with the difficulties: when does
the definition apply to reality, or if there is some reality, how do I
select the proper definition ?

The point that is relevant for this book then is: that the definition
is so good, that it in practice substitutes for many everyday empirical
problems. A criterion for a good definition is: that it can be such a
substitute.

When a definition is a close substitute for reality, then it may
percolate into common culture with more authority. For example: every
citizen can establish the existence of a tax void and Pareto
suboptiomal unemployment purely from the logic of the level of gross
minimum wages and the official tax statutes - and we don’t need big
computers or official bureaus to do some econometrics and then tell us.

Admittedly, there is danger in _seductive_ _and seemingly right_ but
_wrong_ definitions. If ‘child’ is defined as ‘irresponsible young
human’, then we may be tempted to treat children as such and forget to
expect the responsibility that they can handle. But the existence of
this danger should not make us close our eyes to the advantages of good
definitions.

A side issue concerns our concept of ‘space’. Let us first consider an
example of cultural relativism. It appears that different human
cultures can have different approaches to one’s orientation in space,
and that these approaches are wired into the languages used. [58]
Taking a point of reference can be done in three ways: (1) Relative:
taking one-self (“the tree is to the left of the house” - seen by me);
(2) Absolute: taking the sun (“the tree is to the west of the house”);
(3) Intrinsic: taking one of the objects (“the tree is to the back of
the house”). If someone is asked to copy a situation in front of him
towards a place in the back of him, then there will be a different
‘copy’ depending upon one’s language/culture. If you have a cup of
coffee and a pencil in front of you, pick them up, turn yourself
around, and recreate the scene, then a Westerner will use relative
positions, while an Australian Aboriginal will use absolute positions
(and turn the relative positions around). The question now is: while
this only concerns the point of reference, can we imagine something
similar that affects our concept of space itself ?

I take the position that the human mind apparently is able to
conceptualise Euclidean space - and that this actually _defines_ our
concept of space. If we take a non-Euclidean geometry - such as a globe
- then this still can be imagined to exist within Euclidean space.
Pythagoras’s theorem is invalid for triangles drawn on a globe, but to
hold that space is a globe would be erroneous - since our definition of
space would be Euclidean.

One of the questions often posed is whether the universe - interstellar
space - is Euclidean or not. This is a badly posed question. If we
define space as Euclidean, then it is another question whether a ray of
light follows a straight line or is deflected by gravity.

Barrow (1998:p42-44) provides a troubling quote: [59]

“The most important consequence of the success of Euclidean geometry
was that it was believed to describe how the world was. It was neither
an approximation nor a human construct. It was part of the absolute
truth about things. (…) This confidence was suddenly undermined.
Mathematicians discovered that Euclid’s geometry of flat surfaces was
not the one and only logically consistent geometry. (…) None had the
status of absolute truth. Each was appropriate for describing
measurements on a different type of surface, which may or may not exist
in reality. With this, the philosophical status of Euclidean geometry
was undermined. It could no longer be exhibited as an example of our
grasp of absolute truth. (…) These discoveries revealed the difference
between mathematics and science.”

This quote is troubling for the following reasons:

1. If we define ‘space’ as Euclidean, then it is an absolute
truth. This definition seems to maximise our information power. Other
surfaces can be imagined within that space.

2. One might think of ‘empirical space’ as something that must be
measured. The idea is: ‘If it cannot be measured, then it is not
relevant.’ OK, this seems fine in principle. But if a physicist would
use ‘light’ as a measuring rod, then this is asking for problems.
Namely, Euclidean geometry already provides us with our system of
measurement. Defining ‘empirical space’ differently would conflict
with our original definitional grasp of space. Better is: to stick to
the definition, and regard measurements that deviate - e.g. from
gravitational deflection - as the physical properties of the objects
and measurement tools involved.

3. That there is a difference between mathematics and science
does not disqualify the notion of absolute truth. A true deductive
sequence ‘Assumption Conclusion’ has absolute truth. And it should be
realised that scientific theories are mathematical (with the scientist
working on an assumption).

4. It is possible to translate the Dutch ‘lijn’ as ‘point’, and
‘punt’ as ‘line’ (thus conversely) and still find a consistent model
for Euclid’s axioms. But this is a mathematical exercise, and it does
not necessarily have to do with ‘space’.

So it seems that Barrow and I agree for 99%, but still, the 1%
difference features big in some dimension. Note that the discussion
here concerns more a side issue, but it remains useful to indicate the
deeper aspects of Pythagoras’s theorem.

Falsification

The ‘principle of falsification’ is that hypotheses are only scientific
if they are formulated such that they are vulnerable to empirical
testing, and might be falsified. It has been formulated by Popper, see
Keuzenkamp (1994).

The principle has two disadvantages: (1) purely logical, (2)
stochastically.

(ad 1) Take logic first.

Counterargument 1. Regard the statement _All ravens are black_. This
statement will be false when one finds a non-black, say white, raven.
So the statement would be an acceptable scientific hypothesis, since
falsification is possible in principle. But, as the falsificationist
would hold, it would remain a hypothesis, and we should be aware of the
fact that is only a hypothesis, until it had been checked for all
ravens (Tintner (1968:12)). This falsificationist view however is
problematic, since most of us will sense that there is truth in _All
ravens are black_, for example by our definition of a raven.

Counterargument 2. In the extreme, all scientific knowledge would
consist of instances of falsification. It has been falsified that the
Earth is flat, that atoms cannot be broken, that ... But the principle
itself, i.e. that ‘all scientific knowledge would consist of instances
of falsification’, is a definition and is not open to falsification.

While falsification may be a successful research strategy in many
cases, it does not seem to be a fully satisfactory way of organising
science, at least from these two points of logic.

(ad 2) Take stochastics next. Let us regard the typical modelling
situation:

The model:

Estimation:

Observation _X_[+1] forecasts:

Final observation:

_y = X ß +_

_y = X b + e_

_yest_[+1]_ = X_[+1]_ b + _Exp[_e_[+1]]

_y_[+1]

The question now is whether this new observation can falsify the
hypothesis of the empirical estimate. This question is not as simple as
the naive falsificationist first had in mind. The principle of
falsification is formulated as for deterministic reality, while many
empirical models are stochastic. In stochastics, there may be
deviations, and sometimes large ones. There are problems of measurement
in _y _and _X, _the choice of the functional relationship, missing
variables, and the choice of the stochastic specification itself.

One useful empirical answer is optimal control, with the example of a
rocket launched to the moon, where there is continuous adjustment to
observed error (‘falsification‘). This control only works well when
there is a proper definition of the loss function. The issue of the
loss function is a crucial one, but this is not falsificationism.

Logic and stochastics cause me to take the following position.

There is a difference between _all1 _ (universal) and _all2
_(generally, usually, normally). The statement _All ravens are black_
can be seen as:

1. a definition. It then holds universally. Empirical truth then is
conditioned to the logical tautology of the definition that we have
chosen. If we find a white bird that looks like a raven, it cannot be a
raven. (But we think that this definition covers reality, for example
since we have some ideas about genetics and evolution.)

2. an empirical statement - grounded in a stochastic model. It is
shorthand for _All ravenlike birds tend to be rather black_ or whatever
the professional might deem correct. The meaning of such statements is
more subject to context than in the case of well-groomed definitions.

The human mind thus faces the choice: To adopt a definition and run the
risk that this does not fit reality so well, or to adopt a statement on
averages and work out more details of the empirical loss function.
Decisions on such statements thus are sensitive to the loss function,
but the second category requires more detail.

This of course does not solve everything. The distinction of these two
dimensions or perspectives is not like solving all problems in their
domains. Also a definition like _All ravens are black by definition_
does not answer the question whether a particular object is a raven or
is black. Is a size of 10 kilometers acceptable ? Did we look in
daytime or at night ? Must it be alive, and then, what is life ? So the
distinction between definitions and empirical statements is useful, but
it does not solve all problems. The point is not quite that one can
always adjust definitions, but rather that a definition is not reality
by itself. (Though it can get close.)

At one point in history, scientists were willing to accept the periodic
system of elements to catalogue the wide variety of materials around
us. There was apparently little loss involved in accepting these
definitions, or Lavoisier’s periodic table was more gainful than other
catalogs. The definitions did not change the materials, but facilitated
more efficient research. At one point in history, see Mirowski (1989),
economists were willing to analyse human behaviour in terms of utility
maximisation. The approach is an empty box, since any behaviour can be
described as such. For example satisficing behaviour can be represented
as minimising the distance from satisfaction. Also in ‘evolutionary
economics’ the utility maximisation model can be applied though these
researchers are critical of this approach. (While, curiously, Charles
Darwin was inspired, amongst others, by Adam Smith.) The new approach
for laboratory experiments makes us even more critical about the
rationality hypothesis. Utility maximisation however helps organising
one’s thoughts, helps professional discussion, facilitates modelling
and empirical estimation, and is generally considered an advance above
less explicit approaches.

As with the Pythagoras example, but now empirically, there is a switch
from just empirical knowledge to a set of definitions, when the loss
function allows it.

Kuhn (1962) describes major changes as ‘paradigm switches’ (though
someone noted that he used that word in perhaps 40 ways). I rather draw
attention to the change from empirical knowledge to definition. This
change need not be a paradigm switch. Paradigm switches may be the most
intriguing or flashy examples of the introduction of new definitions,
but the change from empirical knowledge to definition does also occur
in ‘normal science’.

Determinism and free will

Holland around 1600 had the theological argument between Gomarus who
defended predestination and Arminius who defended a measure of
volition. This discussion had started before them, didn’t end with
them, and continues till this day, also in these pages.

The 20th century gave a novel twist to the argument, namely quantum
mechanics. Instead of the folly of the gods, there now is a randomizer
with a scientific garb. If objects, and the molecules in our brains,
have random aspects, then this would be neither determinism nor
volition. Quantum mechanics normally is applied at the micro level of
particles, and there is the suggestion that larger aggregations of
masses still would behave in the Newton-Einstein fashion. Schrödinger
however gave an example - his cat - how quantum mechanics could also
extend into this macro world. So the challenge to the debate on
predestination is real. [60]

The quantum model is stochastic of itself. This differs from the
randomness caused by simple measurement errors - the randomness
commonly used in economics. However, economics has some purely
stochastic models of itself too. There is for example the Erlang
queueing model. Consider a postoffice with clients arriving and being
served. Interarrival and service times can be modeled with exponential
distributions, and this allows us to determine the average length of
the queue, the average waiting time, the average utilisation rate of
the service window, and such. If the situation gets more complicated,
then research economists use computer simulation models to find the
best way of operation. This example shows that economics already is
familiar with a model that is stochastic in itself. Note that there are
some ways to re-introduce a degree of determinism - as your barbershop
may require you to make an appointment. The basic observation that we
make here is that the stochastic approach is basically a modeling
method, and there is no implication that arrival and service are
intrinsically random.

The discussion above introduces the various components, and the
question now becomes what to make of it all. The following gives my
solution.

First of all, science _by definition_ avoids the ‘deus ex machina’
assumption. An understanding of reality is looked for without reference
to a god. So our discussion is not burdened with the associations of
eternal damnation (and predestination to this).

Secondly, science _by definition_ aspires at a deterministic
understanding. Scientists may adopt a stochastic approach with only a
limited degree of accuracy, but the target remains a 100% accuracy -
which is determinism. Hence, by definition, scientists have a
deterministic predisposition.
[61]
[62]

Thirdly, the idea of a ‘free will’ is a moral category, differing from
physics. Admittedly, the scientific approach would presuppose that our
moral considerations depend on our brain, and the movements of
electrons and molecules that could be caught in a determistic model -
but the proper conclusion is that we don’t have that model yet. The
existence of time, and in particular the uncertain future, is a
precondition for morality. An ‘existence proof for God’ would be that
in the limit of time, prediction accuracy rises to 100% and all moral
beings are going to make the proper moral choices.
[63] But we don’t know for sure that those choices will be really moral
- and anyway it is hard to see how this could affect us. For example,
we may predict, as social scientists, that when economic conditions
worsen, that politicians then may be more inclined to morally dubious
choices. But we need the passing of time to determine whether this
prediction materialises - and, as human beings, we would still want to
form a moral opinion and discuss the moral aspects. The conceptual gap
between ‘ought’ and ‘is’ remains. Eventually there might be a practical
(non-conceptual) bridge, but for those same practical reasons it isn’t
there yet.

Though science does not refer to gods, we can use a god anyway for
clarification. Janus, the Roman god and name-giver to the month of
January, had two faces, one to the past and one to the future. Figure
17 uses the Janus head as an analogy to locate the various concepts.

Figure 17: Janus head analogy

Note: This only displays the three opposing concepts in one picture,
without implying that all concepts to the left are equal
or that all concepts to the right are equal.

The Janus head analogy works only up to some degree. We don’t know all
that happened in the past, we can use probability statements for the
past too, and thus we cannot replace ‘past’ with ‘certainty’.
Similarly, as said, science has a deterministic predisposition, so the
future basically is predetermined from a scientific point of view. Yet
the head analogy is useful, since it focusses our attention to these
various subtleties.

Thus, clearly, the Arminius and Gomarus debate can be seen as
non-sensical if they got the two categories of science and morality
confused. Even though we can have a deterministic predisposition, we
still can have moral volition (and be judged by jurors on making wrong
choices). Their debate would be proper in so far as Gomarus would take
predestination in a moral sense - but then the debate is not relevant
for us.

Thus, clearly, quantum mechanics drops out as a fundamental category.
It only remains as a research strategy in the face of apparent
difficulties, but it still is on the road to 100% accuracy.

Admittedly, quantum mechanics itself seems to pose that nature would
have random properties at the micro particle level. Some even argue
that this would be the basic example of _true probability_ - while all
other ‘examples of probability’ (like throwing dice) are basically
deterministic (and we only use probability techniques to make up for
our lack of knowledge or laziness in measurement). In particular,
Richard Gill, professor in mathematical statistics at Utrecht
university, gives this argument at a roundtable discussion:

“We should be collectively ashamed not to know anything about quantum
mechanics. I would like to see all introductory texts in probability
theory going a little into the physical (quantum) theory behind the
geiger counter before using some data of alpha particle counts as an
illustration of the Poisson process; I would like a discussion of the
Bell inequalities together with a modicum of quantum mechanical
background to show how elegant probabilistic reasoning shows that the
quantum world is truly random (unless you would like to go for an even
more weird non-local deterministic theory).” (1997b)

Indeed, also economists are familiar with the concept of Brownian
movement, or the random walk, and use this model for example in
analysis of the stock markets. Or in the labour market, with labour
supply _LS_ and employment _LE_, unemployment is _u_ = 1 - _LE/LS:_ but
_u _then basically is a probability, since the model does not provide
an additional explanation why one person works and the other doesn’t.

But Gill’s argument does not convince me. The point is: you may _pose_
that nature would be such, but you don’t know _for sure_. You are still
using only a model. The scientific challenge remains to develop a model
that increases accuracy.

Yes, there is the Heisenberg uncertainty model that if you measure
position then you no longer know speed, and if you measure speed then
you no longer know position: and this model nicely captures a basic
notion of uncertainty. But, try for a better model then - and take some
thousands years more to do so.

[64]

[65]

[66]

As a corollary, we can take a position on path-dependency (hysteresis)
and chaos.

Some authors use the word ‘chaos’ in the sense of path-dependency. For
example, a small variation in first conditions (starting point,
parameter) can cause a widely different result - a butterfly flapping a
wing can cause a tropical storm. Since we already have the term
‘path-dependency’ for this, we better reserve ‘chaos’ for the meaning
of ‘seemingly random’. A chaotic system, in this proper sense, then
gives a fully deterministic description, but the outward appearance
that some variables would be random. Here it is strange that people who
are in favor of ‘chaotic modeling’ also use this to be against
determinism.

Path-dependent and chaotic models can be useful. The orbit of Earth
around the sun looks solid, but over the billion years it seems pretty
random. There is Schrödinger’s cat model that shows the macro world
depending upon a micro state. There are the strange models in history
and biology, where for example a meteor wipes out dinosaurs. OK, all
these models exist, and they can be real good descriptions of true
states of nature. But all this does not disprove the definitory
deterministic predisposition of science. If you would run the movie
again from the start (which is currently said to be a Big Bang, but I
don’t know about that), then you would get, by the models that science
tries to develop, the same result. If you would argue that anything
else might pop up, and your mother could be a dinosaur with a pig’s
head, and if you would develop models that would show this, then you
are quite in danger of being out of science. (You would drop out on
this definition, but could be in on the other criteria.)

Concluding this section, we find that definitions indeed guide our
understanding of nature. The definition of science itself guides our
perceptions - for example when it guides us into taking quantum
mechanics as a model only instead of as ‘reality itself’.

A reason to be strict about this definition of science is that people,
who would argue that nature is basically random, would also tend to
reject deterministic results of science. A deterministic result of
science is for example (1) that divergent indexation of tax exemption
and the standard of living causes a tax void, and (2) that the
existence of a tax void can be used to ‘abolish taxes’ without costs.
It would be a pity if this result were to be rejected because of a
fundamentalist ‘random view of the world’.

From stylized fact to definition

Our subject is the political economy of western welfare states, and in
particular employment and inflation aspects. This subject is quite
complex, and we must be modest about our results. Of course we can use
statistics of the national accounts, and thus indirectly we use the
statistical labour of thousands of statisticians, and indirectly the
results of thousands of firms and of millions of citizens that filled
in their tax forms. Economic literature provides a wealth of models and
interpretations of these data. In my case, I also rely on my own
experience in constructing a national economic model. All this,
however, does not mean that we can forget about modesty, on the
contrary. Nevertheless, it is my conjecture that we can achieve a more
enduring result than just awareness of complexity.

What is interesting in economic discourse is the concept of ‘stylized
fact’. When an economist observes some regularity, he is rather
inclined to use that term. We shall use the term more conservatively,
and we are hesitant about observing regularities. But we also can
fruitfully employ the term when there is a regularity indeed. In some
cases, when the regularity is so strong that our loss function comes in
the epsilon zone, then we even can switch to definitions.

So we adopt the methodology:

(a) state what we consider to be the stylized facts

(b) define our concepts so that the stylized facts are covered by
definitions

(d) link back to conclusions about reality.

A _ proposition - _as a statement on reality - can be regarded as a
mathematical theorem about/within a model of stylized facts. When there
is a tautology, we attain truth by definition.

We here deliberately refer to Bochenski (1956, 1970:20): “The word
‘proposition’ has been variously used, (...) nowadays commonly as the
objective content of a meaningful sentence”.

Some students of the History of Economic Thought will see a clear
resemblance of above methodology and what Schumpeter called the
“Ricardian vice”. Quoted by Tintner (1968:7):

“His interest was in the clear-cut result of direct, practical
significance. In order to get this he cut this general system to
pieces, bundled up as large parts as possible, and put them in cold
storage - so that as many things as possible could be frozen and
“given”. He then piled one simplifying assumption upon another, until,
having really settled everything by these assumptions, he was left with
only a few aggregative variables between which, giving these
assumptions, he set up simple, one-way relations so that, in the end,
the desired results emerged almost as tautologies.”

This is almost exactly what we shall do, except that we generate
tautologies.

Step (d) comes closest to the Popperian falsificationist criterion. Our
deductions need not be insulated against testing, even though this
present book abstains from econometric testing since we are too much
involved in creating our concepts and constructing consistent and
useful _propositions_. [67] Abolishing the Tax Void is a good and cheap
test anyway for the relevance of this analysis.

It is useful to keep Solow’s comment in mind:

“There is something deeply satisfying - not to say suspicious - about
any proposition that seems to deduce important assertions about the
real world from abstract principles.” (1976:148)

So, advisedly, the reader better checks what we are doing here, and
governments should run their own regressions and models before they
make policy decisions. But of course I only dare to present my results
here since I am confident that they, in the hands of competent and true
scientists, allow a real advancement.

Relating to Hicks 1983

In his essay “A discipline not a science” (1983:365-375), John Hicks
argues that economics is too far from the accuracy reached in the
material sciences, and explains that he cannot ‘altogether’ deny that
he himself has converged on a ‘critical’ attitude. This attitude
concentrates on the clarification of terms, i.e. their definitions,
also by using quite unrealistic models. For example: “Though the
concepts of economics (most of the basic concepts) are taken from
business practice, it is only when they have been clarified, and
criticised, by theory, that they can be made into reliable means of
communication.” (p372-3).

Hicks then concludes that economics is a Discipline. His quote of
Keynes (in II.7) above is taken from these pages. My position on this
is twofold - the position of hard science with soft data. On one hand I
embrace the critical attitude. Indeed, we should develop sound
definitions, and remain critical about how these are applied in
communication. That is the meaning of the Definition & Reality
methodology. And it brings us far, since we can advise to abolish the
Tax Void without running regressions and a computer model. On the other
hand, Tinbergen’s efforts have not been in vain, and models with
estimated coefficients are useful tools for policy analysis. For
example, some economists may reject the _existence _of a Phillipscurve,
and all economists should be critical about the data and the parameter
values, but such a _relationship _remains useful in a macromodel that
is used for evaluation of policy alternatives. It would be curious to
accept the concept of a ‘model’ and to accept other relationships like
a consumption function, and reject the use of a Phillipscurve: even
though the uncertainties are quite comparable.

In other words, our method remains econometrics, even though we end
here with an increased awareness of the role of definitions. We are
just in the phase that running regressions is useless if the model is
no good. Regressions come in only when we have a good candidate, and
regressions even might benefit from some definitory relationships. We
even would like to do those regressions ourselves if we had the data
and the time. So, for now, let us first develop what we conjecture to
be the proper model.

20. Structural and reduced form

There is the useful distinction between the structural and reduced
form:

· the structural form represents actual relations as good as possible,

· the reduced form gives the simplest representation, with the
interaction minimised.

With _y _a vector of endogenous variables, _x _a vector of exogenous
variables, and _f_ and _g_ functions, then a structural form is _y =
f(y, x) _and a reduced form is _y = g(x)._

Since econometrics can only approximate reality, the true structural
form can only be approximated. What we consider to be a structural form
is an intersubjective consensus. We anyhow have to adopt an
approximation, which means that many factors have been removed.
However, for two models we can often clearly see that one is simpler
than the other, and then we can usefully apply this distinction between
the structural and reduced form.

The distinction between structural and reduced form also affects the
structure of this book. The next chapters concern the structural form,
actually starting with the textbook IS-LM model. We relax the
assumption of homogeneous labour, and introduce heterogeneous labour.
First we look at labour supply only. Then we look at supply and demand,
and at the equilibrating dynamics, which causes the topic of the
Phillipscurve. We show how the Phillipscurve and the
Constant-Wage-Inflation Rate of Unemployment (CWIRU, a.k.a. NAIRU or
natural rate) shift as a consequence of minimum wages or poverty. We
then relate minimum wages and poverty to developments in taxation. The
co-ordination failure on taxes and minimum wages not only causes the
internal imbalance on the labour market, but also an external
imbalance, with international trade.

The discussion of the structural form results into the need for more
scientific clarity. Though much seems to depend upon empirical
parameters, some aspects however are more fundamental. This leads to
the discussion of the reduced form. We first develop a theorem on the
influence of taxation on employment and unemployment regimes in welfare
states. Since taxation depends upon social choice, we then discuss
Arrow’s theorem on social choice (structural form again). We also note
that there may be a confusion about inefficiency and the existence of a
‘free lunch’. Having established the possibility of rational social
choice, we then develop a theorem on stagnation in the policy making
process (reduced form again).

21. Direct application to the Economic Supreme Court

In chapter 8 we stated: “If the government on the one hand would desire
to use the results of scientific advice for its budget process, and on
the other hand would not opt for an Economic Supreme Court, then its
_definitions _would be logically inconsistent, and it would thereby
tend to create a cause for dishonesty and improper manoeuvreing and
thereby corrupt its processes.”

We can directly apply our Definition & Reality methodology. The point
is that desiring for a scientific base and not making a Court is
logically inconsistent. Parliament and President may _‘define’_ their
‘Council of Economic Advisers’ as ‘scientific’ but when there are
little safeguards, then _reality_ takes over, and the Council will _de
facto_ not have sufficient power to resist political meddling.

The appendices contain an example draft for a Constitutional Amendment
for an Economic Supreme Court and a description, taken from the White
House internet site, of the CEA. The difference should be clear.

Law-givers know: If a law does not fit logic and reality, then people
will see themselves forced to ‘break’ the law. “You are damned if you
do, and damned if you don’t.” People in such situations will tend to
grow dishonest, since it is often easier to massage events rather then
clearly state that the law is impossible and go on strike or whatever.
They don’t see it as ‘dishonest’, but as ‘flexible’. And once people
are on that road, they will rationalise their behaviour by thinking
that this is the way that the world works, and become more willing to
perform other acts of dishonesty.

Conversely, once sufficient safeguards are in place, then the Council
is _de facto_ an Economic Supreme Court (even if it does not have that
name). With a properly defined scientific base for the budgetary
process, economists could also more confidently predict the economy’s
course, since there would be less random noise and chaos about the
application of known knowledge.

22. Methodological summary

We consider all Western economies, or, more properly with Japan
included, the OECD area. Hence, the student of this book will expect
masses of OECD data, and masses of structural models of the OECD
countries, or at least a model for the whole OECD area. There is none
of that. We in fact use only some example data for the small country of
The Netherlands. Why is that ? And how can we possibly utter our
ambitious claims ? The answer to these questions is fourfold:

· there are mathematical theorems and proofs for the reduced form of a
typical welfare state

· we use some key properties that will be documented here

· this chapter on methodology explains the validity of the method

· for the data and structural models we refer to ‘existing economics’.

The approach of this book is to use logic in order to circumvent the
uncertainty of parameter estimates. Though the book doesn’t give full
statistics, it is conjectured that the theorems capture the stylized
facts. A_ proposition - _as a statement on reality - can be regarded as
a mathematical theorem about/within a model of stylized facts. When
there is a tautology, we attain truth by definition.

Our first proposition establishes conditions under which both
unemployment and full employment are possible. This relates to the
_partial _arguments of economists about the labour market. Our second
proposition gives the integral argument, or _general _theory, how (un-)
employment situations are managed. The employment regime can be chosen
by conscious choice, or there is lack of knowledge. Lack of knowledge
forks into two cases. With full employment, the situation is dubbed
‘chance’. With unemployment, it is called a co-ordination failure.

It is useful to state that our point of departure was not mathematical
economics itself. This book has been written against the backdrop of
the voluminous studies Central Planning Bureau (1992a&b) and Colignatus
(1992). It is from this experience that these two propositions have
been selected as being of foremost importance. We want to focus on main
mechanisms that block full employment and prosperous growth in modern
welfare states. It is thought that the two propositions, in a sense
simple but in another sense complex, help to clarify a fruitful
direction for both analysis and policy improvement.

To be sure: this approach does not imply a rejection of time series
econometrics ! I am an econometrician myself. Below I will e.g. develop
a definition of ‘risk’ that deals with uncertainties - and in my view
the 95% confidence interval should be replaced by an interval based on
a well specified loss function. So I am supportive of uncertainty
approaches. However, econometric models also contain definitions and
institutional equations, and it is my conjecture that these have not
gotten the attention required. In particular the regime switch of
1950-1970 to 1970-2005 will be difficult to determine by time series
methods. Studying marginal changes within a regime will not uncover
results about the switch. It would be wrong if time series analysts
would only accept time series as data, and not such regime states. The
Definition & Reality methodology then can help us out. [68]

Governments that become interested in the present analysis will no
doubt require that it is tested against the data of their own country.
This is advisable indeed. However, the claims of this book are
primarily mathematical certainties, and additional empirical data will
mainly provide didactic assurance. Since country parameters are
different, practical policy must rely on the structural models of
course, and data will be needed for detail decisions. But at an
abstract level, the developments would be similar.

Book VI
Structural models

Chapter 23 gives a textbook macro-economic model so that we better
appreciate the point of reference of ‘existing economics’. Chapter 24
clarifies heterogeneity and nonlinear taxation. There is nothing new
here yet either. The subsequent chapters then take up the same subject
matter, and gradually add elements and interpretations that support the
novel analysis.

23. A textbook macro-economic model

Our textbook model is a very simple and unpretentious first year
undergraduate model. It is not interesting for itself, but for our
later discussion.

The IS-LM model

We follow Dornbusch & Fischer (1994), chapters 1 - 4. The basic
macro-economic identity for annual real values is:

_C + G + I + NX YR YD + (RTAX - TRF) C + S + (RTAX - TRF)_

_C_ = consumption

_G_ = government consumption

_I_ = investment
(incl. unintended stocks)

_NX_ = exports minus imports

_YR_ = real gross domestic product

_YD_ = _YR - RTAX + TRF _= _C + S
_= disposable income

_TRF_ = government transfer payments [69]

_RTAX_ = real tax revenue

_DEF _=_ G + TRF - RTAX = S - I - NX
= _government deficit

_S _= saving [70]

We take _G, TRF_ and _NX_ as exogenous and known. We are now only
interested in expectational equilibrium. Aggregate demand is _YR* = C*
+ G + I* + NX. _ With the rate of interest _i _and the marginal tax
rate _r, _behavioural relations are:

_C* = TRF + c (YD* - TRF) + C0_

_I* = I0 - b i*_

_RTAX* = r YR*_

_ _

In equilibrium_ C = C* _gives _YR* = YR - _since _C = C*_ iff _YD =
YD* _iff _I* = S* = I = S. _This can be represented by the IS curve:

_YR = TRF + c (YD* - TRF) + C0 + G + I0 - b i + NX _

_ _

_i = _(_C0 + G + I0_ _+ NX + TRF - _(1 - (1 - _r_) _c_) _YR _) / _b_
(IS)

For the money and bond market:

_L + DB WN / P MX / P + SB_

_L_ = demand for real balances

_DB_ = demand for real bond holdings

_SB_ = real value of the supply of bonds

_WN_ = nominal financial wealth

_P_ = price level

_MX_ = money stock (_M1, M2 or M3_) [71]

Liquidity demand is:

_L = k _(1 _+ h / _(_i - imin_))_ YR_

_ _

Equilibrium on the money market _L = MX / P_ gives the LM curve:

___ _(LM)

Intersection of the IS and LM curves gives equilibrium for _YR_ and
_i_, and from these the other variables can be solved, in particular
the price level _P = MX / L_[_YR, i_]_._

Note that we also use: [72]

_Y_ = _P YR_

While the IS-LM model already tells us something about inflation - via
the quantity of money - there is also the labour market where wages
drive up costs and prices. The IS-LM sectors of the economy and the
labour market are linked via Value Added _Y._

The production function

For our purposes we can use a Cobb-Douglas function with employment
_LE_ and capital _KE_:

_YR = Y0 LE a KE 1 - a_

_Y_ _ P YR = W LE + i PK KE,_

We assume that firms maximise profits - and since we assume constant
returns to scale, there is no surplus. If firms accept wage _W_, then
the marginal productivity of labour equals the real wage _W / P, _and_
_then this determines _LE _which must be at most labour supply _LS.
_Unemployment then follows as _u = 1 - LE / LS. _If companies also
accept the rental price of capital, then the marginal productivity of
capital must equal _i PK / P, _and this determines the employed real
capital stock _KE_, which must be at most total stock _KS._

The additional equations from these marginal conditions are (and we
assume expectational equilibrium on these too):

_LE = Y / W_

_KE = _(1_ - _ )_ Y / _(_i PK_)

With _YR, P _and _i _given from above, there is one degree of freedom
from either _PK_ or _W_. It is customary to close the model with a
relationship that sets the average wage _W_. [73]

_YR_ = real income

_LE_ = employment

_KE_ = employed real capital stock

_KS_ = total real capital stock

_LS = _labour supply

_u_ = rate of unemployment

_W _=_ _average wage

_WT _= _W LE _= total wage sum

_ _

In a full model, the price of capital must relate to investments _I
_and to wealth _WN. _Also, apart from a theory on unemployment, we also
need a theory on idle capital _KS - KE. _We could also include
intermediate goods, as these appeared to have been important in the Oil
Crises. These alternatives however lead too far for our purposes.

Important for our purposes however is inflation. We already indicated
that the price level _P _is relevant for inflation. The crucial thing
to note is that inflation is the relative _change_ of the price level,
so that it is a dynamic concept.

Dynamics versus statics

Let _p _be an arbitrary price.

_Statics_ assumes a timeless dimension. With supply _S_[_p_] and demand
_D_[_p_]_,_ equilibrium (in expectations) is given by _S_[_p_]_ =
D_[_p_] and it solves for the equilibrating price _p·_.

_Dynamics_ concerns developments in time. The price movement _p’ =
dp/dt _is related to excess demand _D_[_p_]_ - S_[_p_]_, _so that_ p’ =
dp/dt = f_[_D_[_p_]_ - S_[_p_]]_. _The solution of this differential
equation gives the movement towards equilibrium. Dynamics causes
different concepts of equilibrium: depending upon the specification of
variables and function, the equilibrium can be market clearing (_p_°)
or the fulfillment of expectations (_p_*). Economic agents generally
have different speeds of reaction when expectations are not fulfilled.
When there are surprises, there can be a ‘trade-off’ between prices and
quantities.

Phillipscurve

For the labour market, dynamics implies a relationship between
unemployment and the change in wages. This relationship is called the
(wage-) Phillipscurve. Sometimes there is an additional assumption of a
strong relationship between wages and product prices, [74] and then the
(price-) Phillipscurve gives the relationship between unemployment and
prices.

The existence of a Phillipscurve thus follows essentially from the
concept of dynamics itself. For the labour market, the price_ _is the
wage _w_ and excess demand is represented by unemployment _u _(thus
negative excess demand; with vacancies neglected partly because of
unreliable measurement), so that _w’_ = _f_[_u_]. Much debate in
macro-economics about whether the Phillipscurve ‘exists’ or not, could
have been cut short by noting that it is a standard market adjustment
equation. The true debate is about the proper form and stability of its
parameters.

In the simplest model we choose inflation, [75] and have, with _u = 1 -
LE /LS:_

dLog[_P_] = _f_[_u_]

and this would add another restriction that closes the model. For
example:

dLog[_P_] = dLog[_P_]* - 0.1 Log[ _u / u*_ ]

would give an expectations augmented form, and when _u = u*_ then
expectations will be fulfilled, and _LE = LS _(1_ - u*_).

It is useful to note that above model does not yet contain an explicit
reaction function of the monetary authorities with regarding to
inflation. Money can be fixed or chosen to grow at a predetermined
rate. In practice there will be a flexible reaction, and then part of
the ‘Phillipscurve regression between dLog[_P_] and _u_’ will reflect
that reaction function.

Macro-economic interactions

The textbook relations are simple in themselves, but the interactions
already can be rather complicated. Figure 18 presents some common
macro-economic interactions.

Figure 18: Some macro-economic interactions

The influence of income in that figure is stated in terms of growth
dLog[_YR_], [76] and the influence of prices is stated in terms of
inflation dLog[_P_]. Positive transmissions are in black and explained
in Table 5, negative transmissions are dashed in red and explained in
Table 6.

Table 5: Positive impulses

_Positive _

_Cause_

_Prime effect_

_Then_

_Then again_

_YR P_

growth

increases demand

adds to inflation

_u DEF_

more unemployment

less income, less tax revenue

more expenditure on benefits

higher deficit

_P i_

more inflation

the Central Bank (CB) raises interest rates to fight it

possibly, though, inflation means more profits and a reduced demand on
loans

and thus a lower rate of interest: but then the CB will maintain the
level of interest

_i DEF_

higher interest rates

the government has a higher interest bill

higher deficit

_DEF i_

a higher deficit

more demand for loans, more supply of bonds

thus a higher rate of interest

_DEF YR_

a higher deficit

sustained expenditure

and thus sustained growth (at least by that channel)

Table 6: Negative impulses

_Negative_

_Cause_

_Prime effect_

_Then_

_u P _

more unemployment

lower wage demands

and thus less inflation

_P DEF_

more inflation

more tax revenue

and thus a lower deficit

_i YR_

a higher rate of interest

makes investments more costly

and thus lower growth

_YR u_

more growth

more demand for labour

lower unemployment

24. Heterogeneity and nonlinear taxation

Heterogeneity versus homogeneity

Homogeneity assumes that _S_[_p_]_,_ _D_[_p_]_ _and _p _are real
variables, while heterogeneity assumes vectors or densities. This book
takes the density approach. In fact, employment _e_[_w_] =
Min[_s_[_w_]_,_ _d_[_w_]] also provides the earnings or income
distribution, i.e. the function that gives the number of people earning
a level of income _w_, for labour supply _s_[_w_] and labour demand
_d_[_w_].

Nonlinear versus proportional taxation

The proportional tax is _r Y_. A linear but non-proportional tax is
_Bentham_[_w, x_]_ = r (w - x)_, though proportionality comes back
again by assuming _x_ = 0. A nonlinear tax adds curvature (see chapter
29), and then interacts with heterogeneous labour.

Some literature

The following references put the argument into perspective.

In his presentation of the IS-LM model, John Hicks (1937) could
disregard differences in labour as being of secondary complication. For
our purposes, however, the case of heterogeneous labour causes a
crucial difference. Policy co-ordination then involves three
distributions:

1. the gross income distribution that corresponds to the productivity
distribution,

2. the net income distribution aspired by the policy maker (‘society’),

3. the actual net income distribution, resulting from taxes imposed
(including e.g. the social security ‘insurance’ payroll tax) and from
expenditure.

There is early recognition in the literature of the need for
heterogeneous labour in discussing dynamics. For example, 20 years ago,
Solow (1976:152), occasionally but not consistently using the more
accurate term ‘surface’:

“George Perry, who was one of the earliest quantifiers of the Phillips
surface, has recently produced an alternative explanation of great
interest [reference]. Perry’s basic insight is that the aggregate
unemployment rate may be an ambiguous measure of pressure in the labor
market when the composition of the labor force and of the group of
unemployed is changing. (...) In other words, the Phillips curve would
have shifted upward. (...) Perry quantifies this observation by making
the plausible assumption that an unemployed body generates downward
pressure on the wage level proportional to the amount of “unemployed
labor” he or she represents. In turn, the amount of unemployed labor
can be measured by the number of dollars of wages it represents.”

No economist working in the field and worth his salt will have
neglected Solow’s paper. Issues of the substitutionability of one kind
of labour for another, and of dispersion measures for the differences
in responses, can found even earlier in the literature.

Van Praag & Halberstadt (1980) present a continuous productivity
distribution.

Bruno & Sachs (1985) give a standard reference for stagflation. Their
formal analysis uses homogeneous labour and proportional taxes, though
some of their statements allow for an interpretation of heterogeneity
and nonproportionality.

The need for modelling heterogeneous labour and nonproportional
taxation is clearly recognized in the literature, see e.g. Beenstock et
al. (1987) and Minford & Ashton (1993). Layard, Nickell & Jackman
(1991), another standard, allow for heterogeneous labour, yet tend
towards proportionality in taxation.

In addition, these references use dynamics but do not explicitly
discuss the consequences of changes in tax parameters. Auerbach &
Kotlikoff (1987) give a wealth of information on fiscal dynamics but do
not specifically tackle stagflation.

Other references which put the Phillipscurve in perspective are Okun
(1981), Blanchard & Fischer (1989), Friedman (1991), The Economist
(1994) and Phelps (1994). Extensive theoretical and empirical work has
been done by the Central Planning Bureau (1992a&b), Gelauff (1992) and
Colignatus (1992b).

25. Summary of current views

It is useful to recognise some current views on the labour market and
the influence of taxes. This allows us to better see the impact of our
new analysis.

A simple view

There exists a simple popular view that makes two errors:

· it is _static _and not_ dynamic_

· it assumes _homogeneity _and not _heterogeneity_.

This model is the comparative statics model with homogeneous supply and
demand for labour. Borjas (1996:159), Mankiw (1998:125) and The
Economist of February 26 1994 present that model. As a model it of
course is consistent and it can help us to get our thoughts started,
but as a representation of real markets it is erroneous.

Figure 19 gives the wage _W _on the vertical axis and supply and demand
quantities on the horizontal axis. (Note the causal order.) It must be
mentioned that marginal tax rates have played a role in the deduction
of the supply and demand curves.

In this Marshallian model, the original equilibrium is attained at the
intersection of the _LS _and _LD _curves, at wage _W°_ and employment_
LE°. _An income tax causes workers to demand a higher wage, and supply
shifts up, to _LS1. _Premiums that raise wage costs for employers cause
these employers to offer a lower direct wage, and demand shifts down,
to _LD1. _The new equilibrium of _LS1 _and _LD1 _is _LE < LE° _ where
employers pay direct wage _W1 > W°_ and where workers receive net _W2
< W°._

For this model, with supply and demand schedules derived with marginal
analysis of utility and profits, there is an important role for
statutory marginal tax rates. First best here are lump sum taxes and
zero marginal rates.

Figure 19: Statics
Marshallian model for the influence of the tax wedge

There are clear objections to this model:

· It is comparative statics, with homogeneous and flexible labour.

· It concerns any kind of tax, while some taxes are socially desired
and generate employment. The model doesn’t distinguish between optimal
and suboptimal taxes.

· Empirical research shows that labour supply elasticities are low.
Elasticities are higher for partners, but that is less relevant here.
People are very much in the position that they have to work for a
living, and taxes generally pose no restraint on the availability for
the labour market. This means that _LS ~ LS1 ~ vertical. _(Borjas
(1996) shows this graph too.)

· The model does not really allow for unemployment. We might define _U
=_ _LE° -LE_, but _LE° _is an unobserved variable. Firms and workers
react to observed variables, and in those terms there is full
employment. Even if labour would be inflexible in this model, then
there still would be no involuntary idleness at the net wage earned.

The use of this model thus is limited. Mankiw (1996) correctly presents
the model as a ‘tax incidence’ model, and we should be hesitant of
other conclusions.

The Simple View however regards this model as a real description of
real labour markets, and it thus makes the category mistake of using
arguments concerning the income distribution for issues of growth and
employment.

The reader is advised to read again Chapter 2 of Keynes’s 1936 _General
Theory_. The_ General Theory_ is in my perception an effort to
seriously develop dynamics. Keynes’s precursors did discuss dynamic
developments, but always ended up in static modelling. See also
Patinkin (1976:140 footnote 4).

In the following quote, Keynes discusses a real wage reduction caused
by prices. For our purposes, we might substitute a real wage reduction
caused by taxes.

“To sum up: there are two objections to the second postulate of the
classical theory. The first relates to the actual behaviour of labour.
A fall in real wages due to a rise in prices, with money-wages
unaltered, does not, as a rule, cause the supply of available labour on
offer at the current wage to fall below the amount acually employed
prior to the rise of prices. To suppose that it does is to suppose that
all those who are now unemployed though willing to work at the current
wage will withdraw the offer of their labour in the event of a small
rise in the cost of living. Yet this strange supposition apparently
underlies Professor Pigou’s _Theory of Unemployment_ [voetnoot] and it
is what all members of the orthodox school are tacitly assuming.”
(Keynes (1936:12-13)).

Note, by the way, that the format of Figure 19 can always be used in
terms of the _average _wage _W. _So the format of Figure 19 may be
inviting to our intuition, in that we think that we indeed can draw a
diagram like that, but we then should be aware that our true model is
heterogeneous labour and not homogeneous labour.

A complex view

An alternative view is more empirical, thus inherently more dynamic,
and builds on Keynes’ observation. Empirical research, see e.g.
Ashenfelter & Layard (1986), Theeuwes (1988), Hum & Simpson (1991) and
Gelauff (1992) shows that marginal tax rates have ‘surprisingly’ low
elasticities. The reason for a lesser importance of marginal rates is
that labour supply is not flexible, but rather fixed. That labour
supply is primairily given by demographic factors, is for example a
well known assumption of practical models developed at the Dutch
Central Planning Bureau. In Western economies people will have to
become active on the labour market in order to earn a living, and taxes
hardly form a barrier. People are still very much like Marx’s
proletariat, and they have little else to fall back on but to supply
their labour. There is some choice for partners and for people on
benefits, but this does not have a major impact. For the majority, if
anything, the average wedge is more important than the marginal one,
see Den Broeder (1989). Recently Minford & Ashton (1993) see scope for
a larger effect of marginal rates, but, their study is still far from
explaining stagflation, partly for the reason that it is not fully
dynamic.

By consequence, the major equilibrating forces exert themselves on the
wage and the related employment. Here arises the dynamic situation of
(wage) inflation and unemployment, and thus the issue of the
Phillipscurve. Thus, conceptually, tax rates have their major impact
not on labour supply but on the Phillipscurve.

The next question then is whether their effects are positive or
negative. The common argument is that a higher marginal rate fuels
inflation. Whether this is the case then becomes the next issue.

Efficiency wages intermezzo

Before we can continue the discussion, a note on the ‘efficiency wage
theory’ is required. The idea is here that, though people are forced to
work to earn a living, they still can choose whether they shirk or not.
They take account of a probability of getting caught and getting fired,
but supervision would be expensive, and, if fired, one eventually could
find another job. Unemployment then is required to discipline the
workers. Borjas (1996:459) provides an introductory discussion, and the
graphs are quite similar to the supply and demand schedules of old.

I tend to regard this approach as an example of academic excess. This
may be an error on my side, but let us look at some of the arguments:
10% of the European labour force is unemployed, hence Europeans
apparently shirk a lot ! And employers are so dumb that they cannot
think of cheap ways to determine productivity, like setting standards
and such. Agreed, shirking is undoubtedly a phenomenon, and eventually
the superior economic model will include a subtle relationship between
wage, effort and productivity to determine the last digits, but all
this is less relevant for the Great Stagflation and the need for an
Economic Supreme Court.

A more sophisticated view

Graafland (1990) introduced another approach at the Dutch Central
Planning Bureau, and he refers here to Hersoug (1984). The
Phillipscurve here is derived using a model of wage bargaining between
unions of employers and employees. The approach is adopted by Gelauff
(1992) on the CPB model MIMIC, Gelauff & Graafland (1994). It recently
is refined by Graafland and De Mooij (1998), Bovenberg, Graafland and
De Mooij (1998), Jongen and Graafland (1998), Graafland & Huizinga
(1999), [77] Graafland and Nibbelink (1999), Oers, De Mooij, Graafland
and Boone (1999), and De Mooij (1999). In this approach, a higher
statutory marginal rate actually increases employment, instead of
reducing it as the Simple View and many standard Phillipscurves would
hold. The mechanism is as follows:

· A higher marginal rate (under constant average) penalizes wage
demands, lowers such demands, reduces (wage) inflation and thus
increases employment.

· A higher average rate (under constant marginal) causes compensating
wage demands at the margin, and reduces employment.

These properties actually are well known, as they are consistent with
analyses concerning a Tax-based Incomes Policy (TIP). For example the
Congressional Budget Office (1977:119):

“In recent years there have been proposals to use tax incentives and
other schemes to encourage more moderate price behavior. (...) Rather
than overriding market forces, these newer proposals attempt to take
advantage of market incentives by making moderate price and wage
increases a matter of self-interest for firms and employees. The best
known of these proposals involves tax incentives to reward or penalize
wage decisions that deviate from some established standard.”

This view however still does not take account of the dynamic marginal
rate. There are also the issues of labour heterogeneity and optimal
taxation that we have encountered in discussing the Simple View, but
that have not had sufficient attention. These issues will be discussed
below.

Confusions

Given more than one view, there is scope for confusion. This has in
fact occurred.

· The OECD policies referred to above, directed at lowering statutory
marginal rates, have been advocated using the rhetoric of the Simple
View even though economic advisers often are aware of the Complex View.

· If one would really think that high marginal rates reduce work effort
and supply, then a situation of high unemployment would call for higher
rates - that would reduce unemployment. Policy however has been to
reduce rates.

Secondly, when these views are confronted with the effects of the
policy of rate reduction, there again is ample scope for confusion.

When unemployment has been reduced, then this is being seen as
corroboration of the Simple View. For example the data on the US now
show the combination of a reduction of taxes on higher incomes and some
reduction of unemployment, and it will now be difficult for policy
makers to accept other lines of arguments. Actually, in so far as there
has been some success in practice, it is because the policies have also
lowered average rates. Higher budget deficits have been relied on to
pay for additional benefits and average rate reductions for higher
incomes. The reduction of marginal rates actually had a negative
impact.

In most cases unemployment has remained high. In this case one should
expect that policy makers would reconsider their views. They don’t seem
to do this, and rather look at the few cases where there seems to have
been success along the expected pattern.

A specific example is the Dutch 1990 tax reform (known as “Oort reform”
[78]). This reform was supported by computations using the MIMIC model,
see Gelauff (1992). The reform reduced both marginal rates and
exemption. The reduction of statutory marginal rates reduced Phillips
curve sensitivities, and induced larger wage claims and lower
employment. The reform however also included a reduction of average
taxes, and this caused employment to rise on balance. We may restate
the situation in more mundane terms: the reduction of average taxes was
sold on the political market as a reduction of marginal rates.
Politicians had their eyes fixed on the reduction of marginal rates and
the reduction of unemployment, and they got what they wanted to see,
without realising that the mechanism in MIMIC was entirely different,
and that proper exploitation of this mechanism would lead to even lower
unemployment.

26. Heterogeneous labour

We will first discuss heterogeneous labour supply, and forward a
hypothesis on its distribution. Note that supply is difficult to
observe, since generally we only observe actual employment, which is
the minimum of supply and demand. However, data on actual earnings do
allow the encouraging conclusion that the earnings distribution can be
approximated by a lognormal distribution. For an indication we look at
Dutch data on the distribution of income in 1950 and 1988. We complete
this chapter by a more thorough sets of definitions for earnings, cost
and income accounting, and we construct integrals that are relevant for
the minimum wage.

Dromedary supply

Let us first regard labour supply.

At a Dutch economists “Masterclass” session in Fall 1991, Orley
Ashenfelter explained that labour supply was unresolved and actually
some kind of a researcher’s nightmare. In a break I put my suggestion
on the blackboard, and my ‘quiggly’ line (see below) at least drew the
compliment of an amused smile. I almost put this suggestion into
Colignatus (1994a), but backed away from that since it was not
essential for that paper (and I used only the normal right hand side of
the supply graph). However, to my surprise and pleasure I saw that same
quiggly line in De Groot & Keuzenkamp (1995) who discuss results of
Quah (1993).

De Groot & Keuzenkamp have another subject than labour supply. Their
problem is whether international economic growth results into
convergence, as Adam Smith’s “The Wealth of Nations” seems to imply. De
Groot & Keuzenkamp refer to the results of Quah (1993) who has compiled
the distribution of output per labourer per country, which turns out to
be that quiggly line.

To understand the point, let me first explain my reasoning on labour
supply. At low productivity, one has to work 24 hours around the clock
in order to survive. For example, if subsistence is at _B _and
productivity is _y_, then the hours are _B / y. _Hours thus quickly
rise when _y _drops (the working poor)._ _When productivity increases,
one quickly starts working less hours, particularly since the kind of
work at that level often concerns hard labour. At higher levels of
productivity again, the kind of work is less exacting and pay is
better, and one may work longer hours again. However, at the highest
levels of productivity, labour again becomes a relative disutility. In
summary, when plotted in a graph, the figure looks like a dromedary,
starting high at the left, having a dip in the neck, then the bump, and
sliding away towards the tail.

If labour supply is like this, then it likely affects the productivity
distribution across nations. While every individual has his or her own
parameters, aggregation may average things out, and as a result one
nation then may stand for a certain income group. Thus Quah’s finding
is consistent with my intuition and indirectly confirms it.

Figure 20 plots the quiggly line, for imaginary income _y_ in thousands
of dollars and subsequent working hours per week, for both long and
short ranges of income so that the curvature can better be appreciated.

Figure 20: Supply in hours per week, depending upon income

Note: These are not observations, just give an hypothesis on shape

I’m still working on a correct form of the complete utility function.
Barro & Sala-i-Martin (1995) give a recent discussion of the trade-off
of work and leisure in the context of growth, and that might be a
fruitful framework. However, for the present purposes, our development
may stop here.

Dutch income distribution data

The literature on the distribution of income has resulted into a
general impression that this distribution can be approximated by a
lognormal distribution, see e.g. Pen & Tinbergen (1977). For the
purposes of our exposition it is useful to test this impression. [79]
Also, since we will discuss long periods of indexation, notably from
1950 till 2002, it is also useful to look at the distribution in 1950
and a recent one. We then take the distribution data in the appendices
for Holland 1950 and 1988.

Figure 21 and Figure 22 plot the resuls of a (rough) estimation. It
appears that we get the best fit when we transform the data into
logarithms (and recompute the frequency densities - i.e. the
transformation required to deal with different class sizes). The
logarithmic data are approximately normal, as can be seen in the plot
of log[income] versus its frequency density. We can transform the
estimated distribution for a plot in the income-frequency format.

Figure 21: Dutch income distribution 1950

Figure 22: Dutch income distribution 1988

In the 1988 plot, the estimation has been done with the 1988
‘parttimers’ dropped, but they are included again in the
income-frequency plot so that we can better appreciate that their
inclusion would confuse a discussion on fulltimers. But it is nice to
see the dromedary shape returning.

We conclude that income can indeed be approximated as a lognormal
distribution, and throughout time; at least as a stylized fact that we
can use for propositions and illustrations. [80]

Definitions and formulas

There are some useful definitions and formulas for heterogeneous labour
markets. These hold for any distribution, not just the lognormal
distribution. Let _y _and _w_ be micro values that have a certain
density. First of all, there are the following accounting definitions,
for annual and nominal values:

· _ _= the profit rate, expressed as a markup on labour costs

· _y_ = labour costs + profit = _w _(1 +_ _) = product revenue =
productivity

· labour cost quote = LCQ = _w / y _= 1 / _ _(1 +_ _)

· labour costs = _w _= (direct) wage + nonwage (but labour related)
costs

· _w _= net labour income + (direct + indirect) taxes + premia + other
nonwage costs

· tax = _T_[_w_] = (direct + indirect) taxes + premia

· gross labour income = labour costs - other nonwage costs = net labour
income + tax

· Neglecting the “other nonwage costs” gives _w_ = labour costs = gross
labour income. (Thus the _w_ are labour earnings only if the other
nonwage costs are zero.)

Observed labour costs have a density _fw_[_w_]. Since the product is _y
= w _(1 +_ _), equalisation of profit rates with respect to labour
would give the labour cost density _fw_[_w_] as a shift of the
productivity density _fy_[_y_]. Normally, though, the profit rates are
equalised in terms of capital, which for example causes different
Labour Cost Quotes (LCQ) per sector of industry, and then the relation
between _fw_[_w_] and _fy_[_y_] is a more complicated affair.

The proper labour supply density _sp_[.] depends on net labour income
(_w - T_[_w_]). But supply can, with the neglect of “other wage costs”,
be regarded as a function of labour cost _w_, as:

_s_[_w_] = _sp_[_w_ _- T_[_w_]]

Labour demand is a density _d_[_w_]. Total supply follows from the
integral:

The employment density is the minimum of supply and demand, and equals
the observed labour cost density:

_e_[_w_] = Min[_s_[_w_], _d_[_w_]] = _fw_[_w_]

For total employment we take account of a minimum wage _M_.

For the discussion below it is also useful to compute aggregate labour
costs and its (nominal) tax revenue:

Important are the average wage _W = WT / LE _ and the average tax rate
_ATXR =_ _TAX / WT _(when we can neglect other nonwage costs).

Densities for unemployment _ud_ and vacancies _vd_ follow from the
difference between supply and demand and actual employment:

_ud_[_w_] = _s_[_w_] - _e_[_w_] & _vd_[_w_] = _d_[_w_] -
_e_[_w_]

The aggregate unemployment and vacancy are _U _and _V, _and their rates
are:

_u = (LS - LE) / LS = u_[_M_] & _v = (LD - LE)
/ LS = v_[_M_]

Figure 23 gives the stylized fact that vacancies tend to occur at
higher income brackets and unemployment at lower ones. The figure is
quite stylized, since it is a difficult issue to construct plausible
_s_[_w_] and _d_[_w_].

Figure 23: Supply and demand of labour

If labour supply _LS _was homogeneous, we would have difficulty
explaining that _u LS _ would be unemployed, since these persons are
similar by assumption. Basically then _u _is a probability.

For heterogeneous labour we could use characteristics and a mechanism
that explains why some are employed and others not. This mechanism
could be related to the shift of the densities over time due to
aggregate demand, inflation, technology, job changes and the like. In
fact, we would use such methods to determine _ud_[_w_] and _vd_[_w_] in
practice - and perhaps we would not start with _w _as the defining
characteristic, but start with other characteristics and work towards
the wage. However, we will not look into this deeply. We will use
heterogeneity mainly to explain the effect of the minimum wage. For a
level of income above the minimum wage we again assume some
probability, quite analoguous to the homogeneous case. Basically, an
agent has offers for various kinds of jobs and incomes, and associated
probabilities (and one for unemployment). The _s_[_w_]_ _and _d_[_w_]
thus have a stochastic base._ _

Minimum wage unemployment differs from the ‘normal’ unemployment above
the minimum. Thus:

_u = um + un_

Only part of _um_ can be gainfully employed when the minimum wage would
be abolished.

Only _un_ will exert a meaningful pressure on wages. A major dynamic
process is that _um_ rises over time, contributing to the phenomenon of
hysteresis. Labour market processes and wage settlements might stay
stable in terms of _un_, i.e. the “normal” unemployment rate, but they
shift in terms of _u_, the overall unemployment rate.

One may wonder why _M _is nonzero, when its abolition would create
employment _ume. _The apparent reason for governments is that labour
markets are not fully competitive and require some regulation. This
issue is taken up again in the next chapter on subsistence.

These integrals don’t say how large the densities are. An indication of
how much _M _‘bites’ is difficult to find. An approach is the
following. Let us define _ms_ such that (for example) 1% of supply has
an earning power of less than _ms_. Similarly, _md_ for demand. Then
Table 7 distinguishes six situations. [81]

Table 7: Combinations of _ms, md_ and _M_

_ _

_ms < md_

_md < ms_

Minimum wage irrelevant (_M < md_)

_M < ms < md_

_M < md < ms_

Minimum wage irrelevant (_M < md_)

_ms < M < md_

_ _

See point (b) below.

_ _

_md < M < ms_

See points (a) and (b) below.

_ms < md < M_

_md < ms < M_

There are some notable effects:

(a) On the supply side, if _ms < M_, then would-be earners of _ms <
w < M_ become eligible for benefits. When they accept these benefits
voluntarily or from social pressure, they, in a sense, form no real
supply. Yet they are supply, otherwise they would not be eligible for a
benefit.

(b) On the demand side, if _md < M,_ then there would be a real
demand for _md < w < M_ if government would reduce _M_. But this demand
is not relevant when _M_ exists.

A crucial point to see is that, as we here are concerned with
productivity, that we can use subsidies to manipulate the densities,
for example by subsidising a particular industry or profession. Doing
this of course causes an accounting problem: does the _w _on the
horizontal axis measure productivity before or after such subsidy ? The
most practical approach is to use _w _inclusive of subsidies - because
market measurements are always inclusive. Subsidising firms would allow
them to hire at higher wages: this would shift _d _to the right._
_Subsidising workers would allow them to work for lower wages: this
would shift _s _to the left. What happens to employment is not a priori
obvious.

It turns out that the minimum wage is important in practice. Our
analysis will strongly rely on minimum wage unemployment. In this we
differ a bit from the original position taken by Keynes. As Tobin
(1972: 122) states:

“But why is the money wage so stubborn if more labor is willingly
available at the same or lower real wage ? Consider first some answers
that Keynes did not give. He did not appeal to trade union monopolies
or minimum wage laws. He was anxious, perhaps over-anxious, to meet his
putative classical opponents on their home field, the competitive
economy.”

In my view, Keynes’s argument (as further explained by Tobin) is to the
point, and aggregate demand, sticky wages and the co-ordination
failures on these are established concepts in macro-economics. However,
the record of the Great Stagflation is very much influenced by the
minimum wage problem, and thus it is that kind of analysis that merits
our attention here.

Amendment to the textbook model on the Phillipscurve

With respect to the textbook macro-economic model in chapter 23, we can
introduce a minimum wage component in unemployment _uM_ that can rise
gradually over the long run due to taxation. With _u_ = _uM_ + _uR_
(_R _from ‘remainder’) a possible Phillipscurve with less dampening
effect of _uR_ is:

dLog[_P_] = dLog[_P_]* - __ Log[ (_uM_ + _uR_)_ / u*_ ]

Alternatively, the two submarkets have their own curves. In both cases,
it must be determined how the two submarkets develop and how they
interact. The most obvious hypothesis is that high productivity labour
sets the trend for the development of wages. When minimum wage
unemployment rises stronger than general unemployment, then the higher
educated have more scope for wage demands, and then there is an upward
effect on wages and prices, even stronger so when price expectations
come into play. This would show an unfavourable (upward or rightward)
shift of the (aggregate) Phillipscurve.

27. Subsistence

This chapter is a bridge between the standard macro model and the
elaborations on heterogeneous labour and taxes. The concept of the
‘welfare state’ depends upon our concept of subsistence and the
elements that go into its index , and on the decisions that we take on
this at the national level.

In Book III we already regarded some indexation of subsistence and
taxes. Here we will refine indexation of net subsistence. Gross
subsistence will be _T_ -1[_B_] as determined by the tax system. A way
to understand this chapter is that it formulates conditions for the tax
system.

We already saw two possible indexation schemes for subsistence: (i) on
average net income or (ii) on gross average income. The latter presumes
that taxes are an indication of welfare too. This current chapter will
look an another way of indexation that takes an intermediate position
that might be better but that might also be needlessly complex.

We will find that if we adopt certain indexations, then we must accept
some divergence in development in other terms.

Definitions

Subsistence labour forms a special group within heterogenous labour.
The group only exists if we acknowledge heterogeneity. In the labour
supply density we already hypothised a ‘dromedary shape’ that partly
reflected the fact that a minimum income means longer hours when the
wage drops. Let us now discuss subsistence more extensively.

With man a social animal, sociobiological and social psychological
causes apply in general. Precisely what these causes are, and how they
apply, is a subject of serious study, see for example Aronson (1992a&b)
and Wilson (1993). A regularity for mankind seems to be, vide these
studies, that in certain cases people show a certain amount of care for
their fellows.

This care should not be overrated. Part of it may not be empathy, but
simply be precaution and an insurance for the event of personal
misfortune. Also, some care obviously reduces the chance of a violent
reaction of the disadvantaged. There are clear examples of empathy
breakdown. For example, archeologists found ancient mines with such
small shafts that these mines could only have been worked by children.
We need not have illusions about working conditions, especially since
it were lead mines. Nevertheless, whatever these clauses and contrary
cases, ‘normal conditions’ seem to provoke a distinct level of care.

A strong assumption is that people have views about the whole income
distribution. A simpler assumption is that people recognise a level of
subsistence - which for dynamics likely implies that they adjust that
subsistence to developments.

The strong assumption might well be that the income distribution is
lognormal for _social_ - and not ‘economic’ - reasons, and that the
economic process only is oriented at directing people to a fitting
place in that distribution. Economic productivity is essentially a
nominal concept. It is not just the technical amount of goods per hour
that can be produced, but also multiplied by the price of the product,
and the price is determined in a social situation where status
considerations apply. The assumption that economic agents have views
about the income distribution actually need not be overly strong. As
Tobin (1972, p122) states:

“(...) This observation led Keynes to his central explanation: Workers,
individually and in groups, are more concerned with relative than
absolute real wages.”

However, for our discussion, we narrow down the problem to the
subsistence or the net minimum wage, and disregard views on the whole
income distribution.

Suppose that a group recognises some subsistence. A group even might be
defined by its shared views on this. For example, members of a royal
family receive a certain allowance that meets their standard of living,
and their standard of living helps to show that they are members of
that royal family. The view oriented at the inner group thus is linked
to the exclusion of others. Others should have less, precisely to
distinguish them from the inner group. Being a royal family does not
amount to much, if you don’t have subjects. This process works all the
way down, so that even people in minimum conditions flatten out
differences among themselves, and seem to compare themselves to beings
of assumed lesser stature. (So the simpler assumption could be used to
build the strong assumption.) This discussion also clarifies that the
size of the group matters. There is only room for a national
subsistence floor if the simpler assumption allows for a large group.
So the simpler assumption properly reads that groups not only define
subsistence for the inner group, which is less controversial, but also,
more controversial, subsistence for society as a whole.

Note that any assumption, simple or strong, is not sufficient by
itself. Society also has the coordination problem of aggregating the
individual preferences on national subsistence, particularly since not
everyone who wants to raise the living standard of the poor has the
personal means to do so. Sometimes there are legal rules. Often labour
unions come in. For example in Holland collective bargaining results
into industry minimum wages that are on average at least 10% higher
than the legal minimum wage. More generally, subsistence is simply a
social convention. A certain level of living is regarded as
inacceptable, both by most employers and by the work floor in general.

One way to implement a welfare system would be to set social security
at _B,_ and leave it at that. There would be no need for a minimum
wage, since employers would have to offer at least _B_. In practice
government nevertheless create a minimum wage system too, and allow a
gap between the working wage and the benefit. One of the reasons is
better control, so that agents are less likely to both receive a
benefit and work on the side. One of the other causes undoubtedly
derives of the social forces that call for a decent minimum. [82]

Sometimes labour market regulators may be aware of the problem of the
minimum wage, and may opt for a lower indexation of _M_ even though it
results into a lower _B._ But the effectiveness of such policies that
reduce subsistence depends upon the strength of conventions in all
factories and sectors.

It is useful to note that conventions are sensitive to various
considerations. For example, the Dutch legal minimum wage holds for
fulltimers, but does not hold for parttimers. Holland now has a lot of
parttime work. [83] It is also interesting to observe that tax
exemption _x_ is established within the bureaucratic realm where there
is no direct confrontation with the standard of living. For its own
historical reasons, exemption is generally indexed on inflation. These
matters, while also being evidence that human care for other people
should not be overrated, again clarify that our subject matter is not
simple in itself. Subsistence itself is very simple, especially to
those who are subject to it, but it can be made complex, especially by
those who govern.

Economic literature

Economic theory has long been aware of notions of empathy, vide Adam
Smith (1759, 1984) on moral sentiments.

Some tax theorists suggest that the social subsistence level should be
exempt from taxation. Hofstra (1975) recalls the Cohen Stuart 1889
analogy, that a bridge must hold its own weight before it can be used.

In his 1980 presidential address to the American Economic Association,
Solow (1980) discussed his reading of Pigou’ work, and writes:

“The last comment of Pigou’s that I want to cite is especially
intriguing because it is so unlike the sort of thing that his present
day successors keep saying. Already in the 1933 _Theory of
unemployment_ he wrote: “... public opinion in a modern civilized State
builds up for itself a rough estimate of what constitutes a reasonable
living wage. This is derived half-consciously from a knowlegde of the
actual standards enjoyed by more or less ‘average’ workers ... Public
opinion then enforces its view, failing success through social
pressure, by the machinery of .. legislation” (p.255). A similar remark
appears in _Lapses_ [Pigou 1944 _Lapses from Full Employment_]. Such
feelings about equity and fairness are obviously relevant to the
setting of statutory minimum wages, and Pigou uses them that way.” (p5)

Solow in the next sentences also emphasises the power of social
pressure, and shows himself aware that the minimum wage need not be a
special application since social pressure is abundant:

“... it is even more surprising ... that employers so rarely try to
elicit wage cutting on the part of their laid-off employees, even in a
buyer’s market for labor. Several forces can be at work, but I think
Occam’s razor and common observation both suggest that a code of good
behavior enforced by social pressure is one of them.”

Types of indexation

We already have encountered these indexes of subsistence:

· The graphs in Book III are based on indexation on the net average
wage _Net_[_W_] = _W - T_[_W_]. This presentation has been chosen since
its approach is more conservative.

· Another indexation is on _W _itself, which thus considers taxes a
part of well-being. Property (13.3e) however shows this equivalent to
the first, for the Bentham tax, provided that exemption is properly
indexed too.

Indexation on gross income (i.e. on _W_) agrees better with economic
intuition, since taxes need not be a real burden, when they generate
goods that enter the utility function. However, some taxes can be
wasteful or can be discarded for other reasons. In the following we
will take a middle position, adding and substracting income elements.
In particular:

· some public goods _Q _are provided by nature: breathing air and the
berries in the field

· taxes go into public goods _Gp,_ that subsistence workers get for
free too (as licensed free riders)

· some government expenditure _Gs _may benefit only special interest
groups (wastefully)

· some government expenditures _Gn _actually benefit the average tax
payer, and should be considered part of ‘net income’

· some taxes go to the support of the unemployed - _B U_ - which the
unemployed cannot provide for themselves

· there is the possibility of different consumption baskets (different
deflators)

· it is recognised that people at subsistence tend to have more sweat
and less leisure

· tax revenue can change disproportionally with income.

Considering these element, it seems that the adoption of a detailed
index would likely cause little difference with gross income
indexation. Many of the additions compensate for many of the
substractions. Also, if subsistence were to lag behind average income,
then it might well happen that subsistence is increased at some point
anyway.

It nevertheless remains useful to develop the detailed index formally.
If your interest in the subject is not very strong, you are advised to
skip the remainder of this chapter. The reader who studies this section
will notice that we do not achieve very much. Some of the formulas look
complex, but on close inspection only say the obvious.

Formal development

We assume a ‘basic insurance’ setup for social security. The unemployed
get a benefit of _B. _At higher earning levels they may have additional
insurance, and be paid on top of _B. _But this is of no concern for our
issue. Also, who is on benefit but gets a job offer, accepts this, on
the penalty of losing the benefit anyhow. This means that nominal
transfer payments are _NTRF = B U_. We also take _b = NTRF / LE = B u
_(redefining the symbol _b _- no longer the IS curve). Similarly_ q = Q
/ LE._

Let _g = NG / LE_ be average nominal government expenditure per worker,
with _g = gn + gp + gs. _We will assume Ricardian equivalence, so that
government budget deficits are regarded as part of taxes, so that there
effectively is no deficit. [84] Hence _TAX = NG + NTRF._

Then the average wage tax rate _AWTR _ _TAX / WT = (TAX/LE) / (WT/LE)
= (g + b) / W. _

For the special interests we distinguish two kinds of situations.

· When average income itself is the special interest, then _gs_ can
also be regarded as net income, part of _gn_, and then this case is
equivalent to _gs_ = 0. Note that we could include _gn_ in _Net_[_W_]
mathematically anyhow (but don’t do this for clarity).

· Alternatively _gs_ 0. In particular, the average income group could
be a victim of a coalition of the poor and the rich, the first getting
a high _B_ and the second a large _gs_. [85] In a democracy with voting
population _LS,_ a majority of _LS_/2 + 1 indeed can levy high taxes on
the other _LS_/2 -1. In that case it would not be fair to regard the
tax on the average wage as beneficial to the common good. (Note that
this analysis for _gs_ 0 is weak, since not all possible
redistributive schemes are considered.)

Price indices for the average and subsistence workers are _P_ and _Pb.
_Real positions thus are _W / P_ and_ B / Pb. _Government prices are
_Pgn, Pgp _and_ Pgs, _giving _gnr _and _gpr _and _gsr. _Similarly _Pq_
and _qr._

The difference in leisure and sweat will be compensated here by
choosing a suitable Real Income Ratio RIR.

All together, we have:

· Net position of the average worker _Net_[_W_] + _gn + gp _+ _q_

· Net position of the subsistence worker _B_ + _gp_ + _q_

· The real income ratio RIR (_B/Pb_ + _gpr_ + _qr_) / (_Net_[_W_]_/P_
+ _gnr + gpr + qr_)

The government would set RIR at a specific value, and then determine _B
_from the other values:

_B = Pb_ { RIR_ (Net_[_W_]_ / P + gnr) - _(1 - RIR)_ (gpr + qr)_ }
(27.1)

One thing to show is that _B _has a small multiplier on itself because
of _b._ We can use the average tax rate difference _Z_ between
national and private average:

_Z _ _TAX / WT - T_[_W_] / _W_

_Z = (g + b) / W - T_[_W_] / _W_

_T_[_W_] = _g + b - Z W _

_Net_[_W_]_ = W - T_[_W_]_ = W + Z W - g - b = (1 + Z) W - g - b_

Using this for the RIR:

· Net position of the average worker _(1 + Z) W - gs - b_ + _q_

· Then RIR (_B/Pb_ + _gpr_ + _qr_) / (_(1+Z) W/P_ - _gsr - B/Pb u +
qr_)

(27.2)

The first term of (27.2) contains a small (negative) multiplier of _B_
on itself. In full employment, _u_ 0.02, and with RIR 0.30 the
multiplier might easily be neglected. That is, neglected in (27.2) but
not for the determination of the RIR in the base year - since _B u_
cannot be neglected for the base of the RIR. Since (27.1) and (27.2)
are mathematically the same, using (27.1) makes that the question of
neglecting that small multiplier does not arise.

Another point is that the index becomes simpler if all price indices
are the same. Taking _P = Pi _gives RIR (_B_ + _gp_ +_ q_) / ((1_+Z_)_
W_ - _gs - B u + q_).

Let us consider a numerical example. Suppose that _gn = gs_ = _q =_ 0
and that prices are equal. Suppose also that _AWTR = TAX/WT_ = 0.30. We
also take the Bentham tax _T_[_y_] = _Bentham_[_y_] = 0.5 (_y - B_).
Let us consider the path that subsistence is half of average income,
i.e. _B/W_ = ½, and then compute the various ratios. Then:

· Indexation on gross average income gives _B / W_ = 0.5.

· Indexation on net average income gives _B / Net_[_W_] = _B_ / (2_B_ -
0.5 _B_) = 0.66.

· Then _T_[_W_] / _W = _0.5 (_W - ½ W_) / _W _= 0.25, and _Z _ 0.30 -
0.25 = 0.05.

· Since _gn = gs_ = 0, _g = gp, _and _AWTR = _(_gp + b_) /_ W = gp/W +
_½ _u = _0.30. If we assume full employment _u_ = 0.02, then _gp/W_ =
0.29.

· Then RIR = (_B / W + gp /W_) / ((_1 + Z_) - 0.01) = (½ + 0.29) /
1.04 = 0.76.

Note that the ratio numbers 0.50, 0.66 and 0.76 by themselves mean
little. In both cases _B _is set at half _W, _so the value of _B _is
not affected. The only point is that the bases are different each time,
and apparently smaller. These bases of course change again for other
assumptions on the various variables and functions. Where there is no
difference at a particular moment (base year), there however arise
differences over time. The following tries to find out more about this.

Progression factor

One way to trace developments over time is to make plots as we did in
Book III. Another approach is more formally, and a commonly used route
here is the assumption of a constant macro-economic progression factor.
This factor is the elasticity of tax revenue with respect to income
(Koopmans (1975:103)), thus _mepf = (Y / TAX) (_ _TAX_ / _ _ _Y). _The
factor is determined by tax parameters, their indexation, the income
distribution and its change. In this case, without a deficit, the
progression factor applies to expenditure too, which may be taken to
mean, effectively, that taxes are indexed such that tax revenue follows
expenditure.

We shall take the progression factor for the average wage, which is
exclusive of profits and the growth of employment. Thus our _ = (W /
g) (_ _g_ / _ _ _W). _We assume a nominal position, thus include price
developments in government expenditure relative to the average wage. We
set _gn = _0_ _now, since it can be included mathematically with _gp.
_We also assume that _ _is equal for _gs_ and _gp_, so that _gs_ =
_gs_[0] _W _ / _W_[0]_ _= _gs_0 _W _ and _gp_ = _gp_[0] _W _ /
_W_[0]_ _ = _gp_0 _W _ . Thus _g_ = _g_[0] _W _
/ _W_[0]_ _ with properly _g_[0] = _gp_[0]
+ _gs_[0].

Then _ _ _g_
/ _ _ _W g / W = NG / WT. _ This has
the specific property that _ = _1 implies that the quote _g / W = g_[0]
/ _W_[0] is constant, and thus _NG /WT _is constant too. We will use
this property below.

Taking _W_ separate:

and hence

(27.3)

Inclusion of the progression factor does not cause special observations
yet. If _ _ < 1 then in the limit of _W_ the indexation can be rather
simple, especially if _Pb qr / W_ goes to zero too. If _ _> 1, then
there could be a point where the markup on _W_ is zero, or subsistence
would have to be zero - which would suggest an unrealistic tax
function. The progression factor becomes more useful if we regard
special cases.

Special cases

Definition: A (democratic) state is “Madisonian”, iff _gs_ = 0. James
Madison remarked that a proper democracy with a majority rule actually
safeguards the interests of the minorities.

Definition: A “real welfare state” aspires at a constant RIR and takes
_q_ = 0. The idea on the latter is that breathing air is prerequisite
to utility and no source of it. The berries in the field are owned by
someone, and no longer free. (If they were free, then Coase’s Theorem
shows that they could be counted as part of income, and hence they
would no longer be free for all practical purposes.)

Definition: A “pragmatic” real welfare state sets _u _= 0 in the
determination of the benefit level and RIR. The factor _B u _really
does not amount to much.

Definition: “Uniform prices” means _P _= _Pb = Pgs = Pgb = Pgn = Pq_.
If this happens then one price index _P_ suffices.

Theorem B1: In a pragmatic Madisonian real welfare state with Ricardian
equivalence and uniform prices, (i)

RIR = _(B + g) / ((1 + Z) W) _(base year)

and

_B = W_ ((_1 + Z) _RIR_ - NG/WT_) (henceforth)

(ii) If RIR is constant, then: (1) A constant quote for government
layouts (or progression factor _ _ = 1) only allows for some variation
in _B/W _by variation in the average tax rate difference _Z. _(2) If _Z
_is constant, then _B _is fully indexed on _W._

Proof:

(i) For the base year: substitute the results of the definitions in the
RIR (vide (27.2)), note that the prices cancel and that _g = gp_. Then
find the base year result as stated, and then use _(NG /WT) W = g _to
get the annual expression.

(ii) For (1), we use _ _= 1 _NG /WT _= _g_[0] / _W_[0] from above.
Then simply rework the equation for a constant.

For (2), if _NG/WT _and _Z _are constant, write _B = c W._ Then _B
/ _ _W _= _c_
= _B / W. _Hence Log[_B_] = Log[_W_].

Q.E.D.

Theorem B2: In a pragmatic Madisonian real welfare state with Ricardian
equivalence and uniform prices, net income indexation is only feasible
for special tax functions.

Proof: To see what happens if _B _is indexed on _Net_[_W_], write _n =
_ _ Net_[_W_] / _ _ _W. _Note that 1- _n_ is the marginal tax rate for
_W_, and that _B / _ _W = _ _B / _ _Net_[_W_] _n._

With _B = W (1 + Z) _RIR_ - g _(theorem B1)_ _use _W (1 + Z)_ =
_(Net_[_W_]_ + g + b) _and get:

_B _= RIR _Net_[_W_] _ _- (1 - RIR) _g + _RIR_ b_

Note that _b_ 0, since we have set _u_ = 0 only in the determination
of the RIR. Then:

_B / _ _W = _ (RIR _Net_[_W_] _ _- (1 - RIR) _g + _RIR _b_) _/ _ _W _

_= _RIR _n _- (1 - RIR) _ g / W + _RIR _u_ _B
/ _ _W_
/
/
/
/
_B / _ _W_= (RIR _n_ - (1 - RIR) _ g / W_)
/ (1 - RIR _u_)
/
/
/
/
/
/
/
/
We again find a small multiplier. Dividing by _n _gives the transform
to _Net_[_W_]:

_B / _ _Net_[_W_] = (RIR - (1 - RIR) _ NG / WT / n_) / (1 - RIR _u_)

Log_B / _ Log[_Net_[_W_]] = _Net_[_W_] / _B_ (RIR - (1 - RIR) _ g /
W / n_) / (1 - RIR _u_)

Indexation on _Net_[_W_] means that the left hand side is 1, and that
_Net_[_W_] / _B_ is some constant. Setting net income ratio _B /
Net_[_W_] = NIR[0]:

NIR[0] = (RIR - (1 - RIR) _ g / W / n_)
/ (1 - RIR _u_)
/
/
/
We want to find the conditions under which RIR is a constant (for the
‘real welfare state’). Solving above expression for RIR gives:

A special case has _ = _1 and thus _NG/WT = g / W _constant, and _n
_constant, i.e. for the Bentham tax function _n _= 1 - _r._ This is
only feasible if _u _is constant too. There is a more general class
when _ g / W
/ n _is some constant, but _u _must be constant here too. In other
cases the RIR is implicitly adjusted to make _B_ / _Net_[_W_]
constant. But nonconstancy of the RIR conflicts with above definition
of the welfare state (that must have constant RIR).

Q.E.D.

28. Phillipscurve

This chapter deals with the confrontation of labour supply with labour
demand, and the equilibrating dynamics. With high unemployment, wage
growth may be reduced. With low unemployment there may be ample room
for wage demands, and wage inflation can rise.

Chapter 25 already provided a background discussion on the
Phillipscurve, and for example pointed to Graaflands c.s. derivation
from a Nash maximising framework. In this chapter we take that possible
development for granted, and concentrate on concepts: what variables
are relevant for a Phillipscurve, and how do we characterise
equilibrium.

It appears to be useful to first develop some concepts of dynamics.

Concepts

The Phillipscurve reflects the hypothesis that (wage) inflation is
influenced by unemployment. Of course other factors are important too,
such as (price, wage) expectations and forward shifting of taxes.
Whatever other influences, the key notion of the Phillipscurve remains
the influence of the employment situation. Wage adjustment now is
considered to be the dependent variable while normally the price would
be the independent variable. Wage adjustment will consist of a shift
along a curve and a shift of the curve, and for both we still use the
term ‘Phillipscurve’.

As remarked, labour supply is relatively fixed. Utility maximisation
and rational calculation will primairily be directed at finding a
competitive wage (competition not necessarily meaning _full_
competition - as we e.g. referred to a Nash equilibrium). An individual
who sets his wages too high will become unemployed. Even the
probability of becoming unemployed will have a sobering effect. Given
this framework, the model must concern a dynamic process of
unemployment (threats) and wage adjustment.

First consider a homogeneous market with price level _P. _Price
adjustment towards the market clearing equilibrium price _P° _depends
upon excess demand, and since excess demand is determined by the price
level, we get a differential equation:

_P’ _= d_P _/ d_t _= _f_[ _D_[_P_] - _S_[_P_] ] = _f °_ [ _P° - P _]

Note that the choice of ‘excess demand’ as the explanatory variable is
arbitrary. We might as well take excess supply, or allow demand and
supply to react differently, or have a different sensitivity to prices
and quantities. Similarly, we can also take the quantity as the
explained variable. And we can also formulate the equation in
expectational variables.

Some authors hold that above relationship for price dynamics is an
hypothesis that needs further clarification. I think that this is too
cautious. Admittedly, it might be too simple to only presume that
agents know that they are involved in a market ‘tatonnement’ process,
and further explanations can be helpful. Agents have various tools
available, and the choice of offering and accepting prices and
quantities can be described, using an optimising framework. The speed
of adjustment in markets depends upon characteristics like the size of
the market, the historical relationships between agents, ‘menu costs’,
and the like. It is also useful to distinguish ‘normal’ periods and
‘shocks’. However, the level of detail depends upon the use of the
model, and above relationship suffices our goal.

Inflation is the rate of growth of prices, i.e. _p _= dLog[_P_] / d_t_
= _P’ / P._ The change in inflation is d_p _/ d_t = P”/ P - (P’)2 /
P2_ in terms of the original price level. Acceleration of inflation
would be d2 _p _/ d_t2_.

We need to clarify a term. The economic literature uses the term
“Non-Accelerating-Inflation Rate of Unemployment” (NAIRU) for that rate
of unemployment that causes d_p _/ d_t _= 0.

This term thus should be “non-accelerating prices” or “non-changing, or
constant, inflation”.

Secondly, it appears that the formulation in terms of differentials is
less useful for practical economics than the formulation in
differences. So we will use differences instead. Inflation then is _p
_= (_P /P_[-1] - 1) (often expressed as a percentage).

Thirdly, we regard wage inflation rather than product price inflation,
thus _ _= (_W /W_[-1] - 1). Please note that we use the different
letter font _ _for wage inflation, since we use _w _for the level
variable in densities like _e_[_w_]. Properly we should substract
productivity growth, but for our purposes we may now assume that
productivity is constant. Note that wage inflation can be different
from price inflation, since productivity is determined in terms of the
output price, and output will not be only consumer goods but also
exports, investments and intermediates.

We will use the term “Constant Inflation Rate of Unemployment” (CIRU)
for that rate of unemployment that causes _p = p_[-1]. Similarly, the
Constant Wage Inflation Rate of Unemployment (CWIRU) gives that rate of
unemployment that causes _ = _[-1]. [86]

We use the term “Equilibrium Rate of Unemployment” (ERU) for that rate
of unemployment that causes wages to adjust to their equilibrating or
market clearing level _° = _(_W° /W_[-1] - 1). The CWIRU might be a
special kind of ERU. The idea is that once inflation has been constant
for a long while, you start expecting it. Table 8 contains an overview
of the concepts.

Table 8: Concepts for wage inflation

_REH: white noise surprise = * + _

_Non-REH: other surprises_

_ _

_CWIRU_

_
= [-1]_

_uf = ERU[FE] _

CWIRU = ERU[REH] = ERU[FE]

Maybe temporarily, but impossible in the long run

_Other_

CWIRU = ERU[REH]

Maybe temporarily, but impossible in the long run

_Non-CWIRU_

_
[-1]_

_uf = ERU[FE] _

_° _= _h_[_uf_, _u_[-1]] + … if expected …

_° _= _h_[_uf_, _u_[-1]] + …

_Other_

ERU[REH]

No equilibrium in any of these senses

Note: We use ° to indicate market clearing equilibrium, and * or E[.]
for expectations and expectational equilibrium. We use · when we
allow for either.

We can recognise at least two equilibria:

· FE: full employment, when all labour resources are used except for
friction unemployment _uf_ = ERU[FE]. Normally _° _is a direct function
of _uf_, for example _° _= _h_[_uf_, _u_[-1]] + dLog[_Money_]. It may
be that people’s expectations on nominal wages are not fulfulled, so
that _° _E[__] _. _A FE policy is only successful if _ = ° _and _u =
uf_.

· REH: the rational expectations equilibrium, when expectations are
fulfilled except for random error. Thus _* _= E[__], it so develops
that _ _= _* + _, and this optimality is only in terms of expectations.
In ERU[REH] unemployment may be far from _uf_ = ERU[FE]. The situation
can be stable if people only regard the price signals (and whatever
else is in the specification), and are satisfied as long as their
expectations are fulfilled.

A homogeneous Phillipscurve

A linear format

Let the change in wage inflation be sensitive to wages with degree _ _
and sensitive to quantities with a function _f_[_u_], with _u _the rate
of unemployment_._ The following gives a rich (wage) Phillipscurve that
contains not only the rate of unemployment but also past and (forward
looking) equilibrating wage inflation. [87]

_ - _[-1] = _ _ (_ - _[-1]) + _f_[_u_] (28.1)

_ _= _ _ __ + (1 - _ _) __[-1] + _f_[_u_]
(28.2)

Equilibria

Generally for the CWIRU from (28.1):

0 = _ _ (_ - _[-1]) + _f_[CWIRU]

CWIRU = _f_ -1[ - _ _(_ - _[-1]) ]

According to the Rational Expectations Hypothesis (REH):_ * _= E[__] =
__. Then from (28.2) - interpreting REH as ‘model consistency’:

_*_ = E[__] = _ _ _*_ + (1 - _ _) __[-1] + _f_[E[_u_]]

_*_ = __[-1] + _f_[E[_u_]] / (1 - _ _) (28.3)

We can also prove that _u_ = E[_u_] and then define E[_u_] = ERU[REH].
[88] Hence: [89]

_ _= _ _[-1] + _f_[E[_u_]] / (1 - _ _)

E[_u_] = _f_ -1[ (1 - _ _) (_ - _[-1]) ] = _u _

In this specification, the CWIRU can be ERU[REH], and ERU[REH] can be
CWIRU. Namely, when _* = _[-1], or when expectational equilibrium is
associated with constant wage inflation. Some ERU[REH] however can
exist with nonconstant inflation that is not CWIRU. Since equilibrium
wage inflation _* _is determined also by other factors such as money,
the ERU need not be constant. Even when _u _= ERU[REH] for each
separate year, then _ _might still have an erratic development over the
years. Similarly, the CWIRU can be an ERU[REH], but need not be. It can
even be that _ = _E[__] but expectations are not REH - since the error
is not white noise.

For full employment, policy is successful, if and only if _u = uf_ and
_ = *, _so that:

ERU[FE] = _uf_ = _f_ -1[ (1 - _ _) (_ - _[-1]) ] (28.4)

This equation has the same format as ERU[REH]. It follows that _uf_ can
be REH, and REH could be _uf_. However, they need not be, since, though
we have used the same symbol _f, _in practice there can be different
functions and also additional variables depending upon the FE or REH
assumption. [90]

Similarly, with this specification there might be constancy, and of
course there might be not. And as said, constancy might not be the real
issue, as small fluctuations in a stable range might be acceptable too.
[91]

Selection of _f_[_u_]

In the selection of _f_[_u_] we have to take account of the fact that
_u _can shift as a result of the minimum wage. Workers below the
minimum wage are not relevant for the labour market, and do not exert a
downward pressure on wage inflation. Above we saw that _u _= _un + um._
Let _fu_[_un_] give the fundamental _nonshifted _relationship for that
part of unemployment that still affects the development of wages.
Conforming to empirical regularity:

_fu_[_un_] = _ - _Log[_un + _]

Here _ _ is a parameter for horizontal adjustment, __ gives the slope,
and _ _is a constant shift in _u._ Note that _fu_[_un_] may be very
sensitive to low values of _un _and _, _since the logarithm from 0 till
1 is very steep, and _un _commonly is measured in percentages and thus
covers that range. Now, for _f_[_u_], an endogenous shift in _u_ then
can be included by:

_f_[_u_] = _f_[_un + um_] = _fu_[_un_] = _fu_[_u - um_] = _ - _Log[_u
- um + ___]

Note that _f_[_u_] here is also acceleration, since 1/(1-__) disappears
in __ and __. Figure 24 gives two regimes, plotted for both the
_f_[_u_] in the left part and the Phillipscurve in the right part.
Parameters are _ _=_ = 5,_ _ = _0, and _um _= 0 [case (a)]
respectively _um _= 6 [case (b)]. It is assumed that _* _ = __[-1] =
2 respectively 5, so that the minimum wage unemployment of 0 associates
with an equilibrium wage inflation path of 2, while the high minimum
wage unemployment of 6 associates with a high wage inflation path of 5.
Since _* _ = __[-1] the CWIRU’s can be found when _f_[_u_] = 0, and
these result in values of 2.7 and 8.7 (= 2.7 + 6).

Figure 24: Dynamics: unemployment and inflation

Given the assumption of _* _ = __[-1] it also follows that the
Phillipscurves are just horizontal translations of the _f_[_u_], and
one can see the values of 2, respectively 5, for the assumed wage
inflations at the CWIRU’s.

The cases (a) and (b) in Figure 24 reflect the developments in the OECD
in the 1950-2005 period. Case (a) gives the situation somewhat like the
1950s. The trade-off of inflation and unemployment then took place at
low rates along the long drawn line. The trade-off of wage (price)
acceleration and unemployment gives the CWIRU. At that point price
acceleration is zero, and inflation remains at a low and constant
value. Case (b) gives the situation of stagflation, where both the
CWIRU and the trade-off-process around it have worsened. The move from
(a) to (b) can be called ‘stagflationary’. In the 1960s and 1970s
authorities targetted for low unemployment at the cost of rising and
eventually high inflation. In the 1980s and 1990s the authorities
targetted against inflation and accepted high unemployment.

The short term Phillipscurve concerns the direct trade-off of
unemployment and (wage) inflation and is given by the long drawn
curves. This trade-off has only limited explanatory value. Nowadays
unemployment is concentrated at the low income section of the income
distribution, and it is not likely that this can be battled with high
wage inflation. This phenomenon is rather explained by the shift of the
CWIRU or the long run relationships between equilibrium unemployment
and wage acceleration, which are given in the left diagram.

It is useful to note:

· The CWIRU need not be constant. It could be if e.g. the relation
indeed is linear and if the coefficients are fixed. But neither need be
the case. The CWIRU in all likelihood is itself a variable that traces
out a path. (Which is another reason why the name ‘natural rate’ is
unfortunate.)

· There is a movement of the curve and a movement along the curve.

· The movement of the curve is not determined by the labour market
alone. Policy makers may neglect labour market measures, and may opt
for high inflation (1970s) or for high interest rates (1980/90s) to
fight minimum wage unemployment that is not affected by these.

On expectations

We may recall the 1995 Nobel Prize for Robert Lucas. The Swedish
Academy put the following text on the internet:

“The change in our understanding of the so-called Phillips curve is an
excellent example of Lucas’s contributions. The Phillips curve displays
a positive relation between inflation and employment. In the late
1960s, there was considerable empirical support for the Phillips curve;
it was regarded as one of the more stable relations in economics. It
was interpreted as an option for government authorities to increase
employment by pursuing an expansionary policy which raises inflation.
Milton Friedman and Edmund Phelps criticized this interpretation and
claimed that the expectations of the general public would adjust to
higher inflation and preclude a lasting increase in employment: Only
the short-run Phillips curve is sloping, whereas the long-run curve is
vertical. This criticism was not quite convincing, however, because
Friedman and Phelps assumed adaptive expectations. Such expectations do
in fact imply a permanent rise in employment if inflation is allowed to
increase over time. In a study published in 1972, Lucas used the
rational expectations hypothesis to provide the first theoretically
satisfactory explanation for why the Phillips curve could be sloping in
the short run but vertical in the long run. In other words, regardless
of how it is pursued, stabilization policy cannot systematically affect
long-run employment. Lucas formulated an ingenious theoretical model
which generates time series such that inflation and employment indeed
seem to be positively correlated. A statistician who studies these time
series might easily conclude that employment could be increased by
implementing an expansionary economic policy. Nevertheless, Lucas
demonstrated that any endeavor, based on such policy, to exploit the
Phillips curve and permanently increase employment would be futile and
only give rise to higher inflation. This is because agents in the model
adjust their expectations and hence price and wage formation to the
new, expected policy. Experience during the 1970s and 1980s has shown
that higher inflation does not appear to bring about a permanent
increase in employment. This insight into the long-run effects of
stabilization policy has become a commonly accepted view; it is now the
foundation for monetary policy in a number of countries in their
efforts to achieve and maintain a low and stable inflation rate.”

The Academy is a bit too assertive. The Phillipscurve need not be
vertical in the long run. It may well be that there is no fixed
solution, and that the long run gives a non-converging movement. Also
Phelps (1994) has reminded us that the CWIRU (in his words the NAIRU or
‘natural rate’) need not be constant.

Secondly, there can be other causes than expectations, and these might
be more important for understanding the present situation. One
important cause is the mechanism of the minimum wage. Hence the models
used by Lucas and his predecessors need not be the relevant models for
explaining the empirical shifts in the Phillipscurves and their
CWIRU’s.

Heterogeneous Phillipscurves

If labour is heterogeneous, then utility maximisation and rational
calculation are not only directed at demanding a competitive wage, but
they are also directed at selecting the kind of submarket (and its
associated wage). This complicates the situation. Can we say that a
dentist is ‘unemployed’ in the market for farmers ? Or closer linked,
that an assistant professor is ‘unemployed’ in the market for
professors ? However, we may note that an individual who sets his wages
too high will become unemployed in any submarket. This causes an
intuition that the selection of submarkets can still be represented by
wage schedules. There will be more equilibrating forces than wages
only, e.g. education or migration, but it can be reasonable to
concentrate on wages.

With heterogeneity, the unemployment that is relevant for a submarket
will have effects on the evolution of the wage in that submarket.
Aggregating, however, we get an effect of macro unemployment on the
average wage. Hence above simple relationship can be retained, but its
interpretation changes from homogeneity to aggregation of heterogeneous
submarkets.

More factors that cause a shift

Above we used _um _to show how the Phillipscurve can shift. Note that
this in fact has only been a didactic procedure. I wanted you to
understand the formulas, and it appeared very instructive to draw
graphs of shifting Phillipscurves. However, when there are _LS
_homogeneous labourers, we have some difficulty explaining why (1 -_
u_) _LS _ could work and _u LS _could not, even though they essentially
are the same. Hence minimum wage unemployment and the shift of the
Phillipscurve due to it, properly belong to the world of heterogeneous
labour.

We here can extend the list of factors that can cause a shift in the
aggregate Phillipscurve:

· The match of demand and supply above the minimum wage may cause
separate problems. We will discuss the issue of _crowding out on the
labour market _below.

· Vacancies will strengthen the position of employees and their unions.
Employers may nevertheless wait with filling vacancies in order to find
better opportunities later.

· There is ‘forward shifting’ of the tax burden _T_[_w_] / _w _from
employees to employers (and then into product prices).

· The Labour Cost Quotes _w _/ _y _ may not just affect the
equilibrating wage (or expectations) but may as well cause a shift.

· Poverty - see below.

We would basically model all submarkets - with minimum wage
unemployment of course only occurring at the bottom. However, let us
first look at the macro level only. Let _us_ be the summary shift
variable inclusive of all factors including _um. _Let _usr _be the
summary shift variable exclusive of _um. _Let _v_ the rate of
vacancies, _TAX/WT_ the tax burden. Let _History_ be the history of all
variables. Then redefine _f_[_u_]:

_us_ = _us_[_u, v, TAX/WT, WT/Y History_] = _um _+ _usr_[_u, v,
TAX/WT, WT/Y, History_]

_f_[_u_] = _fu_[_u - us_] = _ - _Log[_u - us + ___]

Crowding out

A crucial topic is crowding out on the labour market. Highly productive
labour can replace lowly productive labour more easily than conversely,
and this has effect on wage claims. This might be something like a
continuous version of the insider-outsider theory.

Unemployment among the higher skilled is not large. The analysis here
is that this is caused by crowding out on the labour market. When
potentially higher productive people face the choice between
unemployment and a comparatively lower paid job, they choose the latter
(noteably when they are tired of waiting or when the benefit runs out).
They thereby “take the places” of others - who repeat the process to
others below. The initial set-back in pay level tends to translate into
demand for pay rises. Who crowds out, has a stake in trying for pay
rises. A lot of crowding out will cause a mood for inflation. Who have
been crowded out towards unemployment, have some incentive not to
inflate, but have little countervaling power against the general mood
for inflation.

Figure 23 already presented the stylized fact for labour demand and
supply, i.e. that vacancies tend to occur at higher income and
unemployment at lower income. [92]

There is a meaningful aggregation of vacancies and unemployment by
subcategory of low and high productivity workers, giving _Vl, Vh, Ul_
and _Uh_. When vacancies are asymmetrically relevant only for the
higher incomes (_V ~ Vh, Vl ~_ 0), and when there are always vacancies
for higher incomes due to crowding out (_Vh >>_ 0), then _V_ is not
that important. However, _V_ may become important again when _Vl_ is
made nonzero by proper tax policies. If low productivity labour has a
stronger position in the labour market, then the risk of unemployment
is spread more evenly, and trend-setting high productivity labour will
be cautious about wage claims. High values of _Vl_ and _Uh,_ i.e.
vacancies for the low productivity group and unemployment for the
highly productive group, have the largest wage checking effect. High
_Vl_ and _Uh_ make it difficult for the trend setting higher productive
workers to shift the risk of unemployment to the lesser productive
workers. We will not formally develop this point.

Crowding out on the labour market typically refocusses the policy
co-ordination problem to the lower end of the market. This phenomenon
tends to reduce the problem and our vocabulary in these pages to social
subsistence, tax exemption and (legal) minimum wage.

Poverty

A crucial difference between the United States and Europe is that the
US accept more poverty (e.g. by low controls on its minimum wage laws),
while Europe chooses high minimum wages and benefits to raise standards
of living. The shift of the Phillipscurve thus is more obvious and
stronger in Europe than in the US. In the US the working poor still
work, so unemployment is lower, and the shift of the Phillipscurve is
less strong. Sometimes the argument stops here. It remains a topic of
consideration though whether more than just this can be said about
poverty.

Poverty affects productivity directly. A clear case is medical care.
With less medical care, there are longer periods of illness, and more
chances for complications of a less well attended illness. Employers
are less likely to hire less healthy persons.

Poverty affects personal appearance. A shabbily dressed and badly
groomed individual has less chance of employment than a person of
average appearance.

Poverty affects social attitudes. Social seggregation and cultural
differences reduce the chances of employment.

Poverty affects capacities. Rich people need not study much, need not
read many papers, and may only watch soap operas. They are rich, and
can enjoy themselves. But those of the rich who would like to study,
read, watch serious tv programs, and drive out to educational events,
have the means to do so. Those who are not that rich, and those who
have to study to maintain a higher living standard, may work and still
earn enough to enable them to study. Those of the poor section that
might want to do the same, do not have those means.

One aspect of US poverty is crime. Poverty does not actually force
people to crime, as some people demonstrate, but for many it in fact
appears to be very seductive. Jacobs (1996:573), referring to Freeman
(1996:25-42), explains that about 2% of US males is in prison, about
the same rate as long term unemployment in Germany. Taking account of
women, the overall US imprisonment rate is about 1.2%. The highest rate
of European imprisonment is for the UK, with 0.3%. So for the US we
might add 0.9% to the unemployment rate.

Also, additional 5% of US males is on conditional leave etcetera from
the prison system. More have a criminal record. Those points reduce the
chance for employment.

Some of these points, like imprisonment, work directly as a minimum
wage. Some other points rather affect the employment or earnings
distribution, and cause a structural rise of _Ul_.

The submarket Phillipscurves

Here, for simplicity, we take the wage level _w_ instead of wage
inflation. The rates of change can be found by comparing to _w_[-1].

Wage _w, _a continuous vector for each market, depends upon the power
position of employers and employees, which is determined, amongst
others, by the relative situation of unemployment versus vacancies.
Since unemployment and vacancies have been expressed above as functions
of _w _we solve _w _as a fixed point. We also add the equilibrating
_w*_ (or expectations E[_w_]) that are a function of product _y,_ the
tax burden for forward shifting, the labour cost quote, macro variables
and the history of the variables. The submarkets Phillipscurves can
include influences of other submarkets and general developments
pertaining to all markets. A macro-economic hypothesis is that the
development within markets is not merely influenced but even _dominated
by general events_. The relationships are clearly dynamic, and we thus
read all variables as time dependent.

_w_[_y, T, Macro_] = _w_[ _w*_[_y_], _ud_[_w_], _vd_[_w_], _T_[_w_]
/ _w_, _w / y, Macro, History_ ]

Note that modern large models depend upon convergence techniques, and
that the computation of fixed points can be included into convergence
in general (though it would be computationally burdensome).

Shifting back

The stylized facts can be summarized as: [93]

· In the 1950-1970 period, welfare states generally had a _high _tax
exemption level and full employment.

· In the 1970-2005 period welfare states generally had a _low_ tax
exemption level. To ensure a decent stardard of living, required gross
income then rose and exceeded productivity in the low end of the
market, generating unemployment, while shifting the Phillips curve and
reducing its sensitivity.

· Even when the statutory tax system has a low exemption level, then
subsidies for the lowly productive keep them in work. And subsidies can
be at the firm or state level. This is crucial for the Japanese and
Swedish experiences, see e.g. Aoki (1990) and Standing (1990). Note
that, in a _reduced form, _subsidies turn up as ‘system-wide
exemption’. A subsidy is no ‘real’ subsidy if it compensates for wrong
taxes.

Measures to block crowding out boil down to giving the low productivity
group some guarantee for work at decent income. Such guarantees can be
collective/semi-private arrangements of the Swedish/Japanese type. For
the more common mixed economies, the guarantee is market-conforming,
and notably consists of tax exemption.

29. Tax basics

Taxes are relevant for the discussion of stagflation at least for the
following reasons:

(1) Taxes divert income and thus affect aggregate demand, especially
when tax revenues go to benefits and consumption instead of saving and
investments.

(2) Taxes are thought to cause forward shifting, i.e. that taxes are
shifted into wage costs, which then may cause inflation.

(3) Taxes reduce net wages, and might affect the supply of labour.
Statutory marginal rates are thought to have disincentive effects.

(4) If exemption is lower than subsistence, then a higher minimum
wage is required. Differential indexation widens the gap.

In the following we will first discuss the relation of social insurance
premiums to the _economic_ concept of a tax. Then we regard the common
tax structure of OECD countries, where the structure concerns both a
statute and the dynamic adjustment policy. We introduce a nonlinear tax
function and rules on indexation that captures this structure. We then
show the effects of differential indexation, and present our new
analysis on marginal rates.

Tax dynamics can be split into two components: the dynamics of the
short run - where a local temporal equilibrium is attained using the
calculations on the marginals - and the dynamics of the long run -
where the locus of possible equilibrium points is shifted by long run
effects on the levels of the variables. Both components appear to be
equally important for our understanding of the subject. The
observations on the long run can be usefully discussed in conjunction
with the theoretical developments.

Taxes and premiums

In our discussion we will take premiums as part of taxes in so far as
it is economically relevant to do so. This may need some clarification.

Premiums for old age, sickness, disability, unemployment and the like
are often regarded as insurances, and studied separately. In the
practical situation of empirical economies these provisions are often
indeed administered by separate institutions called ‘insurance
companies’. And there indeed exists the possibility to apply the
mathematics and economics of insurance to these topics. However, that
these provisions are called ‘insurance’ should not cause us to regard
them as only such. Part of these so-called insurances are provisions
for the efficiency of the labour market.

To understand this, let us take the case of a low wage labourer.
Suppose that he would have to pay such an amount of premiums, for only
a limited package of insurance, that his net wage would make him
eligible for benefits, or his gross wage would make him unemployed so
that he also gets a benefit. Once he relies on benefits, the mentioned
insurances are provided for him for free.

This thus shows the structural identity of the problem of exemption in
‘insurance’ with the problem of exemption in taxation. Hence, on
economic grounds, insurances here are lumped together with taxes, in so
far as they are provisions for the well functioning of the labour
market.

Note too that governments would be wise to follow a ‘basic insurance
policy’ which holds that workers can be insured up to a basic level but
without payment of premiums. This reminds of the ‘basic income
argument’, but only applies to the mentioned premiums. Similarly poor
people exempt from taxation receive public goods, without paying for
them.

Common structure

Most developed nations have nonproportional taxes, i.e. tax codes with
an exemption at the threshold and then a (rising) statutory marginal
rate. The latter parameters in fact concern the intercept and the slope
of the tax function. There is also a remarkable similarity in the
policy regarding these two parameters (or sets of parameters), see OECD
(1986):

· The policy feature concerning the intercept or exemption.
Exemption generally is low, also with respect to social insurance.
Tax parameters, and notably exemption, are generally indexed on
inflation. Since incomes tend to grow faster than inflation, exemption
lags behind incomes. There is a deliberate tax creep - measured by the
‘macroeconomic progression factor’.

· The policy feature concerning the slope or the statutory marginal
rate.
Both in theory and public discussion there is a consideration that high
marginal rates have disincentive effects. This has resulted in the
policy objective to reduce marginal rates. One way to reduce marginal
rates has been the switch from income tax to VAT.

Given the common notion of budget neutrality, these two features in
policy tend to complement each other. Budget neutrality requires that
the revenue loss due to slope reduction is compensated for by other
proceeds. These other proceeds will often come from the tax creep and
the reduction of exemption. At least, it is often thought that the
reduction of exemption generates additional revenue. This, however,
turns out to be a wrong assumption.

Nonlinear tax function

Book III introduced the Bentham tax function _Bentham_[_y_] = _r _(_y -
x_) with exemption _x _and marginal rate _r. _This function is linear
but already results into nonproportional taxes. Governments in practice
have nonlinear tax schemes that give stronger nonproportionality,
reflecting political views on the redistribution of income.

Strong nonproportionality has a special effect. Since taxes in the
1960s were more nonproportional than nowadays, the tax structure
combined with the lognormal shape of the employment function, and
generated strong nonlinear effects and a strong upswing of the CWIRU in
the early phase of stagflation.

It is useful to introduce a flexible tax function with one more
parameter than Bentham’s function to incorporate some curvature. This
new function allows us to give concrete examples whenever nonlinearity
is useful. For clarity, it appears that this function can approximate
the actual Dutch tax situation. The tax function is:

(_y_
> _x)_
>
>
>
>
>
>
>
>
with _y_ the tax base and _x_ the exemption or threshold, _r_ the
marginal rate in the limit when _y_ goes to infinity, and _c_ a
curvature parameter. The ordered set of parameters is _q _= (_r, x,
c_). [94]_ _We do not use Greek symbols for these parameters since we
will regard them as key strategic variables. If governments would use
this function for practical tax collection, they might note (1) that
exemption would be determined by subsistence, (2) that _r _would follow
from the limit marginal rate for the highest incomes, (3) so that
curvature _c _would follow from required total revenue and the income
distribution. Use of this function thus both allows for a decent degree
of nonproportionality and would reduce much of political debate about
positioning of tax brackets and rates.

A person’s average tax is:

The marginal rate on the marginal dollar can be approximated as _T_[y +
$1] - _T_[_y_] so that the common tax payer will have no problem in
determining it. The proper formula itself is not too simple. At _y_ =
_x_ it starts with the value _r x / (c + x)_ and in the limit it equals
_r_. For the whole range:

(29.1)

Note that the tax function can be transformed into a linear format
consisting of income, average tax and a constant:

_Tax_[_y_] = _r.y_ - _r.x_ - _c.Tax_[_y_] / _y_ = a1._y_ + a2 +
a3._ATR_[_y_]

Colignatus (1992) used this relation for a simple linear least square
estimation that neglects the error on the average on the right hand
side, using 1988 Dutch data for 12 selected income levels. The result
was:

(in 1988 $)

The equation can be plotted for two ranges, (H1) for a low income range
till $25 thousand to show the curvature, and (H2) for a wider income
range till $250 thousand to show the straightness in the limit. In a
plot, the 45-degree line is usefully added to allow visualisation of
net income. Since the Dutch estimate has a high marginal rate in the
limit of 57.2 %, we add US-alike lines (U1) and (U2) with a _r = _40 %
limit. The two ranges are plotted in Figure 25.

Figure 25: Different tax regimes 1988 ($1000)
(H) Holland, (U) US-alike

Exemption

Heterogeneous income

The nonproportional tax clearly becomes important when incomes differ,
i.e. labour is heterogeneous in terms of productivity, labour costs and
income. Lower income earners are affected disproportionally by the
exemption level, not merely in terms of the income distribution but
also in terms of their competitive position versus higher earners.

In Book III, equation (13.1a) already shows how the minimum wage
consists of two elements. For above tax function:

Analytically solving for the minimum wage gives, due to the nonlinear
curvature, two solutions for _M_[_B, r, x, c_]:

Note that the denominators are positive, so that the first solution is
more adequate. If exemption is taken at _x _ = _B, _then these two
solutions degenerate into _M B _and _M _-_ c / _(1 - _r_).

Figure 9 and Figure 8 in Book III plot the tax situation and the effect
of _M _and _B _for curvature _c _= 0 (in the considered range), and for
Holland 2002.

Indexation of exemption

We already mentioned the OECD (1986) report that taxes generally are
indexed on inflation. This indexation though is not consistent over
time. The Economist (1991:45-46) reported:

“the most intriguing proposal now doing the rounds in Congress (...)
is to increase the personal tax exemption (the amount by which taxable
income is reduced for each person in a household). In 1948 the
exemption was set at $600 a person; in 1990 it was $2050. According to
recent evidence before the House of Representatives select committee
on children and the family, had the exemption been indexed from 1948
it would now be worth $7800.”

The Dutch data had already been given in Table 4. Indexation on
inflation need not be optimal. We already looked at indexation of
subsistence, and it might be wise to index taxes on the same base as
gross income, as suggested by property (13.3e) and the discussion on
subsistence in chapter 27.

A note on partners

Statutory taxes generally take account of the household situation.
Sometimes tax terminologies suggest an individual treatment. Regard for
example the Dutch tax code. This states that partners can ‘transfer
their exemption’ to the money earning partner. You may check that Table
4 on the Dutch situation indeed shows an exemption for partners, in the
1997 column, that is double the exemption for singles. The situation in
2002 is a bit more complex due to an EITC.

Note, though, that the Dutch minimum wage roughly is set at the income
level for partners. Singles have less net income since their exemption
is lower, but they are not allowed to work at a lower gross minimum
wage that might be feasible, with the same net income by assigning them
the same exemption as for couples. The Dutch concoction of ‘exemption
transfer’ in fact is extremely silly. It is even more surprising that
it has been introduced while all Dutch tax specialists kept a straight
face. [95] The concoction also complicates the Dutch policy debate,
since a proposal to raise exemption to subsistence now associates, in
Dutch minds, with exemption for couples of _double_ subsistence (which
is exorbitant).

The best tax format would start with exemption at subsistence for
singles.

Secondly, for partners with a single earner, a measure of ‘individual
taxation’ can be introduced in the following manner. The basic ideas
are:

· Home maintenance produces a product, this product is real income, and
income should be taxed. However, part of home maintenance also can be
part of subsistence.

· We may allow for a degree of spillover of income from one partner to
the other. This is the public good argument, i.e. that more people can
benefit while the cost is constant.

· Not all interaction is just spillover. Part of the interaction
concerns an economic transaction. While the single person has to work
for his home maintenance, he also buys it from himself. The single
earner out partner buys it from the home partner. Revenue from this
transaction should be taxable, i.e. on the side of the person that
receives the payment.

Let _yh _stand for the income of the home partner, and _yo _for the
income of the out partner. Let us use the Bentham tax, and apply it
individually. Assign virtual income _H_ to parttime home maintenance
activities - and we are ignorant about the required hours. Let parttime
virtual home maintenance income be part of exemption _x = B’ = B + H,
_with _B _money subsistence or the net minimum wage on the market. The
situation is neutral for a single person, who’s exemption is _x _= (_B
+ H_) while his income is _y + H. _The couple however is treated as
follows:

· The out partner earns on the market _y, _buys _Ho_ from the home
partner, and has spillover _yh_ of the income of the home partner.
Buying something does not add to income however. Income thus is _yo_ =
(_y + _ _yh_), and the tax thus is found to be _r _(_y + _ _yh - B -
H_)

· The home partner has own virtual income _Hh, _earns income _Ho_ from
the out partner, and has spillover _yo_ of the income of the out
partner. Income thus is _yh_ = (_Hh + Ho + _ _yo_) = (2_H + _ _yo_)
since _Ho _= _Hh = H _(we used the indices only for the origins). The
tax thus is _r _(2 _H + _ _yo - B - H_) = _r _(_H + _ _yo - B_)

· Combined income thus is _yo + yh _= (_y + _ _yh_)_ +_ (2_H + _ _yo_)
which consists of earned income, home production and spillover (_yh +
yo_)

The equations solve as:

In the special case that the tax authority thinks that spillover is
zero, then the out partner gets a tax rebate of _rH _in comparison with
the single person. The home partner would not have to pay taxes when _H
_ would be less than _B _(half a day home maintenance work would be
less than a day at a minimum wage). In this case the couple has more
net income than the single person, and the products of another persons
work, though on a pro-person base they would have less. Conversely, if
home maintenance is a highly priced good, then there could be a case to
levy taxes.

If spillover is a nonzero constant, then there is an income level _y
_where the taxable income of the home partner _H + _ _yo - B _will
become positive. A person will have to pay taxes ‘just because’ he or
she forms a couple with a high income earner. If spillover is nonzero
but variable, then the value of that makes taxable income of the home
partner exactly zero follows from _H + _ _yo - B = _0, and appears to
be a function of income _y_:

If _B = 2H _(i.e. home maintenance gets the minimum wage), then for _y
= B, _ = 1/3. This means that the partner remains exempt from taxes as
long as spillover is limited to a third of income. Interestingly, at
that point also the taxable income of the out partner is _yo = (B - H)
/_ = 3 _H _so that he does not pay taxes either (since _x = B + H =
3H _here).

Above relationships show that individual taxation is possible that
takes into account household spillover effects. For us the issue is
primarily interesting for complications about subsistence. We find that
there are no great complications, and we thus will further neglect the
issue of partners.

Differential indexation

With subsistence indexed on income and taxes indexed on inflation,
there is differential indexation, and due to the tax structure there is
a multiplier increase in the minimum wage. Required gross minimum _M
_shows a relative rise compared to other incomes, and it rises faster
than both net minimum _B_ and the general level of income _Y/LE_. In
Figure 10 (in Book III), when we subtract the inflation component from
_x, B_ and _M_, then differential indexation shows up as: _x _stays
fixed, _B _moves with the income density, _M_ moves to the right, and
_M, _as the intersection of the subsistence and tax lines, moves up
more speedily. If productivity in the lower earnings scales doesn’t
rise faster than general productivity or income, then ever more people
grow unemployed.

For all clarity we shall prove this. This chapter uses the specific tax
function (chapter 39 will give a proof independent of form). First we
will show that _M_ grows faster than _B_, and then we will show that
_M_ grows faster than productivity too, causing unemployment.

Let us first derive the real subsistence index _rsi _again, but now for
the nonlinear tax. Recall the definitions of Book III. Let _B = rsi P
B_[0]_ _with _B_[0]_ _subsistence in the base year. Let exemption _x
_be adjusted for inflation with index _P,_ then _x = P x_[0],_ _with
_x_[0]_ _the exemption in the base year that now may differ from
subsistence in the base year _B_[0]_. _Let also _c _be indexed on
inflation as _c _= _P c_[0]. Let the average wage index be _W = P rwi
W_[_0_], with _W_[_0_]_ _the average wage in the base year. Let _h =
x_[0]_ / W_[_0_]_ _and _f = c_[0]_ / W_[_0_]_._

_ rsi = Net_[_W_]_
/ Net_[_W_[_0_]]_ / P =_
/
/
/
/
/
/
/
which for _f _= 0 reduces to the Bentham-_rsi_ deduced in Book III._
_For the limit, in general, we find:

which is normally below 1. Denote the denominator as _F, _and note that
_W_[_0_]_ F_ = _Net_[_W_[_0_]] or _F = 1 - ATR_[_W_[0]].

We use these properties for the following theorem.

Theorem T.1: With _Tax_[_y, q_], minimum wage setting _M = B +
Tax_[_M_]_, _and balanced growth, then: if _B _is indexed on the net
average wage and _x _and _c _on inflation only, then _M _rises faster
than other wages, and unemployment rises.

Note: That _M_ rises faster than other wages is not inconsistent with
balanced growth. For _M _is only the selection of one of the proper
wages that is taken to be the minimum wage.

Proof:

For all clarity, parameter _r_ will not be indexed. Let the price level
index again be _P_. Again _W = P rwi W_[0]. With real wage index _rwi_,
the nominal index is _wi = P rwi_. For heterogeneous wages with wage
density, we have _w _ = _ wi w_[0] along the balanced growth path.

For a dynamic path we have starting position _B_[0] giving _M_[0]. In
the base year the minimum level is taxed at an average rate less than
_r_, implying that _B_[0] > (1 - _r_) _M_[0].

We also use _J _as the index for the real minimum wage:

_M_ = _P J_ _M_[0] i.e. _J_ = _M_ / (_P_ _M_[0])

(1) We first prove that _J > rsi_ in the limit. There are two relations
for _B, _with _rsi _given by the relation above:

_B = P rsi_[_rwi_]_ B_[0]

_ B = M - Tax_[_M_, (_r, P x_[0]_, P c_[0])]

= _M_ {1 - _r_ (_M_ - _P x_[0]) / (_M _+ _P c_[0])}

These equations define _J _as an implicit function of _rsi._ We also
see that _P_ falls away in the right hand side:

_B = P rsi_ _B_[0] = _M_ {1 - _r_ (_M_ - _P x_[0]) / (_M
_+ _P c_[0]) }

_ rsi B_[0] = _J_ _M_[0] {1 - _r _ (_M_[0] - _x_[0]_ / J_) / ( _M_[0]
+ _c_[0]_
/ J_) }
/
/
As _rsi_ and _J_ go to infinity, then _rsi B_[0] ~ _J_ _M_[0] (1 -
_r_). We had _B_[0] > (1 - _r_) _M_[0]. Thus _J > rsi._

(2) We secondly prove that _J > rwi_ in the limit. With limit ratio
_R_:

using the fact that the denominator equals _F _defined above. We want
to prove that _R > _1. Note, then, that _M_[0] < _W_[_0_], and that,
due to the progressive character of the tax, the ratio of net income to
total income must be higher at subsistence than at the average level,
so that:

_R = B_[0]_ / M_[0]_ / _(_Net_[_W_[_0_]]_ / W_[_0_])_
> _1
>
>
>
(3) Thirdly, we look at productivity and employment. For this theorem,
the worst case to start from is full employment. When we start with
full employment at _M_[0], then _M_[0] provides the equilibrium of
supply and demand. Let the supply price (or gross income or
productivity) at the minimum be _ms_[0] and let the demand price
(labour costs) at the minimum be _md_[0]. [96] Then in the assumed
start situation of full employment _M_[0] = _ms_[0] = _md_[0]. Assuming
balanced growth for demand and supply gives the development of the
labour market situation at the bottom:

_w = P rwi w_[0] in general, i.e. for all _w _

_md = P rwi md_[0] & _ms = P rwi ms_[0]

This means that the supplied (inherent) productivity of those at the
(original) minimum grows as fast as the labour costs which employers
could afford. However, the true supply price is not productivity but
the (actual) minimum wage _M_ that grows with _P J _and thus faster
than the_ md_. People in the class [_ms, M_) will not find jobs paying
the social minimum. They become unemployed.

Q.E.D.

Above theorem and proof may be regarded as a bit simple. However, they
help to highlight some useful aspects:

· Differential indexation can have surprising consequences compared to
conventional ideas.

· Instead of thinking that productivity growth reduces employment for
the lowly productive, we grow aware that it is likelier that technology
creates so many job possibilities that employers can finance even
higher costs than subsistence. But the multiplier effect from wrongly
indexing taxes can be even faster.

· There is the combination of nonlinear tax and lognormal productivity,
which causes an upswing of the CWIRU in the early phase of stagflation.

· This holds for a wide class of tax functions, even some very
nonlinear ones.

· Where the term ‘income tax’ is used, it also applies to VAT and
insurance for old age, disability and the like, as long as part of
these are considered to be part of subsistence and thus should be
included in exemption.

· This theorem and proof are for a structural form, and inspire the
theorem and proof for the reduced form that we discuss later.

Raising exemption

Our analysis points to the suggestion of ‘waiving taxes for the lowly
productive’, which can be translated as ‘raising exemption’.
Interestingly, this latter translation appears to provoke some
terminological confusions.

The notion of ‘raising exemption’ is often taken to imply that all
other brackets_ shift along_ with exemption. This causes a huge loss of
tax revenue. E.g. Gelauff (1992), who uses the official general
equilibrium model of the Central Planning Bureau to compute the
economic impact of raising exemption, adopts this expensive approach.
(His scenario also includes the Dutch concoction of the ‘transfer of
exemption’ by partners, so that his implementation is even more
expensive.)

However, there are some alternative implementations. Their common
feature is that taxes above the current minimum wage are essentially
unchanged.

The issue can be clarified by the following two graphs. In Figure 26,
the function with an exemption (bold line) can be compared to a
function without an exemption (thin line) but with a tax credit (bold
line again). The tax credit is given as _c_ = _r_1 _x_ where _r_1 is
the rate of the first bracket (taking that as defined by the tax
credit). The two systems are mathematically identical, when seen as a
vertical translation while keeping the bracket positions fixed.

Figure 26. Piecewise linear tax function with more brackets

A dubious and horizontal transformation is given in Figure 27, where
the assumption of ‘fixed bracket lengths’ has been assumed rather than
‘fixed bracket positions’. When we now substract a fixed sum from the
line through the origin, the original function cannot be retrieved, and
the higher incomes pay more tax. It now seems as if the tax credit is
‘fairer’. However, the true cause is that taxes have been raised by
shifting the bracket positions.

Figure 27. Horizontal translation

The Dutch Government “Tax Plan for the 21st Century” used this
misleading horizontal translation to argue that tax credits would be
more just than plain old exemption. See Colignatus & Hulst (2003:32)
for the misleading statements.

Useful approaches are:

1. Introduce a new separate ‘tax group’ that only holds for workers
below the current minimum wage. Let this group have a high exemption at
the new minimum wage and a normal marginal rate of 50%. Clearly, there
could be jump in taxes at the current minimum wage. However, the high
exemption can be said to apply to all citizens - and many simply don’t
qualify since they do not fall in the new group. (The latter is only
unfortunate for them, if they prefer a high exemption above their
current high income.)

2. One might opt for a 100% marginal rate from subsistence (the new
minimum wage) _up to_ the current minimum wage. In this case there is
no tax jump. High exemption again applies to all citizens, but its
effect is undone by an intermediate high marginal rate region. Whether
this is considered to be a bad situation, depends upon the analysis of
marginal tax rates: see below.

3. Introduce a nonlinear trajectory from subsistence to some place in
the current regime. Since reduction of wage costs generates employment,
the state saves on benefit payments, and some revenue can be used to
reduce taxes also _above_ the current minimum wage. This reduction can
be done in a nonlinear way that allows for a fluent change, without
jumps and without new tax groups. Figure 28 gives an example of such
nonlinear trajectory, where the function _Tax_[.] has been estimated to
fit the 1997 Dutch tax code (inclusive of premiums) but with a
nonlinear repair towards subsistence. The special point is that this
estimated _Tax_[.] has a negative curvature parameter. The 1988 income
distribution has been used to approximate tax revenues. The currency
here still is Dutch guilders.

Figure 28: Nonlinear repair Holland 1997 (Dutch guilders)

4. Figure 29 uses euro’s and the new Dutch tax code and minimum wage of
2002. Using a 75% first bracket allows the minimum wage to shift from
M1 to M2. The shaded area gives the tax revenue lost, which would be
compensated by saved benefits.

Figure 29: Linear repair Holland 2002

We will discuss the optimal regime later, and return to the issue of
raising exemption. This paragraph here was useful to clarify some
terminological confusions. It also indicates that marginal rates will
feature strongly in the discussion about the repair. A marginal rate of
100% or the marginal rates associated with negative curvature seem
prohibitive for practical implementation. At least, in the conventional
wisdom.

A note on the negative income tax

A common topic in the subject of taxation is the concept of a negative
income tax (NIT). A person below a certain threshold receives money
instead of paying it. The negative income tax can be presented as a
‘basic benefit’: all members of society receive allowance _A _from the
state, and pay taxes only on their additional income. The negative
income tax or basic benefit is often presented as a solution to the
current unemployment problem. The Central Planning Bureau (1992a&b) in
fact shows that this can work.

It is useful to clarify the following. We can distinguish three groups
with different effects:

· for the currently employed the NIT has no effect, since they already
are employed and in fact already earn their own basic benefit

· for the people in the Tax Void, the NIT effectively only means the
increase of exemption, and thus one might as well increase exemption

· for workers with sub-subsistence productivity, the NIT indeed
provides additional revenue.

The second effect cannot properly be regarded as a positive effect of a
NIT. Only the last effect is the NIT proper. However, proponents of the
NIT often include the second group when they claim good results. In the
current situation of mass unemployment, the employment effect will also
be largest for the second group, so the effects of the NIT are grossly
overstated. You may be familiar with the joke of the mouse and the
elephant walking on a bridge, and the mouse proclaiming: “We make quite
a lot of noise together, don’t we ?”

It must be noted that proposals on the NIT generally state huge sums of
money. The NIT is very ‘expensive’ since all spouses would apply,
causing the need for more changes in the tax code. [97]

The NIT complexities, and huge sums, also obscure the fact that
abolishing the Tax Void would be for free. Proponents of the NIT thus
can be compared to people at Amsterdam Schiphol airport wanting to go
to Washington, and waiting at the ticket booth till they have enough
money to buy the expensive ticket, while they overlook that, due to
circumstances, the plane to New York flies for free.

The concept of a NIT, intended to do good, generally seems to cause
people to do a lot of harm. The Central Planning Bureau (1992a&b) study
assumed the gradual introduction of a NIT in the course of 25 years,
keeping subsistence fixed at a constant inflation adjusted value of
1990, and the NIT fully introduced at that value in 2015. This scenario
thus has the drawbacks of (a) achieving full employment only in 2015,
(b) not indexing subsistence to general welfare.

It may well be that the Ministry of Finance is less equipped to deal
with employment policy including the measurement of potential
productivity. It would be better to quickly abolish the Tax Void, index
subsistence properly, and restore the normal processes of social
security and workfare to assist the sub-subsistence group.

The following equations clarify the relation between the NIT, exemption
and subsistence. With market income _y, _the Bentham tax function
_Bentham_[_y_], allowance _A _from the state, then net income and
implied tax are:

_net_[_y_] = _y - Bentham_[_y_] + _A _= _y - r (y - x) + A_

_implied tax_[_y_]_ = y - net_[_y_]_ = r (y - x) - A = r (y - (x +
A/r)) = r (y - x)_

So by taking _x _= (_x + A/r_)_ _the allowance in fact means
adjustment of exemption, with the subtle difference that _x _now just
stands for the intersection with the horizontal axis, and not with
exemption proper. Normally _A _would be chosen such that net income at
subsistence _y =_ _B _equals _B, _so that we might as well raise
exemption to subsistence:

_B = B - r(B - x) + A A = r (B - x) x = B_

The marginal rate

The problem

The economic literature shows a conceptual problem, or paradox, on
marginal rates. Statutory marginal rates are important in popular
understanding, but not in the empirical data. Research, as witnessed by
the existing literature such as Gelauff (1992), deals better with the
data, but doesn’t convince the popular view. The following analysis
suggests a solution.

Partial versus total derivative

Conventional theory, public discussion and empirical research generally
use statutory rates as the “marginals”. With _T_[_y_] the tax
associated with income _y_, the marginal rate commonly is computed as _
T_[_y_]_/ y._ For our function this is the partial derivative as used
in equation (29.1). However, the tax function is better understood not
as _T_[_y_] but as the multivariate _T_[_y, q_] with _q _the (now
arbitrary) tax parameters. Agents will tend to take account of
parameter changes. So optimisation remains our paradigm - and it
results into marginal rates - but the better marginal rate is the total
derivative, [98] or dynamic marginal rate (DMR):

_ dT_[_y, q_]_ T_[_y, q_]_ T_[_y, q_]_
_ _ ----------- = ------------ + ------------ dq /
dy

dy y q_

The topic of discussion is _dq / dy. _To proceed from this point, it
appears didactically useful to first restate the conventional reaction
to the DMR, and then develop the new analysis.

A conventional reaction

The conventional reaction is that tax parameters may be indexed to
national income, but are not indexed to personal income. The individual
agent in the economy will not think that his change in income can
affect national tax parameters. Hence _dq / dy_ should be zero.

Let us use the Bentham tax function again. Let us assume that only
exemption is indexed on national income, and in continuous form the
indexation reads as _x = Y _ with _ _as a fixed value for a base year.
Thus:

_T_[_y_] = _Bentham_[_y_, _ Y_] = _r (y - Y) _

It appears that _ _is very small. For example, with _LE _ the number
of tax payers, and _Y / LE_ average income, we may take exemption as a
third of average income, so that _ = x / Y = _1 / (3 _LE_). But the
small size does not invalidate the indexation method, since:

_dLog_[_x_]_ = dLog_[_ Y _] = _dLog_[_Y_]

_ _

Note that _Y _is the sum of all incomes. An income change for an
individual does not affect the income changes of others. Assuming that
other incomes stay fixed, we find for an individual income _dY / dy _=
1. If _y _rises and no other income rises, then the growth of national
income _dLog_[_Y_] is equal to the growth for the single person
weighted by its share in total income:

_dLog_[_Y_] = (_y / Y_) _dLog_[_y_]

It follows that the marginal tax for the individual is:

_d T_[_y_] / _dy_ = _r _(1_ - _ )

Now, since _ _is such a small number, the marginal rate is virtually
equal to _r._

In general we find:

_dq / dy = (dq / dY) . ( dY / dy) = dq / dY_

Since _dY / dy _= 1. If parameters are indexed on national income, then
_ dLog_[_q_]_ = dLog_[_Y_] and then _dq / dY _= _q / Y _ so that

_dq
/ dy _= _q / Y_
/
/
/
which is close to zero since parameters _q _are generally much smaller
than national income. We conclude that _dq / dy = dq / dY_ is not quite
zero, but practically zero, and this seems to corroborate the
conventional reaction to the DMR.

Hence the conventional reaction to the DMR is that the DMR does not
change the traditional analysis on marginal rates. Hence there is no
hope for unemploment along these lines. With ongoing technological
growth and competition of low wage countries, only the flexibility of
labour markets will help to reduce unemployment, even if this means a
reduction of net minimum wages. That, at least, is the conventional
reaction.

The expectations revolution

However, Keynes (1936) explained that proper dynamic analysis
inherently means that we have to consider expectations.

In this case the agent will be aware that parameters are indexed in
some manner. Due to indexation, the term _dq / dy _can take significant
values. Let _q _be indexed on national income growth _Y. _For many tax
functions the indexation of parameters may take the form_ dLog_[_q_]_ =
dLog_[_Y_] - as can be done for exemption and curvature of _Tax_[_y_]_.
_If _ dLog_[_q_]_ = dLog_[_Y_] then

This again may reduce to the_ q / Y_ above. However, if we take
expectations of the growth of national income, which means that the
agent assumes that the other incomes do not remain constant, then:

Thus, next to knowledge about indexation, the agent will have
expectations about the national income growth _dLog_[_Y_], and compare
his own growth of income _dLog_[_y_] to this expectation. In terms of
expectations, _dq /dy _does not vanish to zero. This is especially
relevant when the parameter _q_ gives exemption _x_ that is a sizeable
part of income.

So there is hope for the unemployed.

Discrete form

Above can also be formulated in discrete form. Indexation generally
takes place with a lag, and then the discrete DMR is more adequate.
This is:

_ DMR_[_y_]_ = _(_T_[_y, q_]_ - T_[_y-1 , q-1 _]) _/_ (_y - y-1 _ )_
= T / y_

Book III gives a development for the Bentham tax function, and also
gives plots for regular numerical values. It appears that indexation
and expectations about the growth of national income (relevant for
indexation) again lead to other results than the conventional view on
marginal rates.

Policy simulations

There is one area where the DMR cannot easily be overlooked. This is
the area of policy simulation, where tax adjustment cannot be
neglected. For sure, empirical analyses and government projections
indeed _deal_ with tax parameter changes. For example the well-known
Reagan tax cuts were put into the forecasts at that time. However, we
should wonder now whether the methods have been right. The analysis
above focusses our attention on the impact on individual behaviour,
where we regard the marginal calculation by agents themselves.

Let us regard policy simulations using common practical economic
models. Let us for example regard the effects of a rise of government
investments as financed by taxes, for a sustained period of 8 years
(two presidential terms). To do a simulation properly, the tax function
used must reflect government policy, which includes indexation. For
example, exemption and other brackets are adjusted for last year
inflation while the statutory marginal rates remain the same. The
different investment paths result in different paths for the taxes.
This is not just a model result, but also the agents in the economy
would encouter different regimes. Thus the model generates different
_dynamic_ marginal rates, while the agents are assumed to react only to
the same (_static_) rates. The situation gets even complexer when the
alternative policy includes a different indexation scheme, such as
indexation of taxes on national income. All this means, then, that we
are justified in doubting the validity of current modeling practices.
Modelers should start wondering about this kind of dynamic consistency
(not to be confused with the ‘dynamic consistency of policy’ as another
topic in economic literature on ‘credibility’).

It might even be, then, that the best way to understand the dynamic
marginal rate is to see it as a solution to this kind of dynamic
inconsistency.

Balanced growth

Under balanced growth, taxes will grow as fast as incomes, with a
constant tax share _TAX _/ _Y_, assuming proper indexation of the tax
parameters. A result will be that the dynamic marginal equals the
average tax rate, for all individuals. Book III already mentioned the
key relationship here, in property (13.3e).

We use _Tax_[.] for an illustration. Here a solution for a balanced
growth path is that parameters _x_ and _c_ are indexed on _y_. With the
index for _y_ as _i = P ryi_ ( _i_ > 0), we find for the (individual)
average tax burden that the index drops from both numerator and
denominator:

_T_[ _i y; r, i x, i c_] / (_i y_) = _ r_ (_i y - i x_) / (_i c + i
y_) = _T_[_y; r, x, c_] /_ y_

(Less relevant, (29.1) remains the same too.)

The situation of a constant dynamic marginal rate is depicted in Figure
30.

Figure 30: A balanced growth shift
A-2A: constant frequency, A-C: the same average tax

Let us take the example of a doubling of income. Point A is an
arbitrary point on the employment density. We scale the density so that
A also lies on the tax function (H). For that arbitrary income at A we
determine the average tax as a ray through A and the origin. Now, if
all incomes double, then the employment frequency density shifts, and A
becomes 2A. If tax parameters _x_ and _c _double too, then the tax
function becomes (2H). At 2A the individual pays tax C, which is the
same average tax as in A (vide the straight line through origin, A and
C).

Off balanced growth

Income growth means a shift of the employment density or the earnings
distribution. Earlier we looked at income distributions for Holland
1950 and 1988, and the reader may now better understand why. The Dutch
distributions could be approximated by lognormal distributions, but the
mean, variance and the size of the labour force changed. Taxes also
have been indexed on inflation instead of income. So we may surmise
that there was no balanced growth.

How do agents react when there is no balanced growth ? Indexation to
national income can be said to be “neutral to the income change”. The
tax choices facing an individual, whose income grows as national
income, are constant. The utility reaction thus depends on the change
of income itself. It may be that an individual, whose income might grow
as fast as national income, decides to grow differently, either more or
less, depending upon his leisure-income utility. Since the context is
that all individuals are adjusting, this may be reformulated as that
individuals are determining their place within the income distribution.

Our analysis thus suggests that tax incentives primarily affect
decisions about one’s place in the income density. Any individual
change that differs from the national average can be interpreted, or
defined, as the individual decision to accept another place in the
income distribution. It would be interesting to reinterprete economic
models on growth in these terms, and see whether elegant regularities
can be found or constructed. However, it leads too far to really look
into this matter, since it is not our proper subject.

We conclude that indexation and expectations about the growth of
national income (relevant for indexation) lead to other results than
the conventional view on marginal rates.

30. Dynamic curvature of the tax wedge

Introduction

The tax wedge at the minimum is caused by differential indexation, and
makes for a higher gross minimum wage. This has been clarified above. A
second point is curvature. Due to curvature, the wedge comes close to
its limit value for already low levels of productivity growth. Thus,
the negative effects of the wedge occur primarily at the onset of
economic growth, and are less noticeable when stagnation has already
set in. This already has been indicated above, but the argument can be
developed by giving formulas and plots. Especially, it are the plots
that may help us to understand that the major distortionary effects
took place in the 1960s and 1970s. People looking only at the events in
the 1990s are less likely to see the root of the problem.

In the following we first derive the formulas and then give plots for
the average tax rate (ATR) and the gross-to-net ratio (GNR). The latter
ratio may better express the effect on the gross minimum wage. We find
that the ATR and the GNR at the minimum rise faster than for other
incomes, since the minimum itself moves faster than those other
incomes. For ease of exposition we use the Bentham tax.

Formulas

The average tax rate (ATR) and the gross to net ratio (GNR) are:

_ATR_[_y_]_ = Bentham_[_y_]_ / y = r _(1_ - x / y_)

_GNR_[_y_]_ = y / _(_y - Bentham_[_y_])_ = y / _(_ _(1_ - r_)_ y + r
x_)_ = _1_/ _(1_ - r + r x/y_)

Examples work best. Let subsistence_ B_ be exempt from taxation so that
_x = B,_ and let the marginal tax rate be 50%. The average tax rate
(ATR) of a subsistence worker then is 0, and the gross to net ratio
(GNR) is 1. At twice subsistence, the tax is 50% (2 _B _ - _B_ ) = _B /
2, _ and thus the average tax is 25% and the gross to net ratio of 4/3.
In the limit, i.e. when exemption has been reduced to a negliglible
proportion, then the average tax equals the marginal rate of 50% while
the gross-to-net ratio is 2.

Next, notice two points. First, the formulas by themselves do not quite
show how quickly the limit values are approached. To answer this
question we can best look at some graphs. Secondly, these examples are
static, i.e. at one point in time for different incomes. Thus, when we
make graphs, then we can use a static index, and compare an income
level 1 to an income ten times as large. In dynamics, i.e. when incomes
rise, things are a bit complicated.

In dynamics, and concerning the current practice of adjusting exemption
for inflation, we can take exemption as constant, and look at real
incomes (adjusted for inflation). It seems as if we can take the
formulas and graphs of the statics case, and compare real incomes
regardless of the time. However, in dynamics, ‘minimum income’ is not
just ‘income’ but is a mechanism. The concept of _M _is that it picks
out one income as the minimum, but it can pick that income at a
different rate of growth depending upon the mechanism. The interaction
between indexation, net subsistence, the tax parameters cause a
multiplier effect. Before we make plots we have to develop on this.

Let us first regard a general formula for dynamics, and see that it
seems as if there were no difference with the formula for the statics
case. Let exemption _x _be adjusted for inflation with index _P,_ then
_x = P x_[0]_._ Here we assume that _x_[0]_ _can differ from
subsistence in the base year _B_[0]_. _Let _y _be adjusted for the real
level of income, with index_ rwi,_ too; then _y = P rwi y_[0]_._ Define
_f = x_[0]_ / y_[0]_._ Then:

_ATR_[_y_]_ = r _(1_ - x / y_)_ = r _(1_ - x_[0]_ / _(_y_[0]_
rwi_))_ = r _(1_ - f / rwi_)_ = ATRwi_[_f, rwi_]

It must be noted that _y_[0]_ _depends upon _y, _so that _f _ may take
continuous values. _ATRwi_[_f, rwi_] expresses that if we have a value
of _y, _then we could interprete this as deriving from various
combinations of _f_ and _rwi _as long as _rwi x_[0] / _f_ = _y. _The
dynamic _ATRwi_[_f, rwi_] thus seems no different from the static
_ATR_[_y_]. The complication however comes from subsistence. We cannot
regard _M _as a normal case of _y = P rwi y_[0]_._

Denote the average tax at the minimum wage as, _ATR M _[_rwi_]. We will
use the suffix _‘M’_ in general to signify this dynamic point of view.
[99]

In Book III we derived the real subsistence index _rsi_ for the Bentham
function when _x = P x_[0], so that _B = rsi P B_[0]_._

(13.3d)

Then:

_M = B + Bentham_[_M_]_ __ M = _(_B - r x_)_ / _(1_ - r_)

_M = _(_P rsi B_[0]_ - r P x_[0])_ / _(1_ - r_)

_m = M / P _= (_rsi B_[0]_ - r x_[0])_ / _(1_ - r_) = _m_[_rsi_]

_ATR M _[_rwi_]_= ATR_[_m_[_rsi_[_rwi_]]]

We can develop this a bit further, using _j = x_[0]_
/ B_[0]_:_
/
/
_GNR M _[_rwi_]_= M / B = _(1_ - r x_[0]_ / B_[0] _/ rsi_)_ / _(1_
- r_)_ = _(1_ - r j / rsi_)_ / _(1_ - r_)

_ATR M _[_rwi_]_= Bentham_[_M_]_ / M = _1_ - _1_ / GNR M_ [_M_]_ = r
_(1_ - j / rsi_)_ / _(1_ - r j / rsi _)

Over time, _rsi _will rise to infinity, and limit values will be
_GNR_[]_ = _1_ / _(1_ - r_)_ _and _ATR_[]_ = r _ as for all incomes._
_

_ _

Graphs

First we plot the static ATR and GNR for values of a real net wage
index from 1 till 10. Figure 31 plots the paths for various marginal
tax rates: 10%, 20%, ..., and even 70%, all assuming _x = B = _1_._
These plots show the point made earlier, that the ATR is close to the
marginal rate at already low income values, e.g. 2 or 3 times
subsistence.

Figure 31: Average tax, in statics,
for various marginal tax rates

We might interprete static Figure 31 in a dynamic way. Take _B_[0]_ =
x_[0]_ = _1_, j = _1_. _We may take a theoretical example. If you have
a period of 35 years, then a real growth of 2% per annum would suffice
to double incomes. So in the standard unrefined analysis, the tax creep
in 35 years would cause incomes to be taxed at average rates close to
the marginal rate. [100]

The more refined analysis for the minimum wage takes account of the
multiplier effect. First of all, if real subsistence doubles from
_B_[0] = 1 to _B_[35] =_ 2 B_[0]_,_ the gross minimum wage would be _M
= _(2 - ½) / ½ = 3, and hence we should look in Figure 31 at index 3
instead of index 2. This issue however is a bit more complex, since
when _rwi _= 2, _rsi _is not 2 but 1.7.

In Figure 32 we compare the standard _ATR_ and the dynamic _ATRM_. We
regard only one marginal rate (a 50% rate) and a ‘peg average’
_W_[_0_]_ =_ 2_ B_[0] or _h = _0.5. It appears that the dynamic _ATRM_
is steeper and higher than the static ATR. However, the difference is
not that big. Note though that we would want an average tax rate of 0
for the minimum wage (subsistence) instead of something close to 30%.

Figure 32: Average tax rate,
static and dynamic, for _r_ = 50%

In Figure 33 we regard the dynamic _GNRM_ ’s, now plotted for various
values of _r._ We can see that the rise is largest in the lower reaches
of the graph. For example the 50% rate already reaches the level 1.6
around the index value of 4, and 1.6 does not differ much from the
limit value of 2.

Figure 33: Gross-to-net ratio, in dynamics,
for various marginal tax rates

31. Differential impact of the minimum wage on exposed and sheltered
sectors

Some sectors of the economy are exposed to foreign competition and some
are sheltered from it. These exposed and sheltered sectors are likely
to have a different composition of their labour force, notably
different rates of dependency on the minimum wage. If a national
incomes policy does not respect these differences, a country can have
both unemployment and a surplus on the trade account.

Introduction

The two Oil Crises in the 1970s created a problem for the Dutch economy
which has become known in the literature as the so-called “Dutch
Disease”. When the price of a nationally produced but internationally
traded resource rises - and this happened since Holland is rich in
natural gas and a free rider of OPEC - then this causes the exchange
rate to rise, and then this indirectly causes a reduction of the other
exports and an increase in competing imports. Thus the original
increase in national wealth paradoxically combines with an increase in
unemployment - and eventually a lower growth path.

This chapter concerns the Dutch policy reaction to that Dutch Disease.
If policy is not targetted at stabilisation of the exchange rate by
monetary means and capital flows, but at tinkering with the labour
market, then the situation - the disease - can grow worse.

Our analysis will use the distinction between the ‘exposed’ and the
‘sheltered’ sectors of the economy - a distinction that originates from
Swedish analysis in the 1950s (Meidner c.s.).

The Dutch policy reaction - though with some lag - was a general
restraint of wage growth. This reaction was motivated by reference to
the so-called Vintaf model developed by Den Hartog and Tjan at the
Central Planning Bureau - see Driehuis & Van der Zwan eds. (1978) and
Driehuis, Fase & Den Hartog eds. (1988). [101] The direct assumption
was that high wage costs cause the scrap of old vintages of the capital
stock, resulting in an irreversible loss of capacity. The indirect
presumption was that a relative reduction of production costs could
compensate for the rise in the exchange rate, restoring competitiveness
and employment. [102]

However, in a quite brilliant exposition that up to now has been
neglected to the shame of the Dutch economics profession, Marein van
Schaaijk (1983) of the same Bureau showed that a general wage restraint
neglects the fact that the exposed and sheltered sectors have a
different composition of their labour force, with important effects. He
noted that the exposed sector is industrial and has the larger share of
well educated, highly productive or high value added labour; while the
sheltered sector concerns services and has the larger share of lowly
educated, lowly productive or low value added labour. A uniform wage
restraint - targetted at reducing unemployment rather than balance on
the external account - is too high for the exposed sector and thus
subsidises exports; and the restraint is too low for the sheltered
sector and thus generates unemployment. The restraint of incomes also
means a restraint of imports, aggravating the situation. So Van
Schaaijk noted in fact both the internal and the external imbalance,
recognised that these mirrored each other, and that these were
prolongued, now not by the original energy price hike but instead by
policy.

Indeed, Holland since then has a strong external position - exporting
unemployment to Europe - and a high internal unemployment - where the
unemployment is hidden in ‘disability’ (and hence registered by dull
statisticians as ‘low participation’). Some surplus of the external
account is reasonable given the natural resource, and the capital flows
for foreign investments are useful for when the resource is depleted.
But the Dutch external surplus is excessive.

Van Schaaijk’s suggested remedy was standard and sound. It was and is
to let wages develop in line with productivity. Since Dutch policy is
oriented to maintaining a more equal distribution of income - which
explains part of the policy drive to see a _uniform_ development
in wages - Van Schaaijk advised to use tax policy to correct the
differential development of gross wages for its effect on net incomes.

However, as said, Van Schaaijk’s analysis has been neglected to this
day, and Holland now suffers from a long period of unemployment_ and_ a
trade surplus _and _a general restraint of wages and net incomes. There
is a curious ‘consistency’ in the delusion with policy makers, that
incomes restraint is required to maintain employment by generating a
trade surplus, since, by restraining the home market, most Dutch
employment growth seems dependent upon trade indeed. Strangely,
economic developments caused the Central Planning Bureau to drop the
Den Hartog & Tjan model in the mid 1980s, but the policy of wage
restraint remained.

In the 1982-1991 period I worked at the Central Planning Bureau too,
and had the opportunity to get acquinted - albeit around 1986 only -
with Van Schaaijk’s analysis. Apart from being enlightening by it
itself, it opened my eyes - even while it was standard - to the
importance of tax policy for unemployment, and thereby led to my papers
(Colignatus (1989-1996)) and this present book, on the solution to the
current mass unemployment in the OECD countries in general.

In my papers I have always referred to Van Schaaijk’s 1983 article
whenever it was proper. However, in this chapter I have occasion to
more specifically combine his analysis with my own. This chapter
improves on Colignatus (1996g), and as I wrote there: this combination
of our analyses has been in my mind for a long time, but there was no
time to develop it, as, in fact, this chapter suffers from some time
constraints too.

We shall use a general equilibrium model where the exposed and
sheltered sectors have different combinations of labour as in the Van
Schaaijk observation. But now we take my analysis on the minimum wage,
and let the minimum wage have the differential impact. This is more
relevant for the OECD in general. Note, though, that I do not want to
imply that all OECD countries have a trade surplus; other conditions
are relevant here too, of course.

Due to lack of time we use a closed model. Thus we cannot reproduce the
external imbalance. But we can reproduce the difference in reactions of
the two sectors. We may study situations_ with _full employment
(1950-1970) and _without _this (1970-2005). Below, we give a model,
tables and graphs.

Model

Regard a general equilibrium model with 15 units of highly productive
labour (_h_), 75 units of modally productive labour (_m_) and 10 units
of lowly productive, minimum wage workers and possible benefit
recipients (_l_). The economy has exposed and sheltered sectors that
produce output _yE _and _yS_, while a social welfare function (SWF)
determines the optimal combination. In an open model, the _yE_ would be
traded for _yForeign,_ but here we assume that exports are directly
equal to imports for consumption. The SWF will here be a Constant
Elasticity of Subsitution (CES) function that neglects the distribution
of income:

Output of the sectors is determined by production functions that depend
upon the allocation of the labour factors_ h, m & l._ Since we will
compare two regimes, one with _l_ and one without _l,_ this factor
cannot be complementary (necessary), and hence it is substitutable to
some degree with the other factors. The sheltered sector is a one level
CES with all factors substitutable:

The exposed sector is a two-level CES where highly and lowly productive
labour are complementary, but both are substitutable with minimum wage
labour:

The coefficients have been chosen so that these outcomes resemble a
real economy. We should refrain from making our conclusions too
specific though, since the coefficients are arbitrary.

Graphs

We consider two regimes, one _With l_ (i.e. the minimum wage _M _is not
binding), and one _Without l _(with _M_ binding, causing unemployment
and lower national income). Subsequently, the model is run with the
computer program listed in the appendix; see chapter 37 for another
application of the computer routine (and additional explanations of
terms).

Figure 34 plots the production possibility curves and the SWF
indifference maps of the two situations. The regime with a binding
minimum wage - and less workers - indeed has lower production and lower
utility. The drop in production in the sheltered sector is larger than
in the exposed sector.

Figure 34: Production Possibility Curves & Indifference Maps

Figure 35 plots the Edgeworth-Bowley diagram for factors _h _and _m,
_with Sheltered in the lower left and Exposed in the upper right._ _The
movement is upwards along the contract curve. The highly productive
workers in the second regime become relatively scarce, and command a
relatively higher share of national income.

[103]

Figure 35: Edgeworth-Bowley Diagram

Tables

The following tables give the numerical outcomes of the two regimes.
When _M_ is binding, the subsistence workers _l _are unemployed and
dependent on a benefit. Since they do not work, output and social
welfare are lower. Though there is no explicit social security in this
model, we however can presume that part of earnings of the workers is
channeled to the unemployed, leaving consumption from those earnings
unaffected.

The social optimum is found as in Table 9. The associated allocations
are in Table 10 - left and right side. When you compare the two
regimes, please note that the prices are normalised _per regime _to a
unit price for the sheltered sector, and thus are not comparable over
regimes.

Table 9: Utility, production and national income for two regimes

_ _

_Utility level_

_National income_

_Product prices
Sheltered & exposed_

_Production
S & E_

With _l_

21.20

39.67

0.9579

24.93

15.38

Without _l_

18.16

32.37

0.840

20.74

13.85

Note: All prices are scaled so that the product price of the sheltered
sector = 1. This is also done per regime, so that the price levels over
the regimes are not comparable.

In Table 10 we see that the share of the highly productive in national
income rises. Most of the share of the _l _go to the _m, _but this is
generally viewed as an internal redistribution, and most attention goes
to the share of ‘the rich’.

Table 10: Allocations

_ _

_Allocation with l_

_Allocation without l_

_ _

_High_

_Middle _

_Subsistence_

_High_

_Middle _

Labour units Sheltered

6.53

53.08

9.57

7.07

54.73

Labour units Exposed

8.47

21.91

0.43

7.93

20.27

Labour units Total

Wage

0.88

0.33

0.19

0.74

0.28

National Income Share

0.33

0.62

0.05

0.34

0.66

Note: Using unrounded data on the wages, the high/low wage ratio
in the first regime is 2.69, and in the second regime 2.60.

Conclusion

By proper choice of functions and parameters we have succeeded in
reproducing and hence illustrating the Van Schaaijk observation &
analysis of the differential reaction of the exposed and sheltered
sectors on incomes policy. As Van Schaaijk found, the sheltered sector
loses most, and it would be optimal to have wages reflect productivity.
And similarly, this can be supported by tax policy. Whereas Van
Schaaijk commented on the Dutch policy of the uniform containment of
wage growth, we have concentrated on the minimum wage - as is more
applicable for the OECD. Indeed, if the whole of the OECD would try to
copy the ‘Dutch model’, then this would amount to trying to export
unemployment to each other, and a thing like that surely would not
work.

32. Dynamic optimality

The Phillipscurve revisited

In chapter 25, the ‘more sophisticated view’ section, we mentioned that
Graafland (1990b) elaborated on Hersoug (1984), and recently again in
Graafland & Huizinga (1999). The approach here is a Nash solution to
wage bargaining. The approach causes that marginal tax rates penalize
wage demands and increase employment - contrary to the common thought
that statutory marginal tax rates reduce incentives and hence reduce
employment.

We ourselves forwarded the novel insight of the ‘dynamic marginal tax
rate’: saying that marginal tax rates should be better measured by also
including expectations on parameter changes and economic growth.

The question now arises how these two approaches_ combine_. The Nash
approach uses partial derivatives, while the dynamic approach uses
total derivatives. If we would take the total derivative of the Nash
solution, it might well be that statutory marginal tax rates show an
effect again that is more in line with the conventional view. The four
possible combination cases are shown in Table 11.

Table 11: Two marginal approaches for two Phillipscurves

Phillipscurves

Marginal approaches

_Traditional: only labour supply_

_Nash bargaining_

_Standard marginal analysis_

(1) the marginal tax rate has a disincentive on labour supply and thus
causes wages to rise

(2) the marginal tax rate has a disincentive on wage claims

_Dynamic marginal tax rate_

(3) the marginal tax rate has no disincentive, relevant is the average
tax

(4) ?

I have not performed the analysis yet. By the next edition of this book
I should have. My intuition however suggests - and I keep an eye on
reality - that the two approaches only combine into a stronger argument
against the conventional view. Doing this additional work thus
currently is expected to be a bit overdone just now.

Investment, growth and productivity

The following has been in my mind since Colignatus (1989) but was not
stated in the first edition of this book. One of the key points of
Keynes in the _General Theory_ was that the true, real, savings of an
economy consist of what is invested. All the money that people save
does not count as an investment or real saving. Whatever amount they
bring to the banks or even hide under their beds, it is only money. One
can have nominal saving _S _and price level _P, _but the division _S /
P _is more psychological than real._ _What counts are the houses built,
bridges constructed, lessons learnt, all that can be carried over to
the next period. In fact, a company that produces but can’t sell and
goes bankrupt might actually do society a favour, since at least some
goods have been produced which otherwise might not have come into
existence. The challenge is to get production and investment without
such perceived incompetence or fraud. The economy should be designed so
that those investments come about in an optimal way, where the optimum
must be defined not only in terms of expectations and stability but
also in terms of social welfare and full employment.

Governments, especially European ones, have been experimenting since
World War II with all kinds of methods to control investments, but have
been confronted with two major outcomes: (a) unemployment remained
high, (b) many investments were considered failures. The economic
paradigm since the Reagan years has been to let investments be
determined by the market. Also Dutch social democrats like Wim Kok
supported this approach, since it was thought that employment depended
upon growth while growth depended upon the best investments that the
market could provide. This paradigm led to reduced government outlays,
less fiddling in the market, privatisation, and reduced taxes for the
wealthy who were assumed to do the investing. The 1990s showed the boom
associated with silicon valley - though should properly be associated
also with this policy and the implementation of new financial
instruments. But the boom went bust and the world was reminded of the
logic of Keynes’s depression economics, see Krugman (1999).

The point of criticism is that employment and growth are rather
separate issues. Our own analysis in this book shows that a return to
full employment is possible. The main instrument is to get rid of the
tax void. Employment does not depend upon growth per se but employment
depends upon a properly working system to allocate the work that is
being done in an economy. Growth comes only into the story when we
aspire at higher welfare by means of higher productivity. If we don’t
want growth, we can easily imagine a stagnant economy. That said, most
economies aspire at a growth in welfare. We can do this by designing
new products or by material investments or by creative ways to
reorganise production. [104] Then the problem returns of optimising
investments that define real savings. Since some sections of the
economy are devoted to investments, there is also the Keynesian
phenomenon that investments influence activity, income and nominal
savings.

The paradigm to ‘minimize’ the role of government in investment was
misguided since the relation between growth and employment was
misspecified. Now that we know that the tax void was the main cause of
stagflation we can reconsider the paradigm. The argument that remains
is that government meddling supposedly caused failed investments. The
answer to that argument is (i) that failures must be judged on a
case-by-case manner, by Cost Benefit Analysis, and (ii) that one should
include the concept of Keynesian recession and that some investments
might seem a failure but actually are beneficial. Note that there is no
need for a government deficit since the analysis on the dynamic
marginal rate shows that progressive taxes need not be a drawback for
the richer. If growth is the issue, then the true issue is its
optimality in terms of level and composition and effects.

The line of thought that I would suggest is that this optimum requires
competing investment banks that develop plans during the economic
upswing that can be implemented during the economic downswing. Who
worries about pensions and the EU Lissabon Strategy is advised to
consider this approach. Since the market is an anonymous beast that may
or may not generate such competition, it remains the challenge for
governments to mastermind and manage it all.

Book VII
Social Choice

33. Introduction

Kenneth Arrow (1950, 1951, 1963) presented an Impossibility Theorem in
which he showed that decisions about ‘the general welfare’ are
impossible in certain cases or have to be left to a dictator. Arrow
presented some five axioms that each seemed reasonable when considered
by itself, and he argued as well that these axioms are morally
desirable and fitting to the concept of ‘general welfare’. He also
formulated the problem in general terms so that it concerns choices on
goods or people. Subsequently, he derived a contradiction. This result
caused quite some consternation, but eventually the mathematical rigour
caused acceptance, and since then the Theorem forms the core of many
books, such as Sen (1970) and Mueller(1989). The Theorem was also one
of the reasons to award Arrow the Nobel Prize in economics.

A voting example is given by the US Presidential election of 2000.
Apart from the problems around the ballot process itself, there was a
more basic problem: with main contenders Bush, Gore and Nader, Bush got
elected, but in another system, such as a run-off between the two
‘major’ contenders, the Nader vote apparently would have switched
largely to Gore, making him the US President. So the choice depends as
much upon the system chosen as on the preferences. Can we find a
generally good system ? Arrow’s Theorem suggests ‘No’.

Arrow’s Theorem has had a huge influence on scientific and political
thought. Part of this influence is subtle, where skepsis arises about
the concept of ‘democracy’. That shiny goal loses its appeal when we
don’t know how representatives should be elected and when morally
desirable rules would be impossible. Opting for the natural forces in
the social process may be more pragmatic. The influence of the Theorem
can sometimes be more explicit. Next to the model of the utility
maximising individual, there is the model for society as a whole and
then the maximisation of a Social Welfare Function (SWF). But when a
morally acceptable SWF is impossible, what would be the use of research
into such an inherently flawed concept ? Many nations co-ordinate their
economic policy, and have created institutions for this, like the
Council of Economic Advisors (US), the Commissariat du Plan (France),
the Sachverständigenrat (Germany), and the Central Planning Bureau
(Holland). Such an institution, given its role in the co-ordination of
economic policy, could be expected to do reseach on the national SWF.
However, those institutions tend to abstain from that kind of research,
pointing to Arrow’s Theorem as one of the arguments, if not the major
argument.

Over the years an ‘accepted view’ has grown in economics concerning the
meaning of Arrow’s Theorem. This accepted view however has also implied
a kind of moral stagnation.

There are two main reasons to reconsider the accepted wisdom on the
meaning of the Theorem and to rekindle the debate on it. The first
reason is destructive, since it rejects Arrow’s position; the second
reason is constructive, since it provides an alternative.

These reasons are: (1) There is a distinction between the mathematical
framework on one hand and its interpretation on the other hand. The
Theorem holds, and the impossibility holds for Arrow’s axioms, but the
questions of reasonableness and moral desirability are of a different
kind. (2) The area of application of Arrow’s axioms seems rather
static, while reality is dynamic. By considering the role of time,
there is more scope for morality, and then one can identify a voting
procedure that many would find attractive.

The two following chapters develop these arguments subsequently.
Readers interested in more details are referred to Colignatus (2001),
“Voting Theory for Democracy”. That book develops the theory of direct
single seat elections from the bottom up while it also provides
programs (in _Mathematica_) to eliminate the tedious work of the
calculations of the various voting procedures.

34. The solution to Arrow’s difficulty in social choice

Summary

Arrow’s Theorem holds that no constitution can satisfy certain
properties. In annex to that theorem, Arrow claims that those
properties are reasonable and morally desirable. In Arrow’s view there
thus is the difficulty that people desire a constitution that cannot
exist. While the Theorem stands as a mathematical result, the
additional claims concern some other matters, namely the domains of
reasonableness and morality. It are these claims that have caused much
confusion in the literature. It is shown here that the claims are
unwarranted, since inconsistent properties are neither reasonable nor
morally desirable. It is shown too that Arrow’s axiom of Pairwise
Decision Making (formerly known as the Independence of Irrelevant
Alternatives) is not realistic, and thus unattractive. We show the
existence of some constitutions without that axiom that are consistent
and might be optimal to many. The major error made by Arrow and his
students is to mix up the context of scientific discovery and learning
with the context of application to the real world by educated people.

Introduction

Arrow (1950, 1951, 1963) showed that if certain properties are
postulated for a constitution, then such a constitution would not
exist. This result has been checked by numerous scholars, is accepted
by this author, and thus stands as a mathematical theorem. In fact, we
will give a short proof below.

Arrow also claimed, annex to the theorem, and_ this_ will be at issue
here, that those properties would be reasonable and morally desirable.
He recently repeated that claim in the Palgrave (1988:125). He writes:

“(...) conditions to be imposed on constitutions (...)”

“(...) there is no social choice mechanism which satisfies a number of
reasonable conditions”.

For clarity it is useful to introduce the following abbreviations for
the theorem and its companion claims, and their conjunction:

_AT _ = the Arrow Theorem

_ARC_ = the Arrow Reasonableness Claim = the properties are
_reasonable_

_AMC_ = the Arrow Moral Claim = that they are _to be
imposed_

_ AGV _= the Arrow General View = _AT & ARC & AMC_

Note that Arrow’s phrasing on _ARC_ and _AMC_ is a bit ambiguous. The
“to be imposed” might not be moral but merely logical, in a sense that
one needs at least some conditions to make a constitution. However, the
topic of collective choice is distinctly a moral one. Secondly, Arrow
emphasises what is to be imposed and what is reasonable, but he may not
be in a position to impose his views and morals on us. The best
interpretation of the situation likely is as follows. Presume that
Arrow sees the Founding Fathers at work. He then retreats to his
office, and conjectures: ‘If I interprete correctly what they want,
then it are these properties.’ Thus the _ARC_ and _AMC_ are not quite
Arrow’s personal ideas. Above quotes can best be interpreted as factual
statements on what people apparently want and consider reasonable.

Arrow’s general view has been accepted in many places in the literature
and textbooks, see Luce & Raiffa (1957), Johansen (1969), Sen (1986) or
various other entries in that same Palgrave. For example, Tobin (1990):

“We know there is no way to aggregate individual preferences into
social rankings (...). As if this were not obvious, Kenneth Arrow
proved it rigorously years ago. The impossibility applies to
aggregations across contemporaneous cohorts, a fortiori across
generations living and unborn.”

In a much used book on Cost-Benefit Analysis (CBA), A.K. Dasgupta &
D.W. Pearce (1980):

“(...) no escape route (...) seems yet to be available.”

Apparently feeling that Arrow's argument destroys the foundations of
CBA, they find themselves forced, rather grudgingly, to reduce CBA to
something like information gathering.

In an otherwise recommendable volume of Statistical Science, Gill &
Gainous (2002) find:

“In fact, he proved that unless one is willing to violate one of a set
of reasonable democratic norms, (…inconsisteny...) is an inevitability.
(…) Therefore, collective social decisions cannot yield a truly
democratic system in this sense.”

Jorgenson (1990), once president of the Econometric Society, concludes
‘more positively’ to dictatorship:

“The classic result of social choice theory is Arrow’s (...)
impossibility theorem, which states that ordinal noncomparability of
individual welfare orderings implies that a consistent social ordering
must be dictatorial, corresponding to the preferences of a single
individual.”

Not everybody falls for dictatorship. The impact of the _AGV _generally
comes from the fact that people find themselves, either from moral
obligation or from reasonableness, wanting the impossible. And many
simply stay in that fixture.

Note the subtlety in that fixture. The impossibility is logical and not
just empirical. An example may help. Let me confide that I want to
found a new university on the island of Crete. However, I am not that
rich, so I want something impossible. This however does not put me into
a fixture, since I am used to the fact that I cannot afford some things
that I want. However, the Arrow general view concerns a logical
impossibility, which is something quite different.

We can usefully recognise:

reasonable = rational & realistic

Reasonableness is the intersection of rationality and empirical
realism. Nonexistence may derive from empirical circumstances or from
logical impossibility. Irrationality however is always unrealistic.
Inconsistency cannot _exist,_ in the true empirical sense. For example
a round square cannot exist. The nonexistence of the Arrowian
constitution similarly derives not from empirical reality but from
logical necessity.

Given the _AGV_, the question arises what the reasonableness and moral
presumptions of Arrow’s claims actually are. Are these claims as strong
as conjectured ?

My position is as follows:

1. As has been said on ‘round tables’, it is not rational to
postulate inconsistent properties. People involved in a learning
process may indeed make inconsistent assumptions. However, once the
inconsistency is discovered, it is no longer considered to be rational
to adopt those assumptions. People may enjoy ‘roundness’ and
‘squareness’, but having both simultaneously is seen to be
inconsistent, even inconceivable, and hence unreasonable. The Arrowian
properties are unreasonable in the exactly same manner. Arrow’s pitfall
is to confuse the learning process, his context of discovery, with real
world applications by educated people.

2. Similarly, one cannot be morally obligated to a logical
impossibility. Hence Arrow’s properties are morally undesirable.

These points will be clarified below.

Note that people have in practice rejected some of Arrow’s properties.
Even those scholars who seem to accept the general claim _AGV_, accept,
a fortiori, the implied inconsistency, and thus in practice drop some
assumptions to cope with the real world. Unfortunately, however, the
literature has not converged to some agreement on which properties are
best to drop. The position of this paper will be to forward the
proposition that the Arrow axiom of Pairwise Decision Making (formerly
known as the Independence of Irrelevant Alternatives) is the culprit to
kill. It is a bad axiom for rational collective decision making, since
it appears to be incongruent with that very notion itself.

In the following we develop the concepts, give a short proof and
discussion of Arrow’s Theorem, construct the argument against the
claims, reappraise the literature, and conclude.

Basic concepts

Please note that we will have to redefine some symbols for this chapter
only.

Let _X _be the commodity domain. An element in the commodity domain can
be called an item or a candidate. An agent is a compound of various
properties such as utility, wealth etcetera. Let _S _be the set of
possible compounds on _X. _ With _n _agents, our interest concerns the
function _c: Sn S. _which maps the society into an aggregate
compound. This is generally called the ‘Arrow type of social welfare
function’ or simply a constitution.

A constitution differs from the ‘Bergson-Samuelson type of social
welfare function’ (SWF) - and the latter is defined directly over _X
_as _SWF: X _[0,_ _ ).

Arrow’s Theorem concerns Social Welfare Function Generating Mechanisms
(SWF-GMs) like the _c _above. Thus, a constitution can be seen as a
mechanism that uses the population as input and generates a SWF that
orders all elements in the commodity space. This can be compared to a
Social Decision Function (SDF) that selects only one element, namely
the best of a budget set. This can be weakened further by considering
preference orderings instead of functions. Constitutions generally
associate better with SDF-GMs since parliaments generally don’t care
ordering all proposals. However, these concepts can be translated into
each other via varying the budget set. Since the SWF is the
conventional concept in economics, the word “constitution” can remain
associated with a SWF-GM.

It suffices to restrict _S _to preference orderings_. _These orderings
satisfy reflexivity, transitivity and completeness. It is important to
add that there is no cheating. Let _R _denote normal preference, _P
_strict preference, and _I _indifference. When there is no confusion,
we can also use the symbols , < and =. A suffix denotes an individual
preference, otherwise it is the aggregate. An element in _Sn _is called
a _profile,_ and_ R = c(R1, ...Rn)._

There are the following Arrowian axioms:

_ AWP_ the weak Pareto principle

_ AU_ universal domain (wide ranging preferences)

_ AD_ no dictator

_ APDM_ pairwise decision making (the axiom

f.k.a. independence of irrelevant alternatives)

_ a AWP & AU & AD & APDM._

The Arrow Theorem can be expressed in various equivalent logical forms:

_ AT a falsum_

_ AT’ a ~a_

_ AT” ~a_

_ AT”’ _(_AWP & AU & APDM_)_ ~AD_

with _falsum_ a contradiction or falsehood and ~ the negation sign. If
something leads to a contradiction, then we conclude to the falsehood
of the assumptions themselves.

There is a Kantian distinction between technical, pragmatic and moral
(categorical) imperatives. Utility, as commonly regarded by economists,
likely is of the pragmatic kind. Interestingly, theorists on morality
have developed something called ‘deontic logic’, which appears to give
many similar results as economic theory. Deontic logic however applies
to_ propositions_ and not to _commodity domains_. It is possible,
though, to integrate all these kinds of preferences into an integral
utility index, when we replace a point _x _in the commodity domain by a
statement “The state of the world is _x_”. This integral utility index
likely would be lexicographic, in that some moral and constitutional
issues might dominate pragmatic results in the commodity domain. Thus,
while we would use the same symbols _R, P_ and _I,_ we would need to
look into the structure of the index to find the Kantian distinction as
made by the particular agent. We conclude that we can usefully
introduce and apply some terms from deontic logic. Define:

_Ap _(_~p _ _ p_)_ _means that _p _is allowed (at least as good as
_~p_)

_ Op _(_~p < p_) means that _p _is a moral obligation (one ought to
_p_)

An exemplaric deontic result is:

_ Op ~(A(~p))_

Deontic logic allow us to translate:

_ AMC = Oa_

The use of deontic logic allows a forceful restatement of Arrow’s
difficulty in social choice:

_Oa & ~a_

Let us consider some more properties of morality and deontic logic.

The gap between Is and Ought (_Sein und Sollen_) means the rejection of
_p_ _p Op _(‘If something is, then it should be like that’) and, in
principle, _p Op p_ (‘what ought to be, is achieved’).

Note what this actually means. A statement _p _has a truthvalue 1
(true) or 0 (false), depending upon the state of the world. A statement
_Op _has a ‘truthvalue’ 1 (ought) or 0 (not-ought) depending upon one’s
preferences. Applying the logical calculus for the propositional
operators , ~, ,_ & _thus is a mental exercise, where empirical and
preferential statements are first given the common denominator of
‘accepting as valid’. Also, it may be that in one case both _p _and _Op
_are accepted, but the rejection of _p_ _p Op _means that it is
rejected as a _rule_. [105]

Moral consistency is reflected in the Deontic Axiom:

_ DA p,q_ (_Op & _ (_p q_))_ Oq_

There is some discussion between moral theorists whether _DA_ really
holds. It may be felt that the logic is not very compelling for
empirical relations of dubious causality. However, if _p q _reflects a
logial truth, then _DA_ is commonly accepted.

On reasonableness, it seems a bit better to attach the properties to
the agents rather than to the propositions or commodities. Useful
axioms then are:

_ AF _feasibility, _X _is the budget set (rather than
the whole space)

_ ARe_ agents are realistic (they only consider
feasible options, accept _AF_)

I thus agree with Arrow’s 1950 statement: “My own feeling is that
tastes for unattainable alternatives should have nothing to do with the
decision among the attainable ones; desires in conflict with reality
are not entitled to consideration.” Thus, also, when one point is
(socially) most preferred, it is the one consumed.

The most complex property seems to be good old _rationality_. It
appears that we better introduce the information set or knowledge base
_I(.) _and state the condition that it must contain the Arrow Theorem.
Then:

_ARa_ agents are rational (they accept logic, [106] have a
preference ordering, are morally consistent (_DA_), and are educated on
Arrow’s Theorem (_I(~a)_))

The _I(~a) _condition is a novel aspect, that, however, should not come
as a surprise, given what we said in the introduction. There is a
difference between a learning process and a result. In a common
classroom or used-car-salesman strategy, people are goaded into buying
some axioms as reasonable and attractive, and then burn themselves,
which teaches them. This may be called rational from the viewpoint of
learning. This paper however concentrates on the
after-learning-rationality, the kind of rationality that makes learning
so worthwhile.

How does Arrow’s original approach relate to the inclusion of _I(~a)_ ?
Arrow (1950, 1951, 1963) has no incorporation of learning - though he
later has written on ‘learning by doing’ - so it might be that he
assumes standard economic rationality. If that would be perfect
foresight, then _I(~a)_ is implied. However, it is better to hold that
Arrow in that period discussed constitutional choice _for_ agents and
not _by _agents. The choice for people then is made by some algorithm
or calculating machine. His axioms do not describe educated people
involved in constitutional choice. Alternatively put, another new
result in this chapter is the widening of the scopes of utility and
rationality to the inclusion of knowledge about the constitutional
process itself. In that sense the original Arrowian axioms can be
called incomplete. Alternatively, if the idea is that these axioms
concern educated people, then there is a hidden inconsistency, in that
reasonable agents are assumed to regard inconsistent axioms as
reasonable. [107]

Hence:

_ARC = ARe & ARa_

Restatement of Arrow’s Theorem

It appears very useful to discuss the example given by the Marquis de
Condorcet 1785. Sen (1970) gives a simple example that appears to be
presented first by Nanson 1882. A similar example is reproduced in
Table 12, and I will refer to it as “the Condorcet case”. There are
three parties and three topics _A, B _and_ C_ on ballot, and the
numbers of seats and the preferences are such that, with pairwise
voting and a majority rule, a cycle results: _A < B < C < A_.

Table 12: Condorcet 1785

_Party_

_Seats_

_ _

_Topics ordered by preference_

_ _

_Pairwise vote_

Low

Mid

High

_A_

_B_

_ _

_B_

_C_

_ _

_C_

_A_

Red

_A_

_B_

_C_

Green

_C_

_A_

_B_

Blue

_B_

_C_

_A_

_Total_

_100_

_40_

_60_

_ _

_35_

_65_

_ _

_25_

_75_

_B_

_C_

_A_

It is, in all clarity, not that easy to aggregate votes on more than
two topics. [108] For two topics one can indeed ask for pro and contra,
and find a majority (and occasional ties, for which exist tie-breaking
rules). For two topics one can indeed ask for pro and contra, and find
a majority (and occasional ties). For more topics, votes will scatter
across the topics, and there will often be no clear majority. Therefor,
pairwise voting is a good strategy to get the required information on
the preferences. However, pairwise voting apparently also causes
problems. So, basically, the search is for a strategy without such
problems. And that is, basically, also the suggested value of Arrow’s
Theorem: that it states that there would be no such good strategy.

However, in this Condorcet example, we may clearly conclude that the
cycle primarily means that there is a tie. The situation is in a
deadlock, and the group, as a collectivity, is _indifferent_. That
there are indifferences or ties, is nothing special. Standard economic
analysis allows agents to be indifferent (we even draw indifference
curves), so groups should be allowed to be indifferent too. In
Condorcet’s example, indifference is even a logical choice, since when
we assume something else, then we quickly run into difficulties.

There is the famous case of Buridan’s Ass (AD 1358). A donkey stands
between two equal stacks of hay, at equal distances. He cannot decide
which stack to take, and dies of starvation. The upshot of this parable
is that rational beings can devise a decision. Constitutions generally
state what happens when there are ties. Commonly the Status Quo
persists. (This may happen even if it was one of the topics under
ballot, and apparently was rejected at that stage.) Alternatives are
that the chairman decides, or points are (re-) negotiated, and one can
use dice.

It is important to see the difference between _voting_ and _deciding_.
In two stages, the chairperson first lists the votes, and then only
secondly gives the decision with a tick of the hammer. Table 12
essentially gives a voting field, and no decision yet. There is no
inconsistency as long as we record these results as voting scores, for
example “_B_ has more votes than _A_ in a pairwise comparison”. There
only arises an inconsistency when we change this into a preference,
i.e. decide that “_B_ is better than _A_”. There are additional rules
that translate the field into a unique decision. Part of paradoxical
element in voting derives from confusing voting and deciding.

We can use Condorcet’s example to give a short proof of Arrow’s
Theorem, restricting our attention to majority voting.

Proof: The group decision in the Condorcet case is indifference, so
that _B = C_. Under the axiom of universality we can look at various
preference _profiles_, of which Condorcet’s example is only one. Now
regard the adjusted profile such that the preferences on _B _and _C_
remain the same, but the preference on _A _drops to the lowest
position. The new profile thus is _{A < B < C, A < C < B, A < B < C}._
Since the preferences on _B_ and _C _have not changed, the _APDM_
outcome on _B_ and _C_ should be the same. Majority voting now however
results into _B < C _which differs from _B = C_. Contradiction. Thus
there is a counterexample to the axioms. So the axioms are
inconsistent. Q.E.D.

The merit of this short proof is that it clearly shows the awkwardness
of the _APDM._ In the case of Condorcet’s example the conclusion _B =
C_ is a sound decision, and in the case of the adjusted example the
conclusion _B < C_ is sound too. That preferences outside of the pair
_B _and _C _ have changed is_ vital_ to the group decision, since the
shift helps a change from clear indifference to clear preference. The
preferences on other topics are quite relevant, and not ‘irrelevant’.
_APDM _excludes vital information about the preferences - to be
precise: it destroys information that exists - and it should come as no
surprise that paradoxes and inconsistencies arise. The _APDM _is
incongruent with the notion of group decision making. Perhaps an
individual can exclude information about other topics, but a group
cannot. (Or a brain that works as a group cannot.) It is a surprise
that _APDM _has not been killed right in 1951.

A note on the name of APDM

Arrow (1951, 1963) introduced an axiom “Independence of Irrelevant
Alternatives” (_AIIA_) that has caused much misunderstanding. That
axiom here has been baptised the “Axiom of Pairwise Decision Making”
(_APDM_). Thus the axiom remains the same, only the name is different.
The new name is much clearer about what the axiom really means in
normal English.

Since the name “IIA” is so entrenched in the literature, this change of
name requires some explanation. The explanation is along the lines:

· There is the distinction between voting and deciding.

· Items that cause cycles cannot be called ‘irrelevant’ for decision
making.

· The criterion to separate the relevant items from the irrelevant ones
is rather the budget and is not necessarily found in pairwise voting
for all items.

Arrow's axioms on using the whole commodity domain and universal
preferences introduce the possibility that we might also be obligated
to consider farfetched items. Arrow introduced the _APDM_ to limit this
effect again, since it allows that a decision on our current issues can
be taken independently from other farfetched possibilities. It is
reasonable that people neglect farfetched possibilities. Thus Arrow on
one hand opens the door wide for such farfetched possibilities, and on
the other hand introduces a strict condition that kills the relevance
of this. The whole looks reasonable, since people in fact neglect
farfetched possibilities.

Yet, the whole does not conform with the practical situations in
Parliaments, where the problem is defined for existing voters and where
the issues on table are given by the budget set.

Thus, (a) the notion of ‘irrelevance’ is dealt with by considering the
budget set, (b) the axiom can be named after what it properly does:
pairwise decision making.

If we want to deal with possibly farfetched preferences of some
citizens, which is the moral meaning of the axiom of universal
preferences, then we should work towards practical procedures that
work. Assuming inconsistent axioms is not a good way to deal with that
moral question.

The following sections use formal logic.

A lemma

Lemma A.I: _AF_ implies that a constitution _p_ satisfies the property
_Op p_.

First proof: _AF _means that desires (_Op_) in conflict with reality
(_~p_) are not entitled to consideration. But _p_ _~(Op & (~p)) _is
equivalent to _p Op p_. Q.E.D.

Second proof: We already concluded that the most preferred point (_Op_)
would also be the chosen point (_p). _Thus _p_ _Op p_. (If the point
is not preferred, then the implication is true _ex vacuoso._) Q.E.D.

Discussion: We have enlarged the commodity domain with constitutions,
and hence the axiom of feasibility becomes a bit stronger. The
extension itself is rather weak, since we only extend on consistency
(and not empirical validity). Our criterion is as that a reasonable
society would stick to its rules. The gap between Is and Ought still
exists in principle, but can in practice be bridged by the human effort
to attain one’s ends.

Rejection of the Arrow Moral Claim (AMC)

Theorem A.1: For a reasonable society, the _AMC_ is invalid.

First proof by rationality & moral consistency (_DA_): Assume _Oa. _But
_a ~a, _and with _DA _we get _O~a. _But this gives a preference
inconsistency _Oa & O~a_. Hence _~Oa. _Q.E.D.

Second proof by rationality & moral consistency (_DA_): Assume _Oa.
_Since _a falsum _we find _Ofalsum. _Thus for some _p_0_ _we have
_O(p_0_ & ~p_0_). _But this means _Op_0_ & O~p_0_, _and that is a
preference inconsistency. Hence _~Oa. _Q.E.D.

First proof by realism (_AF)_: Assume _Oa. _By the lemma _p_ _Op p
_we find _a. _But then we have _~a & a, _which is an inconsistency.
Hence _~Oa. _Q.E.D.

Second proof by realism (_AF_): Since _~a _ and above lemma _~a ~Oa,
_hence _~Oa. _Thus the axioms are not morally desirable either. Q.E.D.
Note: _q p _is equivalent to _~p ~q, _and we may take _q = Op._

When the axioms would be morally desirable, then the derived
contradiction would be morally desirable - but nobody can be asked to
do the impossible. Hence the axioms are not morally desirable. This is
a seemingly simple reasoning scheme, but destructive to the accepted
view.

Rejection of the Arrow Reasonableness Claim (ARC)

Theorem A.2: For a reasonable society, the _ARC_ is invalid.

Proof: Given _AF_, infeasible choices are not considered. Since _~a,
_apparently _a _is not feasible, and the Arrow constitution is not
reasonable. So it is invalid that the axioms would be reasonable.
Q.E.D.

Discussion: As we stated above, we have enlarged the commodity domain
with constitutions, and hence the axiom of feasibility becomes a bit
stronger. The extension itself is rather weak, since we only extend on
consistency (and not empirical validity). But the conclusion is strong.
No reasonable society in its right mind would want to accept Arrow’s
axioms as its constitution. Supposedly at a chaotic Boston Tea Party a
constitution _c = a_ might be tried, but pretty soon rational people
would see that they should make another constitution, for otherwise the
situation will remain chaotic, and the Tea Party will not go down into
history as a notable event.

Note that Arrow adopts feasibility, but also wants to impose infeasible
conditions.

When Arrow’s axioms would be reasonable, then they would have to be
consistent as well. However, they are inconsistent. Thus they are not
reasonable. This seems a rather simple scheme of reasoning, but it
destroys the impact of the Theorem.

For the axioms, there is the subtle difference between ‘reasonable’ and
‘seemingly reasonable when considered by itself’. The following is a
good analogy. For a bicycle we want round wheels for when it rides. For
a bicycle we also want square wheels, so that it does not fall when it
stands still. But there are no round squares ! Ergo, conditions that
seem reasonable by themselves, create something impossible and
decidedly unreasonable when combined. To conclude ‘there is no good
bike’ would however be absurd. Admittedly, it is a good teaching method
to first convince students that something would be reasonable, and then
have them derive a contradiction. As with the buying of a bad
second-hand car, the students learn to be careful, and they learn a
respect for science and the value of modesty. This teaching method
however overshoots when people remain believers of the reasonableness
of the assumptions - as apparently happened with the assumptions of
Arrow’s Theorem. A paradox is only a seeming contradiction. Thus there
must exist a system that we are willing to accept as the optimal one.

Many mathematicians have been sensitive to the distinction between
‘reasonable’ and ‘seemingly reasonable when considered by itself’, but
the literature also abounds with instances where this distinction is
not applied with sufficient care. Part of the accepted view thus is a
case of bad communication of the incrowd with the larger public. (Given
above quotes, the incrowd however might be small. Quis custodet
custodes ?)

Selection of the culprit axiom.

The selection of the culprit axiom is straightforward. We order the
axioms by preference, for example _AD > AWP > AU > APDM. _From _~a,_ we
conclude that we have to drop one of the axioms. We drop the least
preferred one. My discussion on Condorcet’s example should generate
support for the rejection of _APDM. _Basically though, scientists can
only advise on preferences, and the proper decision is up to the body
politic.

Lemma A.II: If all agents have _a > APDM_ then, with _AWP_, society
has [_AU, AWP, AD_] > _APDM_. Note: here [_x, y, z_] means the
unordered set.

Proof: _obvious_.

Discussion: When all people put _AU, AWP_ and _AD_ in any individual
order, but all would have _APDM_ below these, then society can reject
_APDM _unanimously. In fact, the condition _AU_ might as well be
regarded as part of the _definition_ of a SWF-GM, and similarly, _AWP_
could as well be regarded as part of the _definition_ of the notion of
collective preference. So the real choice concerns _AD_ and _APDM_, or
between dictatorship or not.Here a selfish dictator and his associates
would have _¬AD > APDM > AD_. The Jorgenson quote suggests his
preference for a benevolent and non-selfish dictatorship, but, also
since such dictatorships tend to turn sour, my impression is that he
would eventually be an associate of a real dictator. Most likely, he
did not understand the situation when the quote was printed.

Note that ordering the axioms means that the deontic predicate _O _is
not homogeneous. This means that deontic logic may be more related to
preference theory than deontic theorists think.

Examples of consistent constitutions

Consistent constitutions violate one of the axioms of Arrow’s Theorem.
Violating one of these axioms is to be considered useful for
reasonableness and morality, rather than the reverse. (That is what we
proved above.)

One general feature is a Status Quo that persists when there are ties.

One example already has been mentioned in the discussion of the
Condorcet problem. With majority voting, a cycle means indifference,
and there are various ways to solve ties. One possible solution is the
persistence of the Status Quo._ _

Another example constitution is the “Pareto-Majority” rule. One first
selects all Paretian improvements from the Status Quo. That is, those
points where some advance while nobody loses. There may be more
Paretian points, such as _B > A _and _C > A,_ with the Status Quo as
_A._ When there is no Paretian order between _B _and _C_, then it
suffices to decide on these points by simple majority. Of course, with
more than two points, majority voting can result into cycling, but that
again means indifference, which could be settled by dice, by the
chairperson, or by other creative ways.

See my home page and The Economics Pack for implementation of these
rules in the program _Mathematica_. Little helps so much as a trying it
out for yourself.

A reappraisal of the literature

Our discussion arrives at a conclusion that differs from the
literature, and thus warrants a reappraisal of that literature. This
reappraisal is not the topic of this paper, but some examples are
useful.

(1) Note that the Tobin quote above was misleading. The problem with
‘unborn generations’ should not be mixed up with the Arrow difficulty.
The Tobin problem actually can have a rather simple solution. It are
the preferences of the currently living that matter, and what they
prefer for the future unborn (which can also be based on a forecast of
such preferences). These future preferences cannot logically be
included, since they don’t exist yet.

(2) Arrow 1951 also stated:

“If consumers’ values can be represented by a wide range of individual
orderings, the doctrine of voters’ sovereignty is incompatible with
that of collective rationality.”

This is clearly inaccurate. The statement suggests that we have to
adopt Arrow’s axioms, while the sensible thing is to reject these
axioms and to adopt both voters’ sovereignty and collective
rationality.

(3) One of the more interesting points made here is the distinction
between the learning process and the end result. How should Arrow’s
result be presented in the future ? Is it possible to maintain the
teaching strategy to call the axioms ‘reasonable’, then have the
students get into a fixture, and them let them find a way out ? It is
good teaching practice ! However, in a Palgrave meant for a wider
audience (or a general encyclopedia that even might be read by
dictators), it might be improper to call Arrow’s axioms ‘reasonable’.
It should be ‘seemingly reasonable’ at the least.

Note that the phrase then becomes less enchanting:

‘there is no social choice mechanism which satisfies a number of
seemingly reasonable conditions’.

(4) I am a bit shocked by Mueller’s (1989, p406-407) discussion of
Arrow’s general view. One would expect a more critical attitude, but
finds instead:

“The Arrow and Sen theorems (...) raise fundamental questions about the
possibility of establishing collective choice procedures satisfying
minimally appealing normative properties (...) But the negative side
should not be overemphasized. We have suggested that both sorts of
paradoxes might be avoided with the use of cardinal, interpersonally
comparable utility information. Arrow explicitly eschewed the use of
such information, and the independence of irrelevant alternatives [thus
Pairwise Decision Making / TC] axiom was imposed to rule out voting
procedures that might make use of such information (... But it) is
possible that the citizens may be trusted to make these comparisons in
an ethically acceptable way.”

Well, interpersonal comparison of course occurs, minimally, when we
assign votes to people, assign rights to put topics on ballot, and the
like. So interpersonal comparison is not as bad as many economists seem
to think. But my solution to Arrow’s difficulty does not rely on
cardinality and cardinal comparison. So, disappointingly, Mueller both
accepts the idea that Arrow would cause ‘questions’ about the
possibility of social choice, and he comes with a wildly wrong
conclusion. This is supposed to be a modern textbook !

(5) What is important, is that the development of economic theory and
the development of real economies have been hindered by the confusion
generated by the standard explanation. Where decision makers were
divided, some interested in social welfare and others not, the latter
group was provided with decisive gunpowder - and beware of people who
have an ideology and even wield a mathematical theorem to prove their
lunacy. Generations of students have been taught by Nobel Prize
laureats that research into social welfare would be subject to
impossibilities. Creative energy has been directed to enlarging the
impossibilities rather than to devising structures that might improve
practical situations. Practical research into social choice functions
and parameters has been aborted, all with reference to a misunderstood
theorem !

Economic research also leads to a suggestion of a constitutional
amendment, see Colignatus (1996b) and the appendix. I hope that this
present chapter helps to clarify that this kind of research is a useful
type of economics.

(6) This analysis also clarifies a confusion about the relation of
constitutions to the SWF. While many economists argued that
constitutions could not be reasonable or morally acceptable, they did
accept the Bergson-Samuelson SWF, even though the latter was derived
from the former - and nobody seems to care about this inconsistency.
Which is now removed, since the properties of the constitution are
projected into the SWF.

(7) It is relevant to note that I gave this analysis earlier, in
Colignatus (1990c, 1992a). This chapter is almost 99% the same as
1997b, and a a rephrasing of the main principles. I have had no success
so far in getting a publication, neither at the CPB nor in a journal.
[109]

Conclusion

Arrow’s Theorem has given some problems in the literature, see the
quotes above. We have achieved the following solution:

· There is more clarity now, by the distinction between the theorem
proper (_a falsum_), the moral claim (_Oa_) and the claim on
reasonableness (_AF _and _I(~a)_).

· The arguments above on rationality and morality have a destructive
character since they reject the accepted view. In another perspective
they are constructive, since they allow the formalisation of (meta)
notions, and bring these back into mathematics again (notably the
voting on constitutions).

· From a mathematical point of view, the Arrow axioms are incomplete
for decision making in a reasonable society.

· It has been shown that the _APDM _is undesirable. Dropping _APDM _is
not a sad state of affairs, as is sometimes suggested in the
literature, but a sign of understanding group decision making.

· The Arrow axiomatisation does not capture the truly desirable
properties required for a constitution, both by incompleteness and
_APDM._

· There are detail results, such as the distinction between voting and
deciding, the integration of preference theory and deontic logic, and a
proof of Arrow’s Theorem that shows clearly the abuse by _APDM._

· We have given examples of consistent constitutions that many might
regard as optimal.

Addendum: Sen’s restatement in “Development as freedom”

Sen (1999a:250-253) contains a short summary discussion on his view on
the Theorem. First I quote him and then give my comment. Sen states:

“The Arrow Theorem does not in fact show what the popular
interpretation frequently takes it to show. It establishes, in effect,
not the impossibility of rational choice, but the impossibility that
arises when we try to base social choice on a limited class of
information.”

This is not correct. Using the information provided by pairwise voting
results, we can decide to a tie (deadlock, indifference) when such
might arise. It is the adoption of the _APDM_ axiom that, wickedly,
turns this indifference into an inconsistency. The _APDM_ does not mean
lack of information, it only corrupts the information that exists.

“At the risk of oversimplification, let me briefly consider one way of
seeing the Arrow theorem. Take the old example of the “voting paradox,”
with which eighteenth-century French mathematicians such as Condorcet
and Jean-Charles de Borda were much concerned. If person 1 prefers
option_ x _to option_ y _and_ y _to _z, _while person 2 prefers_ y _to_
z _and_ z _to _x_, and person 3_ _prefers_ z _to_ x _and_ x _to _y_,
then we do know that the majority rule would lead to inconsistencies.
In particular,_ x _has a majority over _y_, which has a majority over
_z_, which in turn enjoys a majority over _x_. Arrow’s theorem shows,
among other insights it offers, that not just the majority rule, but
_all _mechanisms of decision making that rely on the same informational
base (to wit, only individual orderings of the relevant alternatives)
would lead to some inconsistency or infelicity, unless we simply go for
the dictatorial solution of making one person’s preference ranking rule
the roost.”

Locating the problem in the informational base is erroneous. Clearly,
majority decision does _not_ lead to inconsistencies, for it is the use
of the _APDM_ axiom that does so - and we don’t need it for majority
decisions. The Arrow Theorem does _not_ show that there are
inconsistencies for _all_ mechanisms - we namely can use mechanisms
without _APDM_.

“This is an extraordinarily impressive and elegant theorem — one of the
most beautiful analytical results in the field of social science. But
it does not at all rule out decision mechanisms that use more — or
different — informational bases than voting rules do. In taking a
social decision on economic matters, it would be natural for us to
consider other types of information.”

I don’t know about “extraordinarily impressive and elegant”. Condorcet
came up with his paradox, as earlier people came up with paradoxes when
dividing by zero, as Bertrand Russell had his set-paradox, and as the
Cretian Epimenides said “All Cretians are liars.” Arrow’s Theorem
solves the Condorcet paradox by showing that we must not use _APDM_ -
though Arrow apparently did not realise that. The theorem is basic, and
we must be glad that we have it, as _APDM_ apparently can cause a lot
of confusion, as the last 50 years have shown.

“Indeed, a majority rule — whether or not consistent — would be a
nonstarter as a mechanism for resolving economic disputes. Consider the
case of dividing a cake among three persons, called (not very
imaginatively) 1, 2, and 3, with the assumption that each person votes
to maximize only her own share of the cake. (This assumption simplifies
the example, but nothing fundamental depends on it, and it can be
replaced by other types of preferences.) Take any division of the cake
among the three. We can always bring about a “majority improvement” by
taking a part of any one person’s share (let us say, person 1’s share),
and then dividing it between the other two (viz., 2 and 3). This way of
“improving” the social outcome would work — given that the social
judgment is by majority rule — even if the person thus victimized
(viz., 1) happens to be the poorest of the three. Indeed, we can
continue taking away more and more of the share of the poorest person
and dividing the loot between the richer two—all the time making a
majority improvement. This process of “improvement” can go on until
the poorest has no cake left to be taken away. What a wonderful chain,
_in the majoritarian perspective, _of social betterment!”

Remember that Sen writes this book for a general audience of economists
who will not have gone deeper in social choice theory. Though Sen now
relates basic truisms, his reasoning nevertheless is a bit off. Indeed,
Western democracies tend to have property rights and a “status quo”
rule, and a Madisonian philosophy that democracy actually exists to
protect the minorities. We use all kinds of additional information, in
order to settle problems of fairness and equity. Thus the majority rule
is not suggested for the raw form that Sen uses as an example. Then,
crucially, when Sen suggests that this example clarifies that we must
use more information to solve the Arrow paradox, then this is a
non-sequitur. His argument becomes seductive, since the reader is
seduced into thinking that, indeed, we use more information. But the
truth is that we use this additional information to solve equity
matters, and not to solve the Arrow inconsistency.

“Rules of this kind build on an informational base consisting only of
the preference rankings of the persons, without any notice being taken
of who is poorer than whom, or who gains (and who loses) how much from
shifts in income, or any other information (such as how the respective
persons happened to earn the particular shares they have). The
informational base for this class of rules, of which the majority
decision procedure is a prominent example, is thus extremely limited,
and it is clearly quite inadequate for making informed judgments about
welfare economic problems. This is not primarily because it leads to
inconsistency (as generalized in the Arrow theorem), but because we
cannot really make social judgments with so little information.

“Acceptable social rules would tend to take notice of a variety of
other relevant facts in judging the division of the cake: who is poorer
than whom, who gains how much in terms of welfare or of the basic
ingredients of living, how is the cake being “earned” or “looted” and
so on. The insistence that no other information is needed (and that
other information, if available, could not influence the decisions to
be taken) makes these rules not very interesting for economic decision
making. Given this recognition, the fact that there is _also _a problem
of inconsistency—in dividing a cake through votes — may well be seen
not so much as a problem, but as a welcome relief from the unswerving
consistency of brutal and informationally obtuse procedures.”

Sen is aware that his reasoning is not strict (vide his use of
“primarily” and “_also_”) but, still, he makes the suggestion, which is
erroneous.

Indeed, the spirit of “impossibility” is not, I believe, the right way
of seeing Arrow’s “impossibility theorem.” [footnote] Arrow provides a
general approach to thinking about social decisions based on
individual conditions, and his theorem—and a class of other results
established after his pioneering work — show that what is possible and
what is not may turn crucially on what information is taken into
effective account in making social decisions. Indeed, through
informational _broadening, _it is possible to have coherent and
consistent criteria for social and economic assessment. The “social
choice” literature (as this field of analytical exploration is called),
which has resulted from Arrow’s pioneering move, is as much a world of
possibility as of conditional impossibilities. [footnote]”

This quote just repeats the error - and adds a string of perceptions to
sweeten the cake. The footnotes are references to his “Collective
choice and social welfare”, his Handbook contribution and the Nobel
lecture, Sen (1999b), and add no news, for us, to the essence discussed
here. Indeed, the obviously relevant Nobel lecture just repeats the
error.

Hence, Sen basically does not understand the problem. I do value his
work on social choice since it was a useful guide to me in making
Arrow’s result accessible, and in seeing the various perspectives of
it. As Newton is reported to have said: “Standing on the shoulders of
giants, we can look further.” I cannot wait till Sen writes me that he
enjoys my solution !

Addendum: Mas-colell, Whinston and Green, “Microeconomic Theory”

Andreu Mas-colell, Michael Whinston and Jerry Green ’s 1995
“Microeconomic Theory” is just wonderful. A great book. Generally
speaking, though, since they erroneously write: “Either we must give up
the hope that social preferences could be rational in the sense
introduced in Chapter 1 (i.e. that society behaves as an individual
would) or we must accept dictatorship.” (p780). And the subsequent
discussion indeed leads the student in the bogs and misdirections so
typical of 20th century ‘social choice theory’. The math is OK, but
concerns something like the question of how many angels can dance on a
pin’s head - and the whole induces the student to become wary of social
decision making. (To be sure: I appreciate the other qualities, and
have used the book for sections of my Economics Pack.)

35. Without time, no morality

Summary

Theory shows that voting is subject to paradoxes, while it also appears
that a voting result is caused as much by the procedure as by the
voters’ preferences. From a moral point of view, the choice of the
procedure then is the major issue. A key insight is that morality
presumes time. In a static world everything is given and there is no
place for individuals who have to ponder their moral choices. The real
world is dynamic however and the most challenging voting paradoxes
concern budget changes. The paper develops a new “Borda Fixed Point”
mechanism that provides a better protection to surprises by such budget
changes. Under dynamics, Donald Saari’s argument on symmetry is less
convincing.

Introduction

The currently accepted view is sometimes expressed as that ‘there is no
ideal voting scheme’. The former chapter destroyed that view. There is
no mathematical reason to think that such an ideal cannot exist. Since
Arrow’s axioms must be rejected, they do not form an ideal. An ideal
still can exist, but apparently it is different than originally
thought. Perhaps people have different ideals, but then the
non-existence of a common ideal derives from empirically different
opinions and not from mathematical reasons. Since people can benefit
from co-operation, they can still aspire at a scheme that all can agree
upon.

Above analysis does not answer the positive question yet what would be
a generally good system. The main point here is that everyone should
determine this for oneself. Theory can only help to remain consistent.
The following is a suggestion for a scheme that is consistent and that
could appeal to many.

Control of natural forces in the social process

One important idea is that time plays a role. The basis for this idea
is that, abstractly, morality presupposes time. Without time there
would be no morality. In a static world everything is given, and there
is no place for an individual who has to ponder his or her moral
choices. As economists, we can draw static utility functions and
isoquants, but those are abstractions, and they might distract from the
real moral problem. The moral problem is that _now_ a decision has to
be made while the consequences appear _later_. Afterwards, everything
can be explained deterministically (which is the meaning of
‘explanation’), and by hypothesis, determinism will also hold for the
future. Yet, in the mean time forecasts are imperfect, there is
fundamental uncertainty, and that creates the possibility of morality
(or the illusion of morality).

Economic science is intended to help explain reality. In this reality,
we see an evolution of human beings in a social process of natural
forces. The basic concept is power, in a continuous process, so that
the basic approach uses ratio scales and cardinal utility and not
ordinal scales. Other assumptions than cardinality enter the discussion
_only_ when the group wants to control power, and for example introduce
democracy. A common notion is that economists reject cardinality and
interpersonal comparison of utility. However, the concept of ‘one
person, one vote’ actually imposes some interpersonal comparison of
utilities. Also comparing orderings of preferences implies some
comparison of utilities. The proper perspective is rather that
cardinality is deficient since people can cheat about their preferences
(at least in the current state of technology). The major argument for
ordinality is that it limits the room for cheating. If people could not
cheat, interpersonal comparison likely would be much more popular
amongst economists. The point that ordinality reduces interpersonal
comparison thus seems less relevant than the point that cardinal
comparisons are unreliable since people can cheat.

For example, when a family goes on holiday and has the choice between
Spain or Greece, then little Robby might exaggerate his preference for
Greece and say that he might as well die when Spain is selected. When
the aggregation of preferences would be cardinal, such a huge negative
weight for one option would certainly block it. Imposing ordinality
limits the impact of cheating however. In common textbooks on voting
theory, cheating comes in relatively late, but it is more adequate to
start right away with that notion. The crucial insight is: Arrow’s
Theorem and the voting paradoxes are the price that we have to pay in
order to limit that impact of ‘stategic’ voting behaviour.

Arrow’s orginal question whether there could not exist a generally good
voting mechanism remains a valid question, though. As history has
shown, mathematicians are proficient in identifying paradoxes and in
deriving new impossibilities, and one will not quickly find a
suggestion for a generally good system. But it appears that when we
consider the issue of time, then a solution tends to suggest itself. To
understand this solution, it is useful to first consider three main
contenders, i.e. the ‘traditional’ solutions provided by Plurality,
Borda and Condorcet. There are other methods, but their properties are
such that they need no consideration here.

Three traditional methods

In Plurality, all voters have one vote, and the candidate with the
highest number is selected. Note the problems with this method. The
criterion of ‘highest number’ does not imply that the winner must also
have more than 50% of the vote. If this is additionally imposed, then
this may require more rounds of voting, and then there is the difficult
issue whether candidates have to drop out, and if so, how.

Borda’s method is to let each voter rank the candidates by importance,
then assign weights given by the rank position, to add the weights per
candidate for all voters, and then select the candidate with the
highest value. Note that the method appears sensitive to preference
reversal, see below.

Condorcet’s method is to vote on all pairs of candidates, and to select
the one who wins from all alternatives. Note that such a “Condorcet
winner” does not need to exist. In that case the margins of winning can
be used to solve the deadlock - but this increases the sensitivity to
who participates.

The following example is taken from Saari (2001ab). Consider a budget
of three candidates _A, B_ and _C,_ and let there be 114 voters. When
we neglect indifference and use strict preference only, then with 3
candidates there are 3! = 6 possible ways of ranking them. Table 13
contains an arbitrary allocation of those voters over such preferences.
The highest ranking candidate gets rankorder weight 3, the second gets
weight 2, and the least preferred candidate gets weight 1. In the table
we can read for example that there are 33 candidates with preference _A
> B > C_.
>
>
Table 13: Voting example

_Number of voters_

_Candidates and their rank order weight_

_Sum _114

_A_

_B_

_C_

_ Results of the procedures_

_Mostly preferred_

33+0 = 33

14+25 = 39

25+17 = 42

_Borda_

230

242

212

_Pairs: A vs B_

_ A vs C_

_ B vs C_

The different voting schemes result into different decisions:

1) Plurality: Voters give one single vote to the candidate of
their highest preference. For candidate _A_ we consider its column,
select the rows with the score 3, and add the associated numbers of
voters 33 + 0 = 33. And so on. Candidate _C_ gets most votes, namely
42.

2) Borda: The votes are weighted with the rank order weight. De
column for _A_ is multiplied row by row with the number of voters 3 *
33 + 3 * 0 + 2 * 25 + … = 230. Candidate _B_ gets most votes, namely
242. (Scores -1, 0, 1 might calculate easier.)

3) Condorcet: Voting pairwise over _A_ versus _B_, there are 33 +
0 + 25 = 58 voters who give _A _a higher rankorder than _B. _Etcetera.
Candidate _A _appears to win from both _B_ and _C_, and then is the
“Condorcet winner”.

This example shows that _A, B_ and _C_ can _all_ be winners, depending
upon the method selected. The properties of the methods then are the
true issue.

Above still neglects strategic voting. This could be represented by a
change in apparent position. How do we evaluate this ? It appears that
the Condorcet approach is least sensitive to cheating since in a
pairwise vote there is an incentive to express one’s true preferences.
Pairwise voting however can be unattractive since there need not be a
Condorcet winner, or, when one exists, it may conflict with the
preference rankings. One way to solve the complexity of choosing
between these methods is to compromise by having a run-off election.
The two top outcomes of Plurality or Borda are taken and then subjected
to a pairwise vote as in Condorcet. There is one final consideration.
Simply taking the two ‘top outcomes’ seems unduly simple, we should
consider what these actually are. In France, the election between
Chirac, Jospin, Le Pen and others caused Jospin’s votes to scatter over
all kinds of smaller parties so that he dropped from the race while he
was the Condorcet winner of both Chirac and Le Pen. When we are
compromising, we should focus on determining the two main contenders.

Borda Fixed point

Let us reconsider the dynamic process that occurs within an economy. We
see that under the influence of time, the budget changes continuously.
A voting scheme naturally requires that there is a list of candidates,
but one cause for paradoxes is that that list is not fixed. For
example, in the Borda vote above_, B_ is selected, but if _C _decides
to withdraw (or gets a heart attack), then we would expect _B _to
remain the winner, but suddenly it is _A_ (see the Condorcet vote _A_
versus _B_). Remember also the Bush, Gore and Nader case. We could
consider a procedure to be better when the choice is less dependent
upon changes in the budget.

A way to achieve this is to use the notion of a ‘fixed point’. For a
function _f: D R_, for some domain _D_ and range _R_, the point _p _is
a fixed point iff _f(p) = p_. Let us consider this concept for voting.

Let _P _be the voting procedure, and let _X_ = {_x_1, …, _xn_} be the
budget with all the candidates. Let the unrefined winner be _w_ =
_P_(_X_)_. _Let _Y _be the budget when _w_ does not participate,_ Y_ =
_X_ \ {_w_}. Let the ‘alternative winner’ be _v_ = _P_(_Y_) = _v_(_w_),
i.e. the candidate who wins when the first winner _w_ does not
participate. This is not simply the run-off between the winner and the
common runner-up, since the selection of the alternative winner
requires the recalculation of the preference weights. This alternative
winner can be seen as a ‘summary’ of the opposition to _w_. The scheme
is a compromise since the Condorcet pairwise condition holds for the
winner and the alternative winner. While these notions are defined with
respect to the unrefined winner, we can generalise this to any winner,
and in particular to our optimal winner.

An alternative condition for winning in general is the ability to win
from one’s strongest opponent. This gives the fixed point condition.
Define _f_(_x_) = _P_(_x, P_(_X_ \ {_x_})), which is the general
function ‘the vote result of _x _and its alternative winner’. Then _w*_
is the solution to the fixed point condition _x_ = _f_(_x_):

_w* = P_(_w*, v_(_w*_)) =_ P_(_w*, P_(_X_ \ {_w*_})) = _f_(_w*_)

When the unrefined winner _w _is not a fixed point, i.e. when the
unrefined winner _w_ = _P_(_X_)_ _appears to lose from _v,_ so that _w
P_(_w, v_), then the search process can start again from _v. _

It appears that this fixed point voting procedure reduces the
dependence upon budget changes. There can still be a dependence, but it
is not as large as without the condition.

In Table 13, the Borda Fixed Point winner is _A_. With _B_ the Borda
winner, _A_ is the alternative winner when _B_ does not participate,
and _B_ loses from _A_ in a pairwise match; starting the search from
_A_, its alternative winner is _B, _and _A_ wins from _B_.

More on this can be found in Colignatus (2001). That book has also been
intended as a textbook and it developed _Mathematica_ programs for the
various voting schemes and data manipulations. Given the complexity of
the matter, this working environment has appeared a great advantage.

Relation to Saari’s work

Donald Saari (2001ab) showed that Borda’s method is the only method
that satisfies certain symmetries. His suggestion is that the Borda
rule ‘therefor is best’. This argument does not convince by itself
since ‘symmetry’ is not by itself a moral category. Dynamics is linked
to morality, by the notion that morality presumes time, and thus seems
a better angle.

Consider direct symmetry first. Suppose that your preference is _A > B
> C_ and that my preference is _C > B > A_. The direct symmetry
consideration is that we might both abstain from a vote and stay home,
since our preferences strictly oppose each other. Saari noted too that
voting cycles can be catalogued under the mathematical concept of
rotational symmetry. His subsequent suggestion is that cancellation
should hold for _all_ symmetries for _all_ subsets of voters.

What happens when cancellation of ‘rotational symmetry’ is applied to
subsets ? The following is an example by Saari that cancellation isn’t
trivial then. In Table 14 there are 48 voters, and _B_ is selected by
both Borda and Condorcet. In Table 15, 27 voters have been added who
have the mentioned rotational symmetry, with 9 for each subgroup. Now
Borda still selects _B,_ but Condorcet, and the Borda Fixed Point,
select _A._ In Saari’s view, Borda satisfies symmetry, and ‘hence’ is
the better method.

My reasoning is a bit different. First of all, note that I myself have
used an argument similar to that of Saari. In my view, the typical
Condorcet situation of three preferences _A > B > C_, _B > C
> A_ and _C > A > B_ results into indifference rather than an
inconsistency, and I use this against Arrow’s analysis. So I agree with
Saari’s view that such votes cancel. I applaud Saari’s insight that if
you apply cancellation for _all_ cycles in _all subsets_, then the
logic is to get rid of Condorcet’s method and to use Borda’s method.

Table 14: Start with 48 voters: Borda _B,_ Condorcet _B_

_ _

_Candidates and their rank order weight_

_Number of voters_

_A_

_B_

_C_

_Borda weighted total_

116

124

_A versus B_

_A versus C_

_B versus C_

Table 15: Add 27 ‘neutral’ others: Borda _B,_ Condorcet _A_

_ _

_Candidates and their rank order weight_

_Number of voters_

_A_

_B_

_C_

_Borda weighted total_

170

178

102

_A versus B_

_A versus C_

_B versus C_

Secondly, however, my problem remains that there is the phenomenon of
budget changes. Note that Saari’s example uses a changing electorate
rather than a changing budget. My suggestion is that a change in the
electorate would require a new vote, while we would want to avoid that
in case of a change in the budget. The Borda method would be best,
_only_ when the budget would be really given. When it might change, the
application of cancellation to _all subsets_ becomes doubtful, since
subsets change. There is a fundamental uncertainty with respect to the
future. Consider the following example. At a specific point in time,
the population of a nation is given, and thus the vote for a President
has a specified budget: the population. But, uncertainty sets in again,
when people may withdraw from the race. Only a few actually run. Hence,
we might well want a rule to deal with possible changes in the budget.
Hence, it is not logically required that we cancel votes for all
possible subcycles (also for candidates who are _not_ in the race).
Saari is very strong on the argument that when we accept cancellation
in one case, then we should do so in all cases. I am more sensitive to
the exception: when ‘if one, then all’ does not hold.

Concerning Table 14 and Table 15, my reasoning is - contrary to Saari -
that the added votes cannot be neglected. The argument of rotational
symmetry breaks down when we compare a winner with the alternative
winner - which is a pair - while rotational symmetry requires a third
candidate or more. For the pair, the addition has an effect. When we
consider unrefined winner _B_ and its alternative winner _A_, then the
added votes are in favour of _A_ and no longer ‘neutral’. While _C_ is
important since it shows a cycle for a subgroup of voters, another view
is that _C_ could be neglected since it is not a fixed point. Canditate
_C_ is a typical example of an irrelevant candidate that can cause a
preference reversal in Borda voting. Namely, let us consider Table 15
under Borda voting, and let _C_ decide to drop from the race: then_ A_
becomes the winner. The Borda Fixed Point method has been developed
precisely to deal with that kind of preference reversal.

Thus, when you select your voting method then you must choose between
the properties exemplified by this case. (1) Borda is subject to
preference reversal. In the example of Table 15, when _C_ drops out,
then there would be switch from _B_ to _A_. (2) The Borda Fixed Point
method still depends upon the voting field. In this example, when 27
voters drop out, then there is a switch from _A_ to _B_.

The choice basically is whether we attach more importance either to the
voters or to the candidates. Saari suggests that the candidates are
more important, since he cancels the votes of 27 voters and keeps _C_
in the race. I would say that the voters are important and that
candidate _C_ is less relevant. The proper question would be whether
the winner is a convincing winner. Of course, _C_ can become an
important candidate when we add other voters. But then the argument is
that those voters count, rather than _C_.

Consider the impact of semantics. While it has been a long standing
notion that cycles may also be taken as indifference, so that the votes
cancel, Saari now rephrases this as rotational symmetry, and he
suggests that acceptance of rotational symmetry implies acceptance of
it for all cases and subsets. The label might be a common mathematical
label, but I have a problem with that label in the realm of morality
(and the implied universality). Human beings seem to have biological
preference for symmetry, and by labelling something as ‘symmetry’, it
becomes more attractive. When discussing the different voting schemes,
we should be aware of such effects, and try to focus on what the
properties really mean, and we should make a proper distinction between
a property that is universal and a property that is dependent upon the
situation. Perhaps it might be analysed as the ‘mathematical frame of
mind’ that acceptance of a property for one set also implies acceptance
for all other (sub-) sets, but my conclusion is that when we look
closer, that there is room for more subtlety. Indeed, it might well be
that considerations of symmetry apply to the static situation, but that
we need other considerations for dynamics.

Another example for this need for subtlety is that the ‘rotational
symmetry’ argument breaks down on the _status quo_ (see below).

Saari has also developed an ingenious way to depict voting schemes
geometrically. For 3 candidates, this becomes a triangle, and the
different procedures can be calculated from that. It appears that these
triangles are a good educational tool. However, my experience is that
the computer programs (Colignatus (2001) uses _Mathematica_) are easier
to use, since they take away the need for calculations, while they are
available for more dimensions and also allow for indifference and not
just strict preference. A complex scheme like the Borda Fixed Point
also requires more work with the triangle, while in _Mathematica_ it is
a simple procedure call. It may be noted that above discussion of the
Borda Fixed Point method has been simplified by assuming single
winners. In practice, there can be ties, complicating the search, and
requiring tie-breaking rules.

Pareto

Another consequence of the switch of attention from statics to dynamics
is the recognition of a _status quo_.

There appears to exist another wide-spread confusion about ‘majority
voting’. This idea is that a majority result would still be
democratically valid, even if the winning decision implies a real loss
for the opposition. The counter-example is when the majority decides
that the minority pays $1 to the majority: this is not necessarily a
morally acceptable situation, even though there is a majority. From a
moral point of view, each voting scheme should have two rounds: a first
round to select the Pareto improving points compared to the _status
quo_, and then a second round to select the winner from those Paretian
improvements. The majority rule thus can be regarded as only a
tie-breaking rule, namely for the deadlock when there are more Pareto
improving points. In elections of persons, the status quo can be a
vacancy, and in that respect all candidates could be taken as Paretian.
But the Paretian pre-condition cannot be skipped in general.

The Paretian condition may require some subtlety. Consider the family
choice for a holiday to Greece or Spain, discussed above. If little
Robby considers the holiday to Spain to be a deterioration from the
status quo of not having a holiday at all, then there is moral argument
to say that Spain is not a valid option to take a vote on. However, if
it can be established in a first round that going on a holiday is
unanimously a good idea, then Robby has to accept a possible majority
decision in favour of Spain and against Greece.

One argument against the selection of Pareto improving points is that
people might also cheat about these points. This argument is not
convincing, since Pareto improvement is in one’s own interest. Indeed,
little Robby might try to veto Spain by saying that he does not want a
holiday, and thus he might be trying to bargain to get everybody to
accept Greece. However, this ploy can be prevented by having that first
round on having a holiday, since if he really wants a holiday anyhow,
then he has to show this then. Careful construction of the voting
process thus remains an issue.

A note on cheating

One of the key problems in voting theory is strategic voting behaviour,
better known as cheating. In a scheme like Borda, cardinal utility has
already been reduced to ordinal utility, so perhaps we should be
lenient and allow voters to maximize their utility from the final
outcome by manipulating their vote. But our opinion on this does not
matter, since the ballot generally is secret and we cannot stop people
from voting strategically anyway. In fact, my _Mathematica _programs,
Colignatus (2001), contain routines for cheating. These are simple
routines that assume both full information and that others don’t cheat,
since the mathematics of cheating while assuming that others cheat too
is rather complex, especially when nobody has full information about
the true preferences. Given all this, one surmises that election
results do not reflect the true state.

Thinking about these issues gave me an idea that might be helpful to
elicit the true state. Suppose that each voter is informed in advance
that there is a probability _p _that the ranking order that is
submitted will be used by the election computer for strategic voting.
If the voter submits his or her true ranking, then this is rewarded
with probability _p_ to improve the election result for that voter, and
much better than the voter can, since the computer knows all submitted
rankings. If the voter submits a strategically adapted ranking, then
this is punished with probability _p _namely to improve the election
result for that false ranking. Likely there is a specific value of _p
_that would generate the most truthful election result. Unfortunately,
I haven’t had time to develop this idea.

Conclusion

An election result is ‘as much’ the result of the procedure as of the
preferences. Arrow’s Impossibility Theorem is complex and full with
paradoxes, but the dependence of morality upon time provides a way
towards solution.

There are two key conclusions:

(1) The Pareto condition for the candidates under ballot should not
be neglected - i.e. that only those candidates are voted on that are an
improvement compared to the _status quo_.

(2) The Borda Fixed Point can be seen as a compromise between the
Borda and Condorcet procedures (on Paretian points), and provides a
degree of protection against budget changes.

There is also another conclusion. Voting is complex, and becomes
increasingly complex when the numbers of candidates and voters rise
(especially when we also include indifference and not just strict
preference). Direct election of a President becomes quickly infeasible
for the more advanced voting procedures. From this observation we can
conclude that it is better to have a proportional parlementary system,
so that the elected professionals can use the advanced voting
procedures to select the President. This approach of representation
also prevents that there is a different electoral mandate for President
versus Parliament. Note that the discussion above, on Arrow’s Theorem
and the Borda Fixed Point method, considers single seat elections, and
not multi-seat elections. But the complexity of direct single seat
elections tends to support this conclusion on the overall system of
proportional representation and indirect election of the chief
executives.

36. Some notes on ethics

The following notes on ethics are not well developed but the points are
useful to observe.

(a) I was struck by Keynes’s quote: “along the line of origin at
least, economics - more properly called political economy - is a side
of ethics” (Skidelsky (2000:264)). This is a point that is commonly not
seen by the general public who associate economics with money, and
neither by many economists who don’t appreciate the subject of
political economy.

(b) Ethics focusses on survival and the good life (“flourishing”).
That is, just like laboratory animals require an optimal environment,
humans have their own conditions for flourishing. Csikszentmihalyi
(1997), “Living well. The psychology of everyday life”, clarifies the
required balance between challenge and competence: too much challenge
causes stress while too little challenge causes boredom. The Rasch
model, also known in psychology as the item-response model, or the Elo
model used for Elo rating in chess, seems to fit the situation.

(c) Colignatus (2003), “On the value of life”, essentially focusses
on survival: the lifeyears saved and the allocation over individuals.
On the quality of life, the “flourishing”, I only have a rough outline
“On the price of health”.

(d) The chapter “Without time, no morality” of course links with the
discussion in chapter 19 on determinism and free will, and the general
importance of ‘dynamics’ for this book.

(e) There was a seminar by McCloskey on virtue ethics that was
illuminating and that I can advise to who has a chance to attend. Smith
(1759, 1984), “The theory of moral sentiments”, featured strongly.

(f) A general point in ethical theory is that people aren’t really
‘souvereign consumers’. They grow from dependent children to mature
adults to dependent seniors, so that there is always a degree of
dependency. Political economy takes this into account. The standard
economic approach that assumes souvereign consumers however can still
be useful for analysis even while being limited in this respect.

(g) Another point concerns the distinction between ‘rules’ and
‘rhetorics’. In ethics, it does not suffice to have rules only, since
these must be applied to practical situations – where rhetorics apply.
In law, there are not only laws but also courts. Current literature in
economics tends to emphasize rules. If economics had courts too then
there might be less imbalance. The suggestion that there be economic
courts links with the idea of an Economic Supreme Court.

(h) There are some other advisable books that enrich our
understanding of humanity, (social) behaviour, ethics and its
biological roots, which form the input for and target of political
economy. Tiger (1992), “The pursuit of pleasure”, mollifies the
economistic calculus of utility, which at the same time clarifies that
it still can be useful to use small abstract (simplistic) models to
develop arguments that can improve the lifes of many. Damasio (2003),
“Looking for Spinoza”, delves into the brain to understand human
emotion and feeling. Though many dimensions exist, there still is the
pain and pleasure dichotomy that links to ethics. Damasio also notes
that biological ‘emotions’ (generally) arise split-seconds before being
reflected in ‘feeling’ in the mind. This phenomenon raises the question
of ‘free will’ and the reader is referred to that section in chapter 19
above. De Waal (2001), “Tree of origin”, discusses whether primate
behavior can tell us something about human social behaviour, and the
same themes arise. Cavalli-Sforza (2000), “Genes, peoples and
languages”, focusses on recent human evolution. Diamond (1997), “Guns,
germs, and steel”, makes us aware of the impact of mere geography. All
these books clarify that political economy can be of value for humanity
by keeping an open eye for the study of humanity itself.

(i) Cavalli-Sforza (2000:207) concludes with this statement: “It
will be necessary, for example, to be more successful in spreading the
necessary moral values to the whole world. Is the amount of deception,
hatred, exploitation, and unrestrained selfishness we observe in almost
every society inevitable ? We need not be too pessimistic and should
admit that people do not always display their worst qualities. But it
would be valuable to learn exactly the conditions that elicit these
destructive tendencies, in order to systematically prevent them.
Overpopulation and extreme competition for valuable resources
undoubtedly contribute. Our aptitute for social engineering is limited,
although we must become more serious about work in this area, so as to
end - or at least reduce - major social ills such as poverty,
ignorance, population growth, racism, drug addiction, crime, and other
social epidemic and endemic diseases that afflict us. Our efforts in
this regard can be helped by studying cultural transmission and the
forces of conservatism that hinder useful innovations, as well as the
danger posed by promoting and accepting great changes too soon.” I can
only agree with this, and the current book fits this objective.

Book VIII Supportive notions

37. On the nature and significance of a free lunch

It has been a cause of wonder for the present author why other
economists are not more outspoken on the Tax Void, and why above
theorem on the possibility of returning to full employment meets such
disbelief as it apparently does. In the course of time, I found that
the following issue forms part of the explanation.

Many economists think that there are no free lunches. It may even be a
dogma or mantra to them. With this general attitude, they close their
eyes to the free lunch that presently exists in the inefficient labour
market. They adhere to their ‘no free lunch’ philosophy regardless of
what arguments other people forward. My diagnosis is that this is one
of the reasons why the debate on unemployment is rather stuck.

It actually can be shown that the economy is full of free lunches. We
will discuss two examples below, namely the examples of the consumers
surplus and economic growth. By regarding these examples we will better
appreciate the _nature and significance_ (as Robbins might say) of a
free lunch. When the possibility of a free lunch is accepted, then we
can discuss unemployment in more realistic terms.

Some quotes

The American science fiction writer Robert Heinlein once created a
rough Moon Colony where the rules of the free market are exploited to
their limits. In this colony the phrase “Your money or your life” is
not a criminal threat but a sound business proposal - and a bargain for
many as well. In the same vein all incidents in the novel are subject
to bets - and after some consideration, the reader of this novel may
well accept this as a useful system of rational contingent forward
markets. Then, properly, the slogan & law of this Moon Colony is
TANSTAAFL: “There Aint No Such Thing As A Free Lunch”.

TANSTAAFL is rather “accepted wisdom” in the economics profession, and
not something that is subject to critical discussion. There are only
few explicit statements on the supposed absence of a free lunch. A
recent statement is by Cnossen & Van Ewijk (1995):

“No society limited in resources can for a moment proceed from the
premise [sic] that there is such a thing as a free lunch. Dispassionate
analysis of the problem and hard-headed calculation of the costs of
alternative courses of action are called for. This applies especially
to the economics discipline, which gives center stage to the concept of
opportunity costs.”

So, evidently, in the views of these authors, people disagreeing to
their views on this issue are emotional or soft-headed !

Coase (1994:200) has a fine anecdote:

“Charles Walgreen in 1936 withdrew his niece from the University of
Chicago because he had been informed that the university taught free
love and communism. I know nothing about the university’s teaching on
communism but presumably Mr. Walgreen would not have been mollified to
learn that the true Chicago view is that there is no such thing as a
free love. Eventually, however, Mr. Walgreen was convinced that he had
been misinformed (...)”

The British newspaper The Economist (1994b) and the Dutch economist Van
Bergeijk (1994) state, in reaction to proposals by Snower, that there
would be no free lunch on the labour market. Even with current
unemployment, it would not be possible to change taxes, contributions
and benefits in such manner that this would raise employment
opportunities for the unemployed without other agents having to pay
some bill.

These latter authors use arguments for their views. So their judgement
does not seem dogmatic. However, their arguments have been refuted.
Authors like Snower and myself, and many others, have also pointed to
the possibilities for improvement in the labour market, and these
arguments have not met with convincing rejections. So it may well be
that TANSTAAFL works its ways in the back of the minds and hinders
proper balancing of arguments.

We somehow might welcome the Cnossen & Van Ewijk statement, since it
makes explicit what often is only implicit. In the following I shall
deal with the problem in general. I hope to banish TANSTAAFL to the
domain of science fiction, so that thereafter we can discuss the labour
market in more useful terms.

Consumers surplus

The more innocent examples of free lunches happen around us every day.
For example, in a free country, a transaction occurs only when both
parties get something out of it. TANSTAAFL adepts will hold that when
there is a transaction, and people pay for their lunch, then there
clearly is no free lunch. However, the theory of the consumers surplus
reminds us that you may pay for your lunch, but likely not as much as
you might be willing to pay. If you would not get more out of it, there
would be little point is actually doing the transaction. In everyday
life, we see few people exchanging dollars for dollars, just for the
fun of it. So if _p _is what you pay for your lunch, and if _wtp _is
your willingness to pay, then _wtp - p _is your free lunch.

One might argue that the TANSTAAFL conjecture properly reads that _p
_0. Thus TANSTAAFL-ists accept that _wtp > p, _but the point would be
that you have to invest a nonzero amount before you can reap greater
benefits. It would seem to me that the following is the proper reaction
to this:

1. We might accept a definition that ‘no free lunch’ means _p
_0.

2. However, that definition does not warrant universal truth.
Some goods have _p _= 0, notably endowments, ideas and, in a sense,
public goods.

3. So, please then, do not use this mal-definition to kill
arguments on the labour market that concern new ideas.

4. And, please see the point that it may be advisable to define
‘_p _0’ ‘there are some costs’, and ‘_wtp > p’ _‘there_ _is a free
lunch’_._

In a sense, the discussion might only be about words. But there are
also emotional connotations involved, that should cause us to be rather
careful in that choice.

Economic growth

Economic growth is another instance of manna from heaven, and also a
phenomenon that has been with us since the dawn of mankind.

An invention in one industry will generally have consequences for the
entire economy. The industry of origin can seldom claim all proceeds.
When the optimal ratio of production factors changes, then prices
change. E.g. just by mentioning the possibility of other prices, one
signals to the other parties that there is room for discussion. The
other parties will use that room, and their knowledge and possessions,
to claim part of the economic value of any innovation. Other parties
have had no effort in bringing about the innovation, but they consider
themselves partners in the industry, they know their leverage, and,
thus, exploit it. Their advantage not only concerns the consequences of
a better product, but also an improvement of their income position.

Model

In a general equilibrium framework we consider an economy with 400
units of labour and 600 units of capital. The economy produces food and
clothing, and a social welfare function (SWF) determines the optimal
combination. Here, our SWF will be a Cobb-Douglas function that
neglects the distribution of income:

(SWF)

Labour _a _en capital _k _are allocated to the food (v) and clothing
(k) industries via _av + ak = 400 _and _kv + kk = 600. _Industrial
output is determined by the production functions. Here we take
CES-functions, that have a constant elasticity of substitution between
capital and labour:

Equilibrium and the optimum are found at 278 units of food and 253
units of clothing, with a distribution of the factors of production of
_av/ak_ = 299/101 and _kv/kk_ = 210/390.

The allocation can be shown using two figures. Figure 36 confronts the
social welfare function with the Production Possibility Curve (PPC).

Figure 36: Social Welfare and the Production Possibility Curve

The PPC gives those combinations of food and clothing that can be
produced with the scarce resources. The choice of the highest possible
value of the SWF generates a tangent of a contour of the SWF with the
PPC. The tangent gives the optimal price ratio (thus trading ratio) of
food and clothing.

Figure 37 confronts the production functions of the separate industries
in an Edgeworth-Bowley diagram. The food industry has its origin in the
lower left-hand corner, and the clothing industry has its origin in the
top right-hand corner. The amounts of capital and labour that are not
allocated to the food industry are allocated to the clothing industry.
The drawn contour for the food industry gives those combinations of
capital and labour that produce the same amount of food. That contour
is touched in a tangent by a contour of the clothing industry. The
collection of all tangency points is called the contract curve. The
tangent drawn here passes through the optimum selected by the SWF. This
tangent thus also determines the price ratio of wages and capital rent.

Now we assume that there is an innovation in the clothing industry.
This innovation can be of technical or organisational origin, and it
causes that the same garment can be produced with a little less labour
but a little more capital. To be concrete: the production possibility
is discovered that can be stated in the production function _clothing =
CES_[0.2, 0.5]_._ Is this innovation useful ? The answer appears to be
that labour is the factor that is relatively scarce and that this
innovation allows its better use, so that welfare can rise to 282 units
of food and 269 units of clothing. The allocation of factors of
production becomes _av/ak_ = 309/91 and _kv/kk_ = 202/398.

Figure 37: Edgeworth-Bowley diagram for the factors of production

Figure 38 and Figure 39 present the same plots as before so that one
may see how the economy changes. The figures speak for themselves. It
will be clear that our analysis is comparative statics. How quickly the
prices change, and how quickly the agents react, will be a question of
dynamics.

Figure 38: SWF and PPC of two situations

Figure 39: Edgeworth-Bowley of two situations

The free lunch

Above model was not perfect but helps us to understand how a free lunch
percolates through the economy. It helps us to understand what a free
lunch actually is.

In above model, the innovation falls from heaven like manna. The
innovation is the free lunch. One may see the tautology: If you accept
the model, then there is a free lunch; and you accept the model if you
see innovation as a free lunch.

One may hold that above model is incomplete. One would want to
introduce a separate R&D sector, and then there will be a balancing of
R&D costs and the expected increase in national income. As an
economist, I’m very much in favour of developing such models. However,
actually doing this only moves the question one station further, and
does not answer the proper question. For, it is possible that an
economy spends 99% of its resources to R&D, and still does not come up
with innovations. Good ideas remain like manna from heaven.

You may hold the view that agents already expect economic growth, so
that they will not regard it as a free lunch. This reminds of the
attitude of some children of rich parents who expect a rich inheritance
and who don’t show gratitude for their daily bread. The point to note,
though, is that the concept of a free lunch is not an expectational
variable, but one of circumstance. There is a free lunch or not,
whatever one expects. Indeed, as another example, our wealth is a
cumulation of free lunches in the past. That we don’t experience this
as a free lunch anymore, is more a sign that we are spoiled, rather
than a sign of our dynastic rationality.

And even if we would design a revised expectational concept of a free
lunch: then perfect foresight or rational expectations are only
assumptions. There is always the possibility of a surprise idea. The
future is uncertain (though predictable) - even though our scientific
predisposition is deterministic.

Let me rephrase the point that I want to make here. There are data
(exogenes or endowments such as soil, sun, technical relations and the
like), the economy depends on the use of these, and the development of
the economy can be described in terms of the developments in these
data. The data are for free. Ideas are part of these data, and the
(major) source of uncertainty. In this terminology, there are free
lunches_ by definition_. That is the crux. When economists better deal
with their definitions, we get better economics.

Conclusion

Our discussion on the consumers surplus showed that much may be a
matter of words. However, using an abstract argument and a concrete
small general equilibrium model, we showed that innovation and economic
growth are an example of a free lunch for the whole economy. Our
intention was to refute the attitude of “there aint no such thing as a
free lunch”. Hopefully, this refutation creates more room for
discussion of proposals concerning the present immense inefficiency on
the labour market. The latter discussion is especially important, since
the major proposals for solving the inefficiency concern _ideas_ by
impartial economists.

Note 1999: I was afraid that I would clash with Paul Krugman on this
issue, since he has a Fortune column ‘No Free Lunch’. To my great
relief, Krugman (1999:167) however writes: “And this brings us to the
deepest sense in which depression economics has returned. The
quitessential economic sentence is supposed to be “There is no free
lunch.”; it says that there are limited resources, that to have more of
one thing you must accept less of another, that there is no gain
without pain. Depression economics, however, is the study of situations
where there _is_ a free lunch, if we can only figure out how to get our
hands on it, because there are unemployed resources that could be put
to work. In 1930 John Maynard Keynes wrote that “we have involved
ourselves in a colossal muddle, having blundered in the control of a
delicate machine, the working of which we do not understand.” The true
scarcity in his world - and ours - was therefor not of resources, or
even of virtue, but of understanding.” Hurray!

38. Proper definitions for uncertainty and risk

This discussion will present proper definitions for uncertainty and
risk. Such definitions are required since the current definitions in
common use are rather erroneous and generate conceptual problems.

Uncertainty

The new definitions are - see also Figure 40:

(1) First there is the distinction between _certainty_ and
_uncertainty_.

(2) Uncertainty forks into _known categories_ and _unknown categories_.

(3) Known categories forks into _known_ and _unknown probabilities_.

(4) Unknown probabilities forks into_ assuming a uniform
distribution_ (Laplace) or use_ _non-probabilistic _techniques like
minimax _or _neglect._

Note that these definitions only use certainty, knowledge and the
distinction about categories (category-uncertainty), and that they do
not use the term ‘risk’. Thus an independent definition of ‘risk’ is
possible.

A.S. Hornby (1985) “Oxford Advanced Learner’s Dictionary of Current
English” defines ‘uncertain’ as: “1 changeable; not reliable: _~
weather; a man with an ~ temper_. 2 not certainly knowing or known:
_be/feel ~ (about) what to do next; a woman of ~ age_, one whose age
cannot be guessed”. The above fits this.

Figure 40: A diagram of the new definitions

Risk

Hornby (1985) defines ‘risk’ as: “(instance of) possibility or chance
of meeting danger, suffering loss, injury, etc.” Also: “at the ~ risk
of / at ~ of, with the possibility of (loss etc.)”.

Thus, if there are possible outcomes _O_ = {_o1, o2, ..., on_}, then
the situation is risky if at least one of the _o_’s represents a loss.
The risks are the _oi_ that are losses, thus _Risks_[_O_] = {_oi_ _O
| oi_ is a loss}. The risk factors are the positions or index numbers
of the risky outcomes, the i’s, or the dimensions (the causes that make
such positions to be filled).

We will use the term ‘valued risk’ when a risk is valued with money or
utility. When all risks have been made comparable by valuing them, then
we can add them, and we will use the term _expected risk value_ for the
_expected value of the ‘valued risks’_. Then, crucially, once these
definitions are well understood, then we may also use_ ‘the risk’_ for
the expected risk value. [110]

With such understanding, risk will be _r _ = -E_x_<0[_x_] [111] or for
short _r_ = -E[_x_ < 0]. [112]

Valued risk deals with the cases when probabilities are known _or_ when
unknowns are assumed to be uniformly distributed over known categories.
It is not customary to use the term ‘risk’ for unknown categories. For
example, it is uncommon to say, or write economics papers about this,
that “all our lives are _at risk_ of a suddenly imploding universe, or
black hole hitting Earth, or waking up as a cockroaches”. Such real
‘Acts of God’ are commonly neglected. Note though that it still remains
possible to say that a situation is risky even though one cannot put a
number to it. Above expectation may be indeterminate since one may lack
knowledge about the probability distribution or even the categories.

_ _

_Relative_ risk is defined as _r(t)_ = _t_ - E[_x < t_] for some target
level _t_. Risk (or _absolute_ risk) takes _t_ = 0, and relative risk
would allow for a different target level. [113]

An interesting application is when _x_ is a stochastic rate of return
and _r _the certain rate, so that there is relative risk _r(r)_ _=_ _r_
- E[_x < r_]. This relative risk answers the question: What is the
probable loss with respect to a target return of _r _? Here, _r_ -
_r(r) = _E[_x < r_] gives the weight of underperformance in the total
target return (which weight has to be compensated by probable profits
to achieve the target).

_ _

_Conditional _(relative) risk is defined as _k(t)_ = _t_ - E[_x_
| _x < t_] for some target level _t_. With respect to rates of
return, conditional risk _k(r)_ answers the question: What would one
expect to lose with respect to _r_, if earnings actually underperform
and fall below _r_. Indeed, _r_ - _k(r)_ would give your expected
return when actually underperforming.

Conditional risk is related to relative risk by the property that E[_x_
| _x < t_] = E[_x < t_] / Pr[_x < t_]. The probable loss thus is
corrected for the probability of the loss. Or, the probability measure
in the expectation is corrected so that a density is taken that sums to
1. [114]

Example

In everyday parlance, profit and loss are nonnegative concepts. For
example, if the difference between revenue and costs is $-10, then your
loss is $10. It is only in mathematical economics that profits are
defined as a general profit function such that ‘negative profits’ are
possible. To understand risk, we however return to the everyday
parlance convention.

Let us have a prospect that can give _profit_ with probability _p_, and
_loss_ with probability 1 - _p_. We denote this as Prospect[_profit,
-loss, p_]. We call _profit * p_ ‘probable profit’ and _loss * (1 - p)_
‘probable loss’. Then the following definitions apply:

· Expected Value = _ _= _p profit + (1 - p) (-loss)_ = probable profit
- probable loss

· Risk = risk value = expected value of the risks = probable loss = _(1
- p) loss_

· Risk Ratio = Risk / (ExpectedValue + Risk) = _(1 - p) loss / (p
profit)_

· Thus: Expected Value = _p profit _(1 - Risk Ratio)

· Risk Probability = cumulative probability of all losses (in this case
1-_p_)

Risk is the (absolute value of the) down side of a bet. A venture is
judged to be risky if the probable loss is large. Note that this notion
still is somewhat vague. A probable loss can be large because of the
probability or because of the sum of money involved. This vagueness is
unfortunate, in some respects, but here is little to be done about it,
since this vagueness is inherent in working with probabilities. In
fact, this vagueness is an essentially positive aspect of working with
probabilities. For, when we have different prospects, then we can order
and evaluate them on risk, neglecting differences in losses and
probabilities.

Colignatus (1999, 1999a) further develops these notions for simple
binary prospects, multidimensional prospects, joint prospects, and
continuous probability densities. An interesting application is the
‘Markowitz efficiency frontier’, but now with risk rather than the
spread.

Wrong use in economics 1921-2005

The above definitions are proper in the sense that they conform to
every day parlance and the definitions provided by Hornby’s dictionary
op. cit.. The definitions provided here however differ from the use
within the economics literature. First there are the definitions of
Knight (1921) that have been adopted widely in economics, as for
example in The New Palgrave (1998:III:358). Or it has become custom in
finance to associate risk with the standard deviation. And some
mathematical statisticians use another concept of risk. Let us discuss
these in turn.

Uncertainty and risk

The New Palgrave, Eatwell c.s. (1998:III:358), gives the current common
view:

“The most fundamental distinction in this branch of economic theory,
due tot Knight (1921), is that of risk versus uncertainty. A situation
is said to involve _risk_ if the randomness facing an economic agent
can be expressed in terms of specific numerical probabilities (these
probabilities may either be objectively specified as with lottery
tickets, or else reflect the individual’s own subjective beliefs). On
the other hand, situations where the agent cannot (or does not) assign
actual probabilities to the alternative possible occurences are said to
involve _uncertainty_.”

Indeed, most economic texts use this distinction in this manner (at
least, up to now). However, I cannot disagree more. The objections to
Knight’s concept are:

(a) Certainty and uncertainty are _binary_. So, if a situation is
not uncertain, then we have certainty, and there is no assigning of
probabilities.

(b) If I am uncertain about a situation and assign equal
probabilities to all cases - the Laplace suggestion - then according to
Knight this no longer is uncertainty!

(c) In Hornby’s definition, the distinction is not between known and
unknown probabilities, but the distinction is between _events_ and
_human thought_.

Figure 41 contains a diagram of the objectionable use of terms
1921-2005.

Figure 41: A diagram of the current but objectionable use of terms

The diagram clarifies the inconsistency with the binary character of
certainty/uncertainty, the curious treatment of “Laplace”, and the
over-use of terms by introducing the term ‘risk’ where there already is
the qualification that the probabilities are known.

Risk is not the variance

The finance literature often uses the term ‘risk’ for the variance or
spread (standard deviation) of the distribution of the rates of return
of investments. This would be an improper use of the term. Suppose that
one has a very profitable venture without the possibility of a loss.
Suppose that the rate of return of this venture has a large variance,
from mildly profitable to highly profitable. Is this a risky venture ?
No, not in the usual understanding of the term.

Risk is not the negative of expected revenue

In mathematical statistics, some authors, like Ferguson (1967), define
‘risk’ as ‘expected loss’. However, it appears that they actually
regard ‘loss’ as the negative of total returns (i.e. - revenue), so the
definition used is -(_p profit + (1-p) (-loss))_, which is the negated
expected value. This use of the term ‘risk’ is inappropriate. My
proposal is to use the word “due” to stand for the negative of expected
value, so that the standard statistical decision theory (with the game
against nature) can be described as minimising _due_.

Note on Bernstein’s “Against the gods”

I came across Bernstein (1996) “Against the gods”, and found it equally
entertaining as his “Capital Ideas”. One comment is that Bernstein
indeed emphasises Knight’s and Keynes’s statements on “uncertainty”. My
answer to that is, again, that unknown probabilities or even unknown
categories indeed are serious cases of uncertainty, so that earlier
writers on the subject were right in emphasising that seriousness.
However, we should not be tempted to reserve the word “uncertainty” to
only those cases. So with all due respect to Knight and Keynes, the
definitions provided here are the proper ones.

Note on Wilson & Crouch (2001)

Wilson & Crouch (2001), “Risk-benefit analysis”, adopt the same
definition of “risk” as discussed here. I saw this only after the first
edition of this book. Since professor Wilson has been teaching on the
subject for decades and his book only collects his teaching material I
apparently only rediscovered what was already clear to him. Perhaps my
presentation is a bit clearer since I use the formal E[.] notation.
This chapter remains useful since it clarifies the confusions from the
other definitions. Where risk is the product of probability and
severity, this book also benefits from the emphasis on this definition,
since, where I started to develop this argument after the Fall of the
Berlin Wall in 1989, we have to deal with a future where there are huge
dangers: though with only a small probability but on balance a relevant
risk.

Book IX
Reduced form

39. The possibility of full employment in the welfare state

Introduction

Above we noted that the structural form of western welfare states is
quite complicated. We would like to have a more enduring result than
awareness of complexity, and therefor we adopt the Definition & Reality
methodology. As said, a_ proposition - _as a statement on reality - can
be regarded as a mathematical theorem about/within a model of stylized
facts. When there is a tautology, we attain truth by definition. So we
now (a) restate what we consider to be the stylized facts, (b) define
our concepts, (c) develop theorems and proofs, (d) link back to
conclusions about reality.

The reduced form that is most relevant concerns the (long run)
comparative statics of the regimes of full employment (1950-1970;
Japan/Sweden) and unemployment (1970-2005).

This kind of comparative statics should not induce us to think that we
abolish dynamics, though. Stagflation has both a dynamic (inflation)
and a static or stationary (unemployment) aspect. When we skip proper
dynamics and discuss regime switches in which unemployment features as
an important switch variable, then Phillipscurve processes are included
in the switching process, even though they don’t feature explicitly in
the reduced form.

To attain the necessary level of generality, we use a reduced form
where the economy is mapped into a model with three types of agents.
One type is the net receiver; and two types are net tax payers. Since
the latter two points give a line, that single line represents the
state of the economy. The regime switch depends upon the choice of tax
parameters.

Stylized facts

There are regimes of full employment (1950-1970; Japan/Sweden) and
unemployment (1970-2005).

In the welfare state, it is more efficient to have full employment.
Unemployment causes lower income - not only directly as in
old-fashioned capitalism but also, more noteworthy, by the additional
benefit burden. Unemployment can have an adverse effect on inflation
when it causes a shift of the Phillipscurve.

It turns out that the propositions that are most interesting, from the
viewpoint of political economy, do not require continuity, and can be
formulated by assuming dichotomous High and Low productivity labour,
combined with one class of Benefit recipients. This assumption allows
for a reduced form formulation that allows for generality. For
expository reasons we can take social subsistence and productivities as
purely constant. In the simple mathematical model the dichotomy gives
fixed numbers, in actual observation they are subgroup averages which
depend upon general equilibrium processes. The benefit level is rather
not an average but a threshold, like the surface of the sea at
Scheveningen beach. The words _Benefit_, _High_, and _Low_ give letters
BHL, and this abbreviation may be pronounced - converged upon after
many walks - as ‘beachly’.

It is a stylized fact that welfare states are BHL. Checking this
requires next definitions.

Concepts

Here we will redefine variables such as _H, Z, b, n etcetera. _Also the
reduced tax function will be _T_(.) as opposed to structural _T_[.].
These redefinitions hold for this chapter 39 and chapter 40 - that
together form a reduced form unity.

Definition: Biological subsistence, for survival, is _S._

Definition: An economy is a welfare state iff people without
income are not left to charity, stealing or death, but get a benefit
_B._ The benefit _B_ has the following properties:
i. the net benefit has the social subsistence level _B S_,
ii. people on benefit may not work, [115]
iii. eligible are:
iii-a. permanent benefit recipients (e.g. ‘the elderly’)
iii-b. people able to work but currently unable to earn at least
net_ B _(these people are called ‘the unemployed’).

Remark: it is useful to have category (iii-a) in the model. It
introduces a degree of sufficient complexity. When there are levies
even under full employment, then it is easier to understand that wrong
co-ordination may cause a switch to unemployment. But (iii-a) might
count zero people.

Remark: Property (iii-b) has the effect of a legal minimum wage. It
sets a floor in the market. We might introduce a benefit threshold (for
workers) _XB_ such that _S XB < B,_ but for expository reasons, we
take _XB = B._

Remark: The reservation wage effect is as follows. When vacancies with
net income higher than _B_ are registered, then the relevant
unemployment benefits are simply scratched. This mimics the array of
measures needed for continuous reality.

Remark: This definition implies that people working with subsidies in
the Swedish/Japanese case are not on ‘benefit’. Such subsidies thus
must be accounted differently, basically as part of taxes.

Remark: The black economy (another form of working while on welfare) is
neglected. We neglect also the case that some people hate being on
welfare, and thus continue working even when their net earnings are
below the benefit threshold (_S < net earnings < XB _).

Definition: A welfare state is _bhl_ iff it remains meaningful to
trisect its membership into the economic classes of Low and High
productivity workers and permanent Benefit recipients.

Definition: A welfare state is nonrevolutionary, iff its economic
classes and their data are stable across the change of employment
regime.

Definition: A welfare state is BHL iff it is _bhl_ and
nonrevolutionary.

Remark: Denote High and Low gross productivity as _H _and _L._ Note
that _B _is net. Also_ bhl-ness _technically implies _H >> L B._

Remark: _L_ may be associated with a minimum wage and _H_ with some
average income including profits.

Remark: An example of ‘meaningful’ are subgroup subperiod averages.

Remark: Stability can sometimes be found by normalizing, e.g. take
subperiod _H(t)_ as the subperiod numeraire.

Remark: A person’s benefit is often related to the former period
working wage. However, anything can be clustered into a social
subsistence average. People ‘between jobs’ could be taken to be
basically in the employed cluster, people with serious unemployment
could be in the other cluster. Don’t object that this makes the matter
tautological - since that is exactly what we try to do. (We try to find
the definitions that make our understanding tautological.)

Remark: A nonrevolutionary welfare state still allows for politics and
economic change.

Lemma I: A welfare state is BHL iff there is stability over the
regimes for the variables _B, H, L _and the associated numbers of
agents.

Proof: Self evident. Q.E.D.

Remark: The relevant notion is that the change from unemployment
towards full employment (or vice versa) does not destroy the productive
base of the economy. Instead of taking this notion explicitly, we have
taken a stronger property of nonrevolutionarity, that allows, if
_bhl_-ness applies too, to take (approximate) constancy of the
variables.

Remark: At first glance these definitions seem self-defeating for the
effort to apply the mathematical method to employment regime switches.
When 35 million, nowadays unemployed in the OECD, are supposed to find
a job, then apparently the policy maker is supposed to be able to judge
on the ‘stabilities’ involved. That seems an impossibly strong
assumption. We may however remind about the regime switch from
1950-1970 to 1970-2005. In addition, as modellers we discuss
equilibrium states of various paths. Also, it is possible to give the
variables an incremental interpretation, e.g. take 34 of the 35
(million) as permanently on benefit, and only look at 1 million on the
margin (giving “local-BHL-ness”).

Lemma II: For a welfare state, the (apparent) existence of people
with a productivity _L’< B, _does not block the application of
BHL-ness.

Proof: Consider the pathological case of people with productivity _L’<
B, _i.e. so low that (in whatever regime) their net market income is
lower than_ B._ Take the dentists, who in a regulated market cannot
start a practice, and who are very bad at farming in a flowerpot (which
could be done with a Cobb-Douglas production function). These people
can be treated as:

(1) society is willing to classify them as (iii-a)

(2) like the Swedish/Japanese approach, they may keep on working
with some employer subsidy _Z;_ in that case _L = L’ + Z_

(3) society lowers _B_ to_ B = S _or _B = L’,_ and reconsiders
the problem

(4) if regulations are the bottleneck, then changing these
regulations redefines ‘given’ productivity _L’_. Similarly, if
Keynesian methods solve unemployment, then only if people’s _effective
productivity_ is restored. So the reduced form applies anyhow. (In that
case the regulation or lack of a policy measure is a tax in terms of
the reduced form, and ‘real productivity’ is higher than _L’_.)

(5) they get charity, steal or die, and hence there is no
welfare state.

Hence BHL-ness implies that these cases can be ‘averaged out of the
discussion’ or be left out for expository reasons.

Q.E.D.

Remark: In other words, BHL-ness is sufficient for discussing
employment in the welfare state (but not necessarily for other topics,
for example, how regulations affect productivity).

The theorem

Theorem BHL.1: For a BHL economy, both full employment and
unemployment are possible.

Proof:

The structure of this proof is, that we determine the accounting
equations, find the reduced form tax relations that are implicit in
these, and then deduce the critical tax parameters that determine the
regime switch.

Looking at the BHL concept, the only possibility for variation is in
category (iii-b). The recipients in that class all move together, and
thus there are only two regimes (_in_ or_ out of _benefit dependency).
Given that gross productivity has been fixed, the only possible
variation concerns net income. We assign the term “tax regime” to the
possible states in net income. We find, in other words, that these
regimes are implicit in the BHL concept. Let _t_ be the index for tax
regime 0 (unemployment) or 1 (full employment).

Given BHL-ness, we thus have: _t_ is 0 or 1, and:

_ b_ permanent benefit recipients;

_ h_ persons with gross productivity _H_ and net _N_(_t_)_;_

_ l_ persons with gross productivity _L << H,_ and net
_K_(_t_)_._

The regimes are characterized by net income conditions _K_(0)_ < B_
and_ K_(1)_ B:_

(0) In regime 0, _K_(0)_ < B_ and_ l_ are eligible for benefit
_B_, and they don’t work.

(1) In regime 1, _K_(1)_ B_ and _l_ don’t get benefit _B_, and
they work and earn _L._

On benefit, the welfare rule is strict on not-working, while by
assumption the black economy can be neglected. Off benefit, the_ l_
have no other means of support and thus work, and earn gross _L._ Since
net income cannot be larger, _L K_(1)_ B._

In the following equations, personal income _y_ takes values _H_ and
_L._ Relation (1_-t_) below gives the implied tax system, where the
personal tax _T_(_y, t_) depends upon personal income _y_ and the tax
regime_ t:_

_ T_(_H, t_)_ H - N_(_t_)_ ; T_(_L, t_)_ L - K_(_t_)_ _
(1_-t_)

Two points share a line. Hence, the tax system can be represented by a
straight line, with an intercept and a marginal tariff. These implied
‘parameters’ (actually: reduced form variables) are defined in (2_-t_),
with 2 pairs of 2 equations & 2 unknowns, giving tax exemption
_X_(_t_)_ _and marginal rate _R_(_t_)_._ The line is the _reduced form
_representation, while the statutory system which guides people’s
actions could be anything. Each regime gives a _set_ of reduced form
lines; our interest concerns the boundary line.

_ R_(_t_)_ _(_y - X_(_t_))_ T_(_y, t_)
(2_-t_)

Relation (3_-t_) defines national income _Y_(_t_)_,_ where the personal
incomes are multiplied by the numbers of persons involved. Revenues_ h
H + b _0_ = h H_ are regime independent. Depending upon the regime the
_l_ bring in _L_ or not.

_ Y_(_t_)_ h H + t l L + b _0_ _(3_-t_)

Relation (4_-t_) states the condition of a balanced budget. National
income equals the sum of net incomes after redistribution. The
condition may be called “Walras’ Law”.

_ Y_(0)_ = h H = h N_(0)_ + _(_l + b_) _B_
(4-0)

or _ h T_(_H, _0)_ = _(_l + b_)_ B_

_ Y_(1)_ = h H + l L = h N_(1)_ + l K_(1)_ + b B_ (4-1)

or _h T_(_H, _1)_ + l T_(_L, _1)_ = b B_

The budget condition implies that the tax ‘parameters’ are functions of
each other. Per regime, a higher exemption means a higher marginal
tariff, and vice versa. The regime switch itself might, but need not,
be the exception. Given that marginal rates _R_ are generally regarded
as policy variables, we solve for _X._ With _X_(1)_ L:_

_ _

_ _(4-0) _ h R_(0)_ _(_H - X_(0))_ = _(_l + b_)_ B _

_ _

_ X_(0)_ = H - _(_l + b_)_ B / _(_h R_(0))_
_(5-0)

_ _

_ _(4-1) _h R_(1)_ _(_H - X_(1))_ + l R_(1)_ _(_L -
X_(1))_ = b B _

_ _

_ X_(1)_ = _(_h H + l L - b B / R_(1))_ / _(_h + l_)_ _
(5-1)

There is a _set of _critical levels of gross income _M_(_t_)_ =
M_(_R_(_t_)_, t_)_,_ such that unemployment results iff earnings _L_
are less than _M_(_t_)_._ This follows directly from rule (iii-b). This
critical income solves from:

_M_(_t_)_ - T_(_M_(_t_)_, t_)_ B_

_ M_(_t_)_ = M_(_R_(_t_)_, t_) _= _(_B - R_(_t_)_ X_(_t_))_ / _(1_ -
R_(_t_))
(6_-t_)

Under unemployment, the benefits cause additional taxes _l.B_ which are
levied on a smaller tax base. Given that _l_ are unemployed anyway, the
tax exemption _X_(0) can be lowered, so that the marginal rate is as
low as possible. This has the effect that _M_(0) shifts to the right,
so that the gap between the possible wage _L_ and the wage ‘required
for a decent living’ widens. There is obviously hysteresis, of a
‘catastrophic’ kind. Conversely, _M_(1)_ _can range in _B M_(1)_ L_
and allow for larger _R_(1)_ _though this could have little effect
since also _X_(1)_ _rises (see below). While these properties apply to
the reduced form, the same mechanisms apparently apply to the
structural form too (as they concern the same reality).

Substituting (5_-t_) in (6_-t_) gives _M_(_t_) as an explicit function
of _R_(_t_)_._ The regime switch occurs at _M_(1) = _M_(_RS,_ 1)_ = L_
with _switch_ marginal rate _RS_ and implied exemption _XS:_

_bB - _(_h + l_)_ _(_L - B_)_

RS =_ ----------------------------- (7-_RS_)

_h _(_H - L_)_

_bB - _(_hH/L + l_)_ _(_L - B_)_

XS = L ----------------------------------_ (7-_XS_)

_bB - _(_h + l_)_ _(_L - B_)

Rewriting conditions _K_(0)_ < B_ and_ K_(1)_ B_ gives:

_ _{_L - T_(_L, t_)_ < B_}_ __ _{_ X_(_t_)_ XS & L < M_(_t_)}
(8_-t_)

_ _{_L - T_(_L, t_)_
> B_}_ __
_{_X_(_t_)_ XS & L > M_(_t_)} (9_-t_)

Now consider the regimes, and determine whether they can exist:

Full employment: Given that_ L > B, _it follows from (9-1) that the tax
exemption can be chosen on or above the critical value _XS._ Hence _XS
X_(1)_ < H._ A prime example is _X_(1)_ = B._ Hence (iii-b) is empty.

Unemployment: _L_ is given as the market clearing wage for low
productivity persons. If_ X_(0)_ < XS,_ then taxes on these persons are
increased, and their net income drops below _B._ Given that _K_(0)_ <
B,_ they are eligible for benefits, and apply. Hence (iii-b) is not
empty.

It has been shown that both cases are possible. Q.E.D.

Remark: This exposition may seem an overly complex translation of the
Cohen Stuart 1889 quote (above) to the welfare state situation. The
proof might have said “self-evident” after the first paragraph. Given
the record of unnecessary unemployment, this author may however be
excused for driving the point home. The usefulness of the BHL concept
may be, that officials now can report, “we have diagnosed _l_ people on
benefit who should be able to earn _L > B _on the market, so let’s try
to find out how we are stopping them from doing so”.

Remark: A more didactic exposition may start with a _structural _tax
relation, e.g. with_ R(t)_ replaced by _r_ in (2_-t_); see for example
the Bentham tax. Then one can show that a _ceteris paribus _reduction
of the tax exemption will increase unemployment. Hence, for the return
of full employment it is necessary (but not sufficient) to increase
income tax exemption - or something from the _ceteris paribus _part.
Then, the second step in the exposition (as we have done here) is to
rename the axis into _compounded variables _(including VAT,
regulations, subsidies, excises, charity, etcetera), and then consider
(2_-t_) as the reduced form. Then we find necessary and sufficient
conditions. This however only works satisfactorily for an accepted
model of a real economy.

Remark: The theorem doesn’t establish that unemployment has only _one
_cause. Various kinds of unemployment have various causes. But, when
various causes are mapped into the world of BHL-ness, then the theorem
applies. For example, a long term unemployed academic would be
categorised as unskilled labour, even though his employed colleagues
earn much more. (The BHL concept thus is drastic. The reasons for
applying it have been explained elsewhere.)

Remark: The theorem is strongest in the _t =_ 1_ t =_ 0 part. Given
full employment, it is easy to mess it up; and it is easy to see that
you can mess it up. The other way around is less obvious. Here, both
the requirement _L B_ and Lemma II are crucial. For expository reasons
those are sufficient, but not as sharp as they could be. For example,
we might accept a small loss in _H_(1)_ H_(0)_, _as long as net
_N_(1)_ N_(0)_.
_However, even then the analytical structure remains, that productivity
_L _is _assumed, _so that it doesn’t come as a big surprise that
employment is possible. This actually is similar to the Arrow-Debreu
setting, where endowments are assumed, and full employment appears to
be possible. The modern reader might be inclined towards assumptions
that generate the impossibility of full employment. (See for example
the Grandmont (1983) setting of expectatory mismatch.) However, each
impossibility can be questioned too. It is up to _reality_ what model
applies. Stated differently: the value of above tautological theorem is
that it helps us to understand what is implicit in our concepts, so
that we may be more aware in observing whether these concepts apply.
This fits in with our concept of a _proposition._

Remark: The reduced form also captures the ‘physical tax’. The lack of
infrastructure, machines or tools may ‘tax’ people - and once these
have been provided, they could start earning income, and their earnings
would, crucially, be larger than needed to pay for the equipment.
Economists of course understand this concept of a physical tax - as the
lack of efficient capital markets, or the frustration of those by taxes
- but the crucial point is the abstract one. When people don’t earn
anything, and the economist suggests to abolish some tax, then a
listener may become upset, since how can you abolish something that
people don’t pay ?

Graphical presentation

Diagrams help understanding the analysis. Figure 42 shows two tax
regimes, _T_(_y,_ 0)_ _and _T_(_y,_ 1), characterized by different
exemptions _X_(0) and_ X_(1)_,_ and different critical incomes _M_(0)
and_ M_(1)_._ The main difference is net income at _L_. In regime 0,
net income at _L_ falls below subsistence, causing unemployment and
higher taxes to pay for benefits.

Figure 42: Tax regimes

It can be seen that _T_(_y,_ 0)_ _is above_ T_(_y, _1),_ _or that
average tax rates are lower under full employment. On the left section
of the horizontal axis, _X_(0)_ < X_(1)_. _On the right section, since
taxes in regime 0 are higher and levied on a smaller tax base, _T_(_H,_
0)_ > T_(_H,_ 1)_._ Thus the effect on the average tax rate is clear.
The effect on the marginal rate depends upon the numbers. The case
depicted here, with a higher marginal rate in regime 1, is only one
possibility; but it shows that a higher marginal rate can combine with
actually lower taxes.

40. The possibility of co-ordination

Chapter 40 showed the technical possibility of full employment for a
welfare state. Chapter 34 showed that social choice is feasible, in the
sense that there are consistent and reasonable constitutions that
society might deem attractive. In particular, there is the example of a
constitution that uses the efficiency criterion (Pareto optimality, PO)
to select its policy. There still remains one issue to settle. This is
the issue of information. Society might have a consistent preference,
and consistently prefer full employment above unemployment, but when
people don’t know that it is possible, and instead even have theories
that tell them that full employment is impossible, then society might
still choose for unemployment as the best of all evils. The issue of
information already featured in our discussion of Arrow’s Theorem, and
now returns for our discussion of unemployment.

We again follow the procedure given by our methodology. We select
stylized facts, develop our concepts, deduce results, and link back to
reality. We will first construct a subsidiary lemma that is very
general and concerns any suboptimality due to misinformation. Then we
take our theorem on the possibility of full employment, recognise it as
an item of information, insert it, and construct our theorem on the
possibility of co-ordination. [116]

Stylized facts

Recorded full employment situations may have been caused by ‘chance’.
Policy makers in 1950-1970 may have thought that functional finance was
effective, while it also was the tax exemption level. A re-evaluation
of the history may however also show that leading economic advisers in
the 1950s may have been wiser than those of the 1960s.

It remains a stylized fact that much of the subject matter on
employment is well-known. For example in Holland, CPB economists Van
Schaaijk (1983), Bakhoven (1988) and Colignatus (1990) pointed the way
to full employment. The state of knowledge turns out to be part of the
model.

There is a Pareto Optimizing Change (POC) iff some advance and none
suffer. A change from unemployment to employment need not be _strictly_
POC. Note that we already have resolved that we don’t need high
unemployment to keep inflation in check. So the CWIRU is no argument
against a POC. There are other clear reasons that pose a problem. First
these two:

· Some bureaucrats have plush jobs administrating the unemployed, and
would lose their job and sense of power.

· The unemployed would lose their leisure. For some, the combination of
low benefit _B _and leisure might be preferable to work at a higher
income.

We can overcome these barriers by going back to basics, i.e. to our
definitions. First of all, the bureaucrats are reminded that they are
there to serve the public cause (‘res publica’) - and thus they have
signed a contract - before they got the job - that they will welcome
full employment and raise no anti-POC objections. In the same way, the
people on the dole have signed a contract - before they got the benefit
- that they will accept a job at a living wage, and will not raise
anti-POC objections either.

A final observation is that the power elite, those who determine the
SWF, might enjoy unemployment of a section of the population for some
strange other reason. They might not care about the increase of income,
freedom and welfare from a change towards full employment, but they
would prefer the idea of people in helpless positions and the warm
gratitude they show for their benefits. A king needs subjects. We
resolve this problem by proper formulation of the theorem.

Concepts

Note that we use the symbols of chapter 39 (that forms a unity with
this chapter).

Above theorem on the technical possibility of full employment is
essentially incomplete. It has not been specified how the tax regime
comes about. The tax regime is an expression of the social choice
already made, but it has not been explained how a particular choice has
been caused. What is required is a power distribution on the _b + h +
l_ agents in the economy. In conventional terms the power distribution
is expressed as a social welfare function SWF, and the tax regime is
the result of the maximisation subject to the state of information _I_:

_ maximise SWF(h, H, N, l, L, K, b, B, t; I)_ (40.1)

Using a SWF serves expository purposes. When turning to practical
application we could use the Drissen & Van Winden (1990) approach. But
the logic of both approaches is the same.

The introduction of regime indicator _t _as a separate variable in the
SWF means that it stands as a proxy. The economy is not simply a
collection of individuals maximizing utility over consumption and
labour. There are some institutional aspects too. An example of an
institutional influence is that some social security officials might
benefit from unemployment, since it keeps them in attractive jobs. All
such (Public Choice) phenomena can be collected on their point of
relevance: the employment regime_ t._

Secondly, there is information _I. _Ever since Keynes and Tinbergen, or
even earlier, but for some economists more acutely since Muth and
Lucas, economists have given attention to the information sets that
guide the activity of agents. This concerns not just plain knowledge,
but rather what people believe about the state of the world. The
information sets may contain individual and social aspects, like own
prices and the (announced) general price level.

Variable _I_ is an aggregate. It represents the state of knowledge of
those in power, where ‘having some power’ is a state of nature given by
an array or by a distribution. The latter is not further developed
here. A basic point however is that if some economist would know how to
solve unemployment, but those in power don’t, then the budget set is
_IB,_ while _I < IB _- and those in power apparently prefer not to
know. [117]

The use of variable _I _could complicate the analysis in various ways.
R&D could be an economic activity affecting social welfare itself,
amending (40.1) etcetera. But the present formulation suffices for our
purposes. Note, the maximisation process itself finds its operational
implementation in the actual work of some agents in the economy. Such
work might be implicit and thus not explicitly remunerated. More
conventionally there are some administrators (e.g. a “Council of
Economic Advisers“) who are explicitly paid for their information
handling activities (often: whatever outcome on _t_).

Piore (1987) reminds us that unemployment is not a natural disaster
like an earthquake, but derives its cause, nature and significance from
the social system as a whole. In this line, when unemployment arises,
we would find the solution by studying the whole system. This includes
information. And Piore’s reminder, being a reminder, is a piece of
information. Indeed, one important social type of information concerns
theory itself, and economic models in particular. The development of
the theory of Rational Expectations (or model-consistency) implies this
too. Economic theories about unemployment are themselves part of the
information sets in society. An adequate description of unemployment
not only requires a statement of taxes, social security and e.g. legal
minimum wage, and their technical interaction, but also a statement of
people’s perceptions, of the theories in the journals, and of what
journalists and politicians make of these.

When unemployment arises, it may be caused by the power distribution,
but the cause can also be plain lack of knowlegde. It may very well be
that Piore’s proposition has not gotten sufficient attention from
policy makers and advisers. And this lack of attention, if it were
true, would be a prime example of the influence of the information set
on economic activity.

There are two relevant states of information: _I = _1 meaning that
those in power perceive of a (sound, compact) solution of unemployment,
and _I = _0 meaning that this is not the case. Note that knowledge
about the theorem on co-ordination, that is to be formulated next,
might but need not be included itself in _I = _1.

The Dissipation of Knowledge _I _by science, education and media need
not be detriment to those in power, but it might be. In the latter case
_I _would not be POC in the ordinary sense. However, many would hold
that _I morally _dominates POC - and if these people are in power,
then this conviction is reflected in the SWF. Note also that _I _need
not be positive, e.g. when a wise king dies or a wise government party
loses the elections. Note that when _I _coincides with a shift in
power, the prime cause can be both personal properties involved or the
information; but here everything is aggregated into the latter.

We conclude this section by a short abstract discussion of the concept
and properties of information, and Lemma III.

Regard a controlable dichotomous system with states _s = _0 or_ s = _1.
Two consecutive states are of the form {0, 0} and {1, 1} where the
regimes are maintained, and {0, 1} and {1, 0} where there is a switch.
If policy is conscious, then the movement from one state to the other
(or the same) depends on information - and thus there are four lists of
basic information. With 4 such items, an agent’ mind can possess any
combination. There are 15 of such combinations: namely 1 case where all
4 are known, 4 cases of only 3 items, 6 of 2 items, and 4 cases when
only 1 is known. It will be useful to compress this abundance.

The following definitions are useful:

Definition: Basic information is a _list_ of “what one does” to
have one state in one moment and another state in the next moment. An
example list is: {“Provide oxygen and a dry place”, “Light the match”,
“Let it burn till it is all cinders.”}. Other examples are recipes,
film scripts, computer programs (“Click on a button”). We can denote
basic information as _BI_(_s_1, _s_2). Note: In this version of the
proof we allow basic information to be true or false.

Definition: A state _s _is said to be _controlable _iff there
exists - in principle - _true_ basic information on both _s _and _1-s,
_and the agents have the resources to use this information. Note that
this information need not be known by the agents (need not be
available), and it need not even be known to the agents that the matter
is not unknowable.

Definition: Information is _available_ when at least one agent in
the economy has it. (This is stronger than the ‘existence in principle’
of controlability.)

Definition: Sound information _J(s)_ is a list of _both _what one
does to maintain _s_ _and _what one might do to change _s_ into _1 -
s_, using _true_ cause and effect relations. Thus _J_(_s_) = _BI_(_s,
s_) _BI_(_s_, 1-_s_)
| truth. Denote an arbritrary belief as _J’_(_s_) - that however will
not be sound since it would not be necessarily true.

Remark: True information is sound when the information concerning {1,
1} and {1, 0} is joined, or if the information on {0, 0} and {0, 1} is
joined. One may e.g. know how to burn or not to burn a match, but not
how to restore cinders into a match again (except for restarting the
universe, but that is not likely controlable). Let 1 stand for match,
and 0 for cinders. Then _J_(1) exists, but _J_(0) doesn’t (only partly,
to maintain cinders as they are). Using sound information rather than
basic information has analytical advantage. A Roman emperor may think
that he maintains his good fortune by sacrificing to the gods. We
rather discuss cases where governments deliberately abstain from wrong
policies.

Remark: Consider the list {“If you happen to flip back to 0, use
_BI_(0, 1) to go back to 1”}. Can we classify this as _BI_(1, 1) ? We
could allow this if the cost of the temporary flip is low. For example,
riding a bicycle requires continual readjustment of equilibrium. We can
define _BI_(_s, s_) = {chance(_s_, 1-_s_)} _BI_(1-_s_, _s_) | truth,
as implied control information. But since this does not give
_BI_(_s_,1-_s_), the implied control information does not give sound
information. Stated differently, we are interested in durable states
_s,_ and not in flipping states. If we observe _s _then we want this to
be caused by deliberate rejection of the use of _BI_(_s_, 1-_s_). We
also regard cases in which implied control would be costly.

Definition: The tuple (_J_(1)_, J_(0)_, s_)_ _is the state of a
sound system. Note: Though the information is denoted as a function of
_s, _information in a controlable state is the prime cause and _s _the
prime effect.

Definition: Information is called _compact_ iff _J_(0) _ J_(1)_.
_Note: Compactness means that one knows the explanation of one state,
iff one knows the explanation for the other state. Then we can use a
single variable _J _or _J’._

Definition: A state _s _is said to be caused _by chance _iff a
situation of _s _and unsound belief _J’(s) _are stable. It is said then
that there is a _hidden cause_ linking _J(s) _to_ s._

Definition: If the sound information concerns a model then we can
denote _J_ in binary values, with 1 = ‘the model is known’ and 0 = ‘the
model isn’t known’, rather than use the whole list of statements. With
binary information, compactness _J_(0) _ J_(1)_ _becomes _J_(0)_ =
J_(1)_._

Remark: Consider the example of the Roman emperor. His model is
‘_sacrifice fortune_’ (and if fortune slips after a sacrifice, then
apparently more sacrifices are required). One of his basic informations
is _BI_(_~fortune, fortune_) = {‘_sacrifice fortune_’, ‘In this case
sacrifice’}. Since _J’_(1)_ J’_(0) this is a compact belief.

Remark: If _s _is the case, and one doesn’t believe _J_(_s_)_, _so that
_J_(_s_)_ _= 0_,_ then one believes some alternative _J’_(_s_). Someone
unfamiliar with matches would have the unsound (perhaps only basic)
information ‘this is just a piece of wood’. More complex situations
need thorough analysis. E.g. someone may know the text of a theorem and
benefit from that, but may not know its proof.

Lemma III: If there is sound information (_J_(1)_, J_(0))_ _on a
controlable dichotomous state _s,_ then:
(i) if the information is not compact then there are 8 states of the
system, with 4 states implying a hidden cause,
(ii) if the information is compact, these numbers are halved.

Proof:

We tabulate the possible states of the system (_J_(1)_, J_(0)_, s_) in
Table 16.

In cases (rows) (3), (4), (6) and (7), the agent doesn’t possess sound
information and believes some _J(s) _(e.g. ‘the world is as it is’),
but he chances at _s_ nevertheless. This implies that there is a hidden
cause. (For example, the state of the system was inherited, and the
agent wishes to keep things as they are. In that case (_J’_(1)_,
J’_(0)_, s_)_ _has causality within a more complex model, describing in
more detail how people act on their beliefs.)

If the information is compact, we only consider states (1) to (4).
Q.E.D.

Discussion: To understand the proof, look for example at row 6: There
is a true model for sequential states {1, 1} and {1, 0}, or to maintain
1 or change to 0. But nothing is truly known about maintaining 0 or
changing back from 0 to 1 (though beliefs can exist). Observed is _s_ =
0. Perhaps it once was a conscious choice to go from 1 to 0, and
perhaps one uses the implied control {chance(0, 1)} _BI_(1, 0) |
truth. But we are concerned with durable cases for which implied
control would be costly. We want to see deliberate rejection of the use
of _BI_(0, 1). But this information is not present. Hence the endurance
of 0 is caused by chance.

Table 16: States of the system

_J_

_J_(1)

_J_(0)

_s_

_meaning_

(1)

given _J_ = 1

one chooses

_s =_ 1

(2)

given _J_ = 1

one chooses

_s =_ 0

(3)

given _J_ = 0

one chances at

_s =_ 1

(4)

given _J_ = 0

one chances at

_s =_ 0

(5)

given _J_(1) = 1

one chooses

_s =_ 1

(6)

given _J_(0) = 0

one chances at

_s =_ 0

(7)

given _J_(1) = 0

one chances at

_s =_ 1

(8)

given _J_(0) = 1

one chooses

_s =_ 0

Note that a conscious choice is made when one does not use
the information to switch to the other state.

The special theorem

When we apply Lemma III, which is about information handling in
general, to our subject matter of employment, we get what for this area
amounts to a theorem. The first theorem is special since it assumes the
BHL property.

Definition: There is wrong co-ordination if a SWF optimal change is
blocked only by ‘lack of knowledge’ of the power elite while the
information actually is available. (Co-ordination can go wrong on other
counts too.)

Theorem BHL.2: Given theorem BHL.1:
(i) full employment results from conscious choice or chance
(ii) unemployment results from conscious choice or from wrong
co-ordination

Proof:

Theorem BHL.1 shows that full employment for the BHL welfare state is a
controlable dichotomous state. The theorem is sound and compact. Thus
Lemma III applies.

Possible states of sound compact knowledge and employment _(I, t)_ are:

(1) (1, 1): having the knowledge, full employment results;

(2) (0, 1): lacking the knowledge, full employment results; thus
there is a hidden cause; thus it is by chance;

(3) (1, 0): having the knowledge, unemployment results; thus,
the explanation comes from the power distribution, so that full
employment is not to the advantage of those in power, and the choice
for unemployment is conscious;

(4) (0, 0): lacking the knowledge, unemployment results. Note
that theorem BHL.1 is available knowledge (e.g. it was published by
Colignatus (1992b, 1995a, or this book)). [118] Where we currently
speak about ‘lack of knowledge’ then we mean the knowledge of the power
elite, who do not fully use the knowledge budget set. Introduction of
theorem BHL.1 into the knowledge bank of the power elite unveils two
subcases:

(4.1) There is a switch to (1): optimal change was blocked only by
lack of knowledge, while the information actually is available: hence
wrong co-ordination;
(4.2.) There is a switch to (3): information doesn’t matter.

Q.E.D.

Remark: In both employment regimes we have ‘conscious maximizing
behaviour subject to the state of information’, but the regimes cause
different conditions. There is little use in subdividing case (2). If
more information is introduced, then the power distribution may cause
unemployment. This effect however has already been covered in (3). See
the note “more on chance”.

Remark: Cases (3) and (4.2) give the situation where the possibility of
full employment merely is logical but not empirical. It is conceivable
that power parameters and political reaction patterns are such that the
economy remains in a state of unemployment forever.

Remark: In case (4.1), and when there are subpopulations of theorists
(‘those who know’) and policy makers (‘those who can do’) then there is
the _Van Schaaijk Corollary: _“Those who know, cannot do anything about
it; those who can, don’t know.” The addendum here is that ‘not-knowing’
is no excuse for a policy maker who should know.

There remains the interesting point of the potential difference between
Pareto Optimality and SWF optimality, when information is the active
variable. One may remember the bureaucrats in their plush jobs and the
benefit recipients who enjoy their leisure. Here Lemma IV applies.

Definition: A situation is _Properly_ Pareto Optimal (PPO)
compared to an alternative iff it would be PO when some conditions are
properly defined and interpreted - while it seems non-PO when these
conditions are ill-defined and wrongly interpreted.

Lemma IV: For a BHL economy, regime 1

(i) has the highest level of national income,

(ii) is PPO compared to regime 0.

Proof:

(i) Equation (3_-t_) immediately implies _Y_(1)_ Y_(0)_._

(ii) Regard the change from 0 to 1:

(B) permanent benefit recipients are not affected by a regime
switch,

(H) _N_(1)_ N_(0)_,_

(L) _K_(1) _ B._

Hence all agents improve in a material sense. Thus regime 1 is PO
compared to regime 0, if we restrict_ _attention to these income
aspects. The actual choice is made by the SWF, and this choice includes
power effects of the bureaucrats (who may want to maintain
unemployment) and the unemployed (who enjoy leisure while on benefit).
This contorted SWF can be cleaned up by proper contracts and execution
of those contracts. Then PO is restored.

Q.E.D.

Remark: It stands to reason that if a change to full employment occurs,
it is mainly because it is POC. This highlights the problem of wrong
co-ordination.

Remark: In normal work-ethic conditions, the income-leisure utility
considerations of the _l_ low productivity workers improve too, when
they move from forced leisure to a decent job. It is conceivable
though, that the advance in net income does not compensate for the loss
of leisure. Therefor, the concept of PPO is useful. In another respect,
the voting power of _l_ may be small, and when society decides that
unemployment was a silly affair, the _l_ may be said to have had an
unintended bonus while it lasted. (Society might even try to recover
that bonus.)

Remark: There is scope to define and judge PO from some fundamental
rights rather than from the actual bureaucratic flux.

Remark: In an applied general equilibrium context we would have to deal
with complexer aspects, like people fearing to lose their jobs, and the
loss of income resulting from crowding out. Adding ‘approximately’
would help Lemma IV surviving.

The general theorem

Definition: There is wrong co-ordination if a SWF optimal
change is blocked only by ‘lack of knowledge’ of the power elite while
the information, though not yet available, still could be found rather
quickly by not much effort. (Co-ordination can go wrong on other counts
too.)

Theorem G.1: If full employment is a controlable dichotomous state
for which sound compact information exists in principle, that also can
become available rather quickly by not much effort, then:
(i) full employment results from conscious choice or chance
(ii) unemployment results from conscious choice or from wrong
co-ordination

Proof:

Work along the proof of theorem BHL.2. Note that BHL.2 fills in the
properties that are now provided by hypothesis: controlability,
soundness, compactness, and availability. Note that controlability
means that the information exists in principle, while it need not be
available yet.

Q.E.D.

Remark: Theorem BHL.2 thus gives an existence proof for this general
theorem, i.e. shows that it is not vacuous.

Remark: The value of the theorem is that it focusses our attention on
the perceptions that we have to deal with when judging the arguments in
this book. Some questions to be answered are: (1) Do we still believe
in full employment (only friction unemployment), or do we think that
there are serious bottlenecks - or do we even think that we live in a
probabilistic universe ? (2) Do we seriously believe that governments
have done their best, or at least a reasonable effort, for (a) using
available information, (b) finding additional solutions ? (3) Do we
really think that the BHL-concept is useless, and that governments have
been right to neglect the papers on them ? (4) Do we seriously believe
that the PO-changes that seem so likely, are _not_ POC ?

On the interaction of the reduced form theorems

Our analysis has not provided complete statistics on existing welfare
states, and it can neither replace the need for more study, especially
with the cornucopia of applied general equilibrium modelling. The
analysis here does however fit in with the stylized facts. It is good
strategy to apply logic to circumvent the uncertainty of parameter
estimates. There is sufficient reason as well to accept that the two
propositions forwarded here give main results in a nutshell.

The first proposition is that both unemployment and full employment are
possible for the (BHL) welfare state. The second proposition is that
unemployment follows from either conscious choice or wrong
co-ordination caused by (deliberate) lack of knowledge, and full
employment from choice or chance.

It may be emphasized that the logical force of the argument derives
from the undeniables both that one can take subgroup averages and that
two points share a line. That line finds its translation, in economic
vocabulary, of a social welfare function with a power interpretation.

Above discussion on information is a small step in formalising rather
well-known insights. Formalisation, how small the step may be, can be
crucial to get the statistics going, and in helping to establish what
the state of the world actually is. Apparently we need statistics on
what economic advisers and policy makers believe.

Above discussion provides a foundation for a policy conclusion, that it
would be good for many welfare states with declared objectives on full
employment to improve on informational procedures.

More on Paul Krugman

Krugman still is ignorant about my analysis (DRGTPE, first edition):

(a) the need for constitutional reform on the Economic Supreme Court,

(b) reform of the tax system and the return to full employment and
growth.

The gap between me and Krugman is getting smaller though:

(a) Krugman abhors the current polical role of the CEA. Perhaps he sees
the need for constitutional change towards an Economic Supreme Court.

(b) Krugman has a life-long aversion of taxation theory. But this is
where the solution for unemployment can be found (otherwise he might
have seen it already). Krugman advances the conclusion that income
inequality furthered extreme right-wing conservatism. This provides
fertile ground for my analysis on the tax void and the dynamic marginal
tax rates.

I think that it is advisable that Krugman reads my work. Of course he
is entirely free not to do so. We can even understand that since he
hates tax theory so much. He is likelier to do so however when Holland
is boycottted and when that circus draws his attention. Hence, boycott
Holland. If Paul starts reading my work, he best starts with DRGTPE.

The Dutch tragedy of the murder of Pim Fortuyn in 2002

In 2002, now two years ago, Holland saw the political rise and murder
of prof. dr. W.S.P. (Pim) Fortuyn. He had been a professor of Erasmus
university and had been a long time critic of developments in Dutch
society. He had been lecturing around the country, his lectures enjoyed
some popularity, and he was well aware of the worries among the general
public that were however neglected in official policy making by prime
ministers Ruud Lubbers and Wim Kok. The events of 9-11 showed Fortuyn
partly right and this caused the mood swing that so surprised both
foreign observers and the Dutch policy making elite itself. Holland,
that always was so calm and tolerant, suddenly became the scene of
turmoil, alleged racism, political murder, and a landslide change of
the political landscape. After the murder of Fortuyn his party got 17%
of the vote, which is not much in international comparison, but it came
from nil and it had a huge impact on the median voter position and
Dutch coalition politics.

[132]

Fortuyn has been systematically misreported, both in Holland and
abroad. The best proper description of him is that he was a libertine –
different from both a liberal and a libertarian. He valued personal
liberty much more than a liberal but still saw the need for a social
framework where a libertarian rejects it. It comes to mind that Fortuyn
followed Voltaire’s views here.

It is useful to clarify the distinctions. The best example still seems
to be Fortuyn’s own homosexuality in relation to the new immigration
into Holland. In Fortuyn’s view people are free to denounce
homosexuality as worse than being a pig. Some people indeed have this
opinion, both some native Dutch and some of the new immigrants. Fortuyn
valued the freedom of expresssion so that there could be scope to start
a dialogue. If thoughts would be repressed then this would cause them
to go underground and they might pop up in unpleasant ways. By
consequence Fortuyn himself should be free to comment on outdated
cultural conventions and the unnecessary unkindness to pigs if not
people themselves.

What happened in this debate is that many commentators, particularly in
Holland that still is sensitive to the discrimination of the Jews and
the Shoa in World War II, feared that Fortuyn discriminated against
moslims. This focus did injustice to Fortuyn’s position for he did not
target moslims and he intended no discrimination but defended their
freedom of speech. By misrepresenting Fortuyn in this way, attention
also shifted away from his other proposals on government, the economy
and for example also the public health system. All this caused a
shallowness of the debate, a shallowness that fed on itself. Fortuyn
protested that he was being demonised and appealed to prime minister
Wim Kok to protect him.

It is crucial to observe that Dutch key politicians joined the
demonisation, including Wim Kok whom Fortuyn had turned to for help.
Fortuyn was no racist and no fascist, the Dutch key politicians knew
this, but they still issued statements that implied that he would be
racist and fascist. It is important to realise that Fortuyn’s true
ideas were known, for example from books that he had written over the
course of years, while Dutch key politicians have the support of staff
to research material. Their idea might have been that it was an
election campaign and that election campaigns are ‘dirty’. My idea
however is that these Dutch key politicians crossed a line and exposed
themselves as liars. Even when Fortuyn protested that he was being
demonised, they did not stop, and in that manner they contributed to
the climate in which the gunman saw himself called into action.
(Noteworthy, that gunman says that he did it to protect society, but he
is an environmental activist who considers pigs to be members of
society.)

Let us consider the evidence. The demonisation of Fortuyn consisted of:

(a) bad listening and wrong citation

(b) the grapevine

(d) in words and behaviour

(e) with mass demonstrations and pies in his face (mixed with vomit
and excrements).

Let me quote the key politicians. The Dutch sources are AD
Tijdsdocument (2002) and Volkskrant (2002) and I give my own
translation.

Paul Rosenmöller (leader of the green left, GL) calls him “not just
right-wing, but extreme right-wing” (which implies fascism).

[133]

Thom de Graaf (leader of the liberal democrats, D66) refers to Anne
Frank’s “Achterhuis”.

Ad Melkert (leader of the social democrats PvdA): “He crosses a line
that you are not allowed to cross. Holland, wake up !” Later he adds:
“You wake up, and you see Le Pen. You wake up, and you see Fortuyn.”

[134]

Gerrit Zalm (leader for the conservative liberals VVD) : “a dangerous
man”.

[135]

VVD chairman Eenhoorn: “the Mussolini type of leader”. [136]

Marcel van Dam (influential columnist, both on national TV and in a
widely read newspaper, also PvdA): “lower than a low-life”. [137]

Wim Kok (prime minister at that time, PvdA): “sowing of hate and
discord”. [138]

Evaluating the situation and these statements, the Dutch political
scientist Cas Mudde concludes, see AD Tijdsdocument (2002:82):

“(…) can be documented that Fortuyn was demonised by politicians like
Melkert, Rosenmöller and Zalm.” [139]

Nobody denies that Kok et al. were right to be worried about
developments in Dutch society after 9-11 and the Dutch elections of
2002. Nobody denies their special reponsibility in terms of leadership.
In their own view, they might well have been right in opposing Fortuyn.
(I didn’t vote for him or his party either.) But they should not have
corrupted the information. [140]

After the 2002 elections, Kok, Melkert and Rosenmöller have left
politics. Kok is now at the bank ING and Zalm helped appoint Melkert to
the position of Dutch representative at the Worldbank. Have Dutch
society and Dutch politics recovered from the Fortuyn ordeal by now ?

It must be observed that there were no other politicians who stood up
_to defend_ Fortuyn where he was obviously being demonised. It is
basically this group that now has taken over command. Thus, the current
Dutch prime minister Jan Peter Balkenende kept silent. It later turned
out that he had a deal with Fortuyn not to attack each other since they
both wanted to replace the sitting coalition. But neither did he defend
Fortuyn against the slander. The current leader of the social
democrats, Wouter Bos, also gave his silent support to the lies by
Melkert. He now admits that some mistakes have been made, though he
apparently still supports Kok and Melkert and apparently does not mind
that they have tried to fool the public, while it has already been
discussed in Dutch newspapers that Melkert might be a candidate to
become a European Commissionar. The sad observation remains that while
key politicians have stepped down, they have been succeeded by the same
breed, the ones who kept silent while Fortuyn was demonised. The Dutch
situation still is a mess and science still gets censored.

It is not just the politicians. The 17% who voted for Fortuyn’s party
did not become a member of that party. They complain that the
government did not provide bodyguards but if they had paid
contributions, Fortuyn could have hired those himself. The Dutch have a
strange relation to their wallet.

The rest of the world is amazed over the events in Holland, that had
such a fine reputation of liberty and tolerance and openness of mind
and that uncritically followed Bush and Blair on Iraq, talks about
dress codes, the banning of books (even of medieval writers), the
return of the death penalty, the closing of “coffee shops”. Some
political commentators conclude that the current Dutch government is
slowly executing Fortuyn’s agenda. It is hard to judge this, since that
agenda was also fuzzy and inconsistent at points. While Holland now
seems to get the toughest immigration laws in Europe, it is difficult
to call this Fortuyn’s agenda, since that was not Fortuyn’s main point.
Also, if you would take immigration and integration serious, I would
suggest that my analysis on unemployment is very important for that. It
may also be noted that some people continue demonising Fortuyn. Anyway,
the real thing that the world should be amazed over is not so much the
closing of the Dutch mind but how it came about that this mind is
closing.

The point is that Holland still needs to focus on the real questions.
If you agree, boycott Holland.

(PM. There is one thing about Fortuyn that needs retelling. After his
murder, his party commissioned a statue. This statue was transported to
its destination in an open truck in upright position, in proud
demonstration. The driver however misjudged a tunnel and in full speed
the statue was beheaded. There he was, his person and ambition murdered
and his memory turned hilarious… But, that this story is hilarious
means that we basically respect Fortuyn as a good man. Otherwise it
would be ridiculous. That the story is worth retelling, will contribute
to his memory.)

On the European Enlargement

It is good to see the attention that the European Enlargement gets in
the media these days.

Of special note is Timothy Garton Ash (2004), that May 1 2004 is the
beginning of a new century. This article strikes the proper balance
between realism and the idea that we should have a big party. A nice
touch are his jokes. Question: “Rebbe, is it possible to create
socialism in one country ?” [141] Answer: “Yes it is, but then you must
go live in another country.” Question: “Are the Soviets our friends or
our brothers ?” Answer: “Our brothers – you can choose your friends.”

The Books Supplement of NRC Handelsblad of May 1 2004 appropriately
also discusses John Gillingham “European integration, 1950-2003”,
Christopher Booker and Richard North “The Great Deception”, and Jacques
Delors “Mémoires” (apparently French).

Interesting, and only available for Dutch people now, is Renée Postma
(2004), from the reporter of NRC Handelsblad for Central Europe. What
strikes me from her account is the robber baron period after the fall
of the Berlin Wall and the hurt that still exists. The reader is
quickly confronted with suicides from persons who were brought in
hopeless conditions. I am very moved by this, for my paper (1990a) that
was blocked from discussion by the directorate of CPB was intended
precisely to prevent all this.

Dutch readers can benefit from Postma’s account. On page 113 she shows
that the Dutch prime minister Wim Kok did not know what he was talking
about when he promised Poland that Holland would employ 40,000 Polish
nurses.

Job flows in the enlarged EU are a hot topic, but there are a lot of
confused arguments like this. The best approach is that each economy
targets full employment, so that only those people migrate who freely
opt for it. Problems in the labour market can be solved in Holland too,
so migration is second best and hides the real problems. Poland also
needs lots of nurses. Foreign training of course is useful, and so on,
but if economic conditions force people to move permanently, then
something seems to be wrong with the economy. John Kenneth Galbraith
(1979), in his booklet on poverty, has forcefully shown that migration
has historically been one of the best ways to fight poverty, but those
historical circumstances were different. In the present situation,
investments in Central Europe are the key approach and that means that
people are needed in Central Europe.

A key passage in Postma’s book is:

“In Central Europe there is a romantic vision about the Dutch citizen.
He would be the example of a successful relationship between government
and individual, a rational being who decides on the base of both
self-interest and the common interest and thus finds the social
optimum. According to the Hungarian writer Pétér Nádas the Dutch have
understood the importance of compromise. Only by co-operation at all
levels it is possible to keep a dry polder.” (p105).

Postma confronts this view with the events around prof. dr. W.S.P.
Fortuyn. I can usefully confront it with the ideas in DRGTPE as well.
For foreigners it may be difficult to get a grip on Holland. A key
point is this. Holland has 16 million inhabitants and may be regarded
as a relatively small country. In a specialised professional field,
such as macro-economics, everyone tends to know everyone else. Social
control, biases, prejudices, stigma, and so on, can occur. As a
Dutchman, I presume that Dutch society is admirable in many respects,
but perhaps we are also a bit spoiled (and not only because of our
resource of natural gas).

The EU has quite some challenges ahead. It is also obvious that my
analysis is not mentioned in the debate on them while it is the best
way to meet them. Hence boycott Holland.

Advice to vote NO on the current proposals for a European Constitution

My advice is to vote NO on the current proposals for a European
Constitution.

The reason is that these proposals are scientifically unsound. For
example, they lack an Economic Supreme Court, and they do not satisfy
the conditions explained in Colignatus (2001) “Voting Theory for
Democracy”.

Obviously, a vote is a political statement, and not something what
science can determine. If people want a sloppy constitution then they
are entirely free to do so. Science can only contribute to consistency
between what is claimed for that constitution and what will be its true
effect. Given the claims, vote NO.

My analysis on social welfare and voting is part of the censorship by
the directorate of the CPB. Hence boycott Holland.

A note on my own position

I already expressed the hope that you would not boycott me, my
publisher and my internet provider (or those in general).

I have wondered whether I should also beg for such leniency for my
family and friends. This would turn into quite a logistical operation.
I have turned 50 this year, there is quite a trail. Also, I already
told that I contacted some ‘other-globalists’ in Amsterdam with the
question whether they would be willing to ask their foreign friends to
boycott Holland: perhaps they should be absolved from harming
themselves as well. Perhaps we can make a sticker or label “Don’t
boycott me because I boycott Holland” and sell this, with the proceeds
to the tropical rain forests (that also suffer from the censorship by
the directorate of the CPB).

All this is rather complex and one can imagine that people ask why I
don’t simply emigrate. But I hope that you agree that the censorship by
the CPB directorate shouldn’t force me to depart from my loved ones.

It is decidedly simplest to boycott all Dutch. My loved ones might
suffer, but the rational gamble is that the boards of Shell, Ahold,
Baan, Unilever, KLM (Air France), ING, ABN AMRO, Numico, Philips,
AKZO-Nobel, DSM, etcetera, and also the mayors of Amsterdam, Rotterdam,
The Hague, Utrecht, Leiden, Delft, Maastricht, and even the rather
sleepy mayor of Groningen wake up before that, and send out their
envoys to Parliament to do something about this rather weird situation.

Yes, I have really tried everything else possible. My efforts have been
listed in Colignatus & Hulst (2003), but a selection for an
international audience is:

· Dutch government has an Office of Integrity, but this has been
installed only recently (suggesting that there were no solutions
before?), and they don’t take ‘old cases’ (even though the directorate
of the CPB still censors the analysis: I recently asked for some proper
decisions, the court established that they should reply, and they
replied as a censor does).

· The Academy of Science (KNAW) sees no task to cover the official
governmental research institutes that claim a scientific status, such
as CPB, SCP, RIVM.

· I’ve also asked my last employer, the Department of Public Health at
Erasmus MC, whether they would support a suggestion to KNAW to
investigate the CPB case because of its importance for the integrity of
science. Professor Richard Gill of Utrecht University already supported
that suggestion. If Erasmus MC thinks that I have some professional
standing, as they renewed my contract in October 2003, perhaps they
also value my judgement on this issue on the integrity of science. The
censorship by the directorate of the CPB also has consequences for
Public Health, not only in Holland, but via economic theory in all
countries. To my regret, this discussion appeared difficult to resolve.
For a longer discussion, see my website on the topic of public health.

· I’ve written a string of newspaper articles in the beginning of the
1990s, but to no avail. This is about the same period when Fortuyn was
put down by Kok and Melkert as well. Nowadays newspapers fundamentally
neglect me, seem to regard me as some idiot who should stay in his
cage. My recent book with Hans Hulst has had a decent and highly
positive review in the magazine for Dutch teachers in economics, and
similarly in a newsletter for socially involved workers in the
Churches, but got a short negative put down in a social science
journal, and has otherwise been neglected.

The censorship of science now takes almost 15 years. This year I turn
50, and that is a good moment to take stock. Institutions are stronger
than people, what resources remain? I see no other prospects. So, alas,
I must advise you to boycott Holland.

(May 1, 2004)

Appendix: After 20 years of mass unemployment:
Why we might wish for a parliamentary inquiry

(Abstract and summary only)

http://www.dataweb.nl/~cool/Thomas/Nederlands/TPnCPB/Record/1990/12/18/
index.html

Thomas Colignatus * December 18 1990

CPB internal note 90-III-38

Abstract

A synthesis of economic theory is presented, the solution to
unemployment is restated, the intellectual need for a parliamentary
inquiry is established, and as an example to such inquiry the
performance of the _Centraal Planbureau _is evaluated.

Summary

In Holland, mass unemployment persists already for about twenty years,
and will continue to do so for many years to come. Economists agree on
the obvious solution, the reduction of labour costs. But for some
reasons our decision making process doesn’t generate that decision.
Policy measures that are taken, actually are troublesome, like the
creation of a _Centraal Bureau voor de Arbeidsvoorziening _(CBA), or
the recent ‘temporary and red tape’ ten percent subsidy on minimum
wages (WLOM). The policymaking situation is analyzed in a more formal
manner, to allow for more abstract reasoning. This requires a social
welfare function, an income redistribution function, and a production
function (for the unemployed cq. subsidized workers). In fact, we might
attain the goals of high growth, price stability, full employment and a
just income distribution, by means of monetary, fiscal and subsidy
instruments. The conclusion however is that the present policy
sclerosis derives from insufficient interest in and information about
the form and location of those mentioned functions, and lack of
interest In optimization itself; and_ _this again may be caused by
institutional weak spots. A review of the issue and of the policymaking
process could be beneficial and actually logically needed. Among
others, this would include a review of the _Centraal Planbureau _(CPB),
that has not properly endogenised government behaviour in its models,
projections and analyses. It is suggested that such review would be a
task for parliament; and the logic for a so-called _parlementaire
enquete _is compelling. Clarity on the issues is essential too for the
European debate and our advice to the Eastern European countries.

*) The author is an econometrician at a government agency that has some
involvement with the economic policy making process; the article
expresses his own views only. This paper is adapted from a presentation
at a parallel session at the conference in honour of prof. W. Albeda
“The future of industrial relations in Europe” June 7-8 1990,
Maastricht, The Netherlands

46. Final conclusion

Considering all these arguments, I think that it is best that
economists advise their parliaments to investigate these matters. The
television cameras should not focus on the debate between the parties,
for a while, but on the didactic discourse between politicians and
scientists.

Epilogue

I like to thank Guido den Broeder for publishing my earlier work
(1992b). I want to thank my friends of the Samuel van Houten
Genootschap, Eric van Stappershoef and Fred Kromhout, for my earlier
publication “Trias Politica & Centraal Planbureau” (1994b). I thank
Hans and Auke Hulst for their 1998 “Werkloosheid en armoede, de
oplossing die werkt” (“Unemployment and poverty, the solution that
works”), written with my assistance. Hans and I wrote “De ontketende
kiezer” (“The voter unchained”) in 2003. All these books were good
products and provided the encouragement of a work well in progress.

I thank Stephen Wolfram and the people at Wolfram Research Inc. (WRI)
for creating _Mathematica_, a system for doing mathematics on the
computer. Without this, this book would have looked quite different, or
not have been there at all. I thank Leendert van Gastel and André Heck
of the - now no longer existing foundation - Computer Algebra Nederland
(CAN), and Dick Verkerk of the - very existent - CANdiensten for the
opportunity to visit CAN at that time. I thank Asahi Noguchi (1993) and
Silvio Levy for originally creating the_ Mathematica_ package on
Applied General Equilibirum analysis, and for giving their permission
to rework it and to include it in my own _Economics Pack_ (1999), that
this book uses.

Specific thanks are also due to Bob Parks of the Economics Working
Papers Archive (EconWPA) of the Washington university at St. Louis.
Over the course of the years much of this work has been put there, and
this has been very useful.

On content, I thank prof. dr. Jules Theeuwes (Leiden University), prof.
dr. Hans Weddepohl (Amsterdam University) and prof. dr. Jan Siebrand
(Erasmus University Rotterdam) for their comments on some of my earlier
papers. A discussion with prof. dr. Henk Folmer (Wageningen University)
contributed to more clarity in the argument as well. All responsibility
is mine of course.

I like to thank my former colleagues at the Dutch Central Planning
Bureau (CPB). Without them I would not be the economist that I am now,
and I can do them no greater compliment than by advising that the
bureau should be promoted, with some modification, to an Economic
Supreme Court. My special thanks go to Martin Vromans and Carel
Eijgenraam.

I am also indebted to my close friends and family, both Dutch and
American, without whose support this work could not have been created.

I think that I usefully state again that I protest against the abuse
that has been inflicted onto me by the directorate of the CPB and that
has hindered the due course of science.

Not that I entertain any illusion. Most people and organisations that I
contacted have been particularly uninterested. Policy makers do not
like the idea that the government itself contributes to stagnation.
Voters seem to accept unemployment as a natural phenomenon. Academic
economists are mainly interested in their own line of research and the
possibility of publishing in some journal. Scientific truth, and the
interest in scientific integrity in the policy making process,
somewhere gets lost. So, having this experience since 1989, an educated
guess would be that it might take many more years before my analysis is
accepted and before there is any chance that the abuse can be
corrected. The main worry of course is that unemployment and poverty
hang in here too.

Appendices

On the definition of economics

The body of the text explains the difference of and relationship
between ‘economics’ and ‘political economy’. I propose that we all
stick to those definitions. But it remains useful to relate to
definitions provided by other authors.

Marshall (1890, 1947, p1 and 43) first equates Political Economy and
Economics, and then splits them up again:

“Political Economy or Economics is a study of mankind in the ordinary
business of life; it examines that part of individual and social action
which is most closely connected with the attainment and with the use of
the material requisites of wellbeing.”

“Economics is thus taken to mean a study of the economic aspects and
conditions of man’s political, social and private life; but more
especially of his social life. The aims of the study are to gain
knowledge for its own sake, and to obtain guidance in the practical
conduct of life, and especially of social life. The need for such
guidance was never so urgent as now; a later generation may have more
abundant leisure than we for researches that throw light on obscure
points in abstract speculation, or in the history of past times, but do
not afford immediate aid in present difficulties.

But though thus largely directed by practical needs, economics avoids
as far as possible the discussion of those exigencies of party
organization, and those diplomacies of home and foreign politics of
which the statesman is bound to take account in deciding what measures
that he can propose will bring him nearest to the end that he desires
to secure for his country. It aims indeed at helping him to determine
not only what that end should be, but also what are the best methods of
a broad policy devoted to that end. But it shuns many political issues,
which the practical man cannot ignore: and it is therefore a science,
pure and applied, rather than a science and an art. And it is better
described by the broad term “Economics” than by the narrower term
“Political Economy”.”

Here, ‘economic aspects and conditions’ refer to the provision for food
and shelter, the working life etcetera. Nowadays we would tend to
include more subjects, and still say that ‘economics’ is involved in
it. To us, ‘economics’ sets in (as a sufficient but not necessary
condition) as soon when some preference decision is to be made.
Marshall’s tools, as for example the scissors of supply and demand,
have been applied to this wider area of application too. This indeed
may well be the luxury situation that he expected.

By consequence, it is useful to still use the name ‘economics’ for the
wider subject areas, even though allowing for more subjects causes less
‘economic content’ than Marshall perceived. Economics thus is
characterised by the approach, method and tools used. On the other
hand, ‘political economy’ then concentrates on one particular subject:
the management of the state. Much of Marshall’s “Principles” will,
paradoxically, then be relevant for political economy.

Gambs and Komisar’s 1968 textbook “Economics and man”, chapter 1,
gives a nice overview of the various definitions that early economists
have provided. A longer quote (of those quotes) usefully enriches our
understanding of the definition of ‘political economy’.

“What is economics all about? It is often defined as the science of
wealth or as the study of how mankind gets its living. Statements like
this are certainly useful, but they are also too general. When we try
to take the next step, we get into trouble. We meet difficulties in
pinning economics down because its practitioners are in disagreement
about the scope and nature of their science, and attempts to
particularize lead to protests from opposing schools of thought. The
only definitions on which agreement is possible are broad ones like
those given above, or humorous ones like “Economics is whatever an
economist wants to talk about.”

The reader may have misgivings about studying a science in which
disagreements arise at the very start. His doubts are indeed well
founded but should not too quickly turn him away. After all, there are
still differences of opinion even in astronomy and phyics, chemistry
and biology. Psychology remains a free-for-all. No considerable field
of knowledge is so completely understood that all of its scholars speak
with the same voice. The process of reaching a balanced conclusion
often requires a sifting of the testimony of contradictory witnesses.
In any event, stress on differences should not obscure the fact that
all sciences, including even economies, agree on many things. There is,
besides, an enormous store of historical and descriptive
matter—economic facts—that is well worth knowing and concerning which
there is little dispute. We shall hope that the burden placed on the
reader of suspending judgment and viewing the same things in different
lights will not be too heavy.

One of the dominant schools of the day looks upon economics as study of
what happens when we try to reconcile the scarcity of things with the
insatiable wants of human beings. Most things worth having, except the
air we breathe are scarce — scarce enough, at least, to command a price
and not to be available to all in generous quantity. Among the less
dominant and dissenting schools is one that considers the study of the
disposal of scarce goods too restrictive. Some members of this class
focus their interest on the moral codes, business practices, social
instimtions, legal framework, and the like under which we get our food,
clothing, and shelter. They study an economic system — capitalism, for
example — in much the same way that an anthropologist studies the
Klamath Indians or some primitive tribe of a South Sea island. They
ask, and try to answer, questions that have little to do with the
disposal of scarce goods.

The student may find it helpful to examine the definitions given below.
They represent the thought of several periods and schools. In these
definitions the older phrase “political economy” is more or less equal
to the modern word “economics.”

Oeconomy, in general, is the art of providing for all the wants of a
family, with prudence and frugality …. What oeconomy is in a family,
political oeconomy is in a state (Sir James Steuart, 1712-1780).

Writers on Political Economy profess to teach, or to investigate, the
nature of Wealth, and the laws of production and distribution:
including directly or remotely, the operation of all causes by which
the condition of mankind, or of any society of human beings, in respect
to this universal object of human desire, is made prosperous or the
reverse (John Stuart Mill, 1896-73).

Political Economy treats chiefly of the material interests of nations.
It inquires how the various wants of the people of a country,
especially those of food, clothing, fuel, shelter, of the sexual
instinct etc., may be satisfied; how the satisfaction of these wants
influences the aggregate national life, and how in turn, they are
influenced by the national life (Wilhelm Roscher, 1817-94).

Political Economy or Economics is a study of mankind in the ordinary
business of life; it examines that part of individual and social action
which is most closely connected with the attainment and with the use of
the material requisites of well being. Thus it is on the one side a
study of wealth; and on the other, and more important side, a part of
the study of man (Alfred Marshall, 1842—1924).

Economics is a study of the “community’s methods of turning material
things to account” (Thorstein Veblen, 1857—1929)

Economics ... is concerned with that aspect of behavior which arises
from the scarcity of means to achieve given ends (Lionel Robbins, 1898—
).

. . . Economics is ... a social science; that is, it deals with the
behavior of men in organized communities. Its special province is the
behavior of social groups in providing the means for attaining their
various ends (Wesley Mitchell, 1874—1948).

The theory of economics … is a method rather than a doctrine, an
apparatus of the mind, a technique of thinking, which helps its
possessor to draw correct conclusions (John Maynard Keynes, 1883—1946).

A few comments on the above may help. The first definition, by Steuart
was conceived before much formal and sustained thought by a succession
of scholars had been given to what we now name “economics”. Steuart was
a mercantilist, primarily interesed in the wealth of the British crown
and its capacity to support a navy, pay soldiers, and build and
maintain the King’s highways. His concern was not with the nation as a
whole — the artisans, farmers, and other men of low degree. In
contrast, the next definition, by Mill — a very acceptable definition
even today — does consider the society as a whole. It also calls
attention to the “laws of ... production and distribution.” which are
still at the forefront of economic interest. With the exception of the
definition given by Lionel Robbins, all of the others reach down — like
Mill — into the entire community. Veblen and Mitchell are dissenting
economists (…) Yet both echo the phrase of Marshall, a major orthodox
economist, about “the attainment . . . of the material requisites of
well being.” Marshall, Robbins, and Mitchell place emphasis on human
behavior. This is a desirable emphasis, lest we forget because of our
shorthand way of speaking that human beings are the cause of economic
phenomena. For example, economists are much concerned about the rise
and fall of prices; but prices do not rise and fall. Human beings mark
them up or down. The majority of American standard or orthodox
economists would endorse the definition given by Marshall, not only
because it is a good one, but also because of his great authority. Yet
Robbins’ — so completely different—would also meet with great favor.
What economists like about this pithy definition is that it goes to the
heart of an issue which engrosses many of them: how to reconcile
scarcity or the niggardliness of nature with the unlimited desires of
man. Economists like to say they will not be needed in heaven. The
reason is that in paradise, wants are few and resources boundless. Its
inhabitants will never have to decide how much to spend and how much to
save, how heavily to tax, how much butter to give up in order to have
guns.

The definition given by Keynes, the most widely acclaimed economist of
the 20th century, is a rather puzzling one. Economics is here defined
partly as a “technique of thinking.” What does this mean? Obviously,
any organized body of knowledge directs the mind in ways that are
foreign to other organized bodies of knowledge. The chemist thinks
about how atoms combine, whether they combine explosively or quietly,
what happens when you restructure the atoms of a molecule. In this
sense, we get a unique “technique of thinking” in almost any
specialized activity, including economics; indeed, even baseball,
football, and other sports impose a special technique of thinking, But
is his all that Keynes has in mind? Certain well-known techniques of
thinking include induction and deduction. Behaviorist psychologists —
at least in the early days—reduced thinking to inaudible speech; the
philosopher John Dewey described thinking as problem solving. Without
clarifying, Keynes seems to claim for economics a unique method of
ascertaining truth—one which is either a substitute for or an addition
to the more widely known methods suggested above; something you would
not find in a book of logic, only in a book of economics. If this is
his meaning, we must reject the definition, for the method of
scientific investigation and techniques of thought are the same for all
kinds of data; and in any case, there is a difference between the
concerns and data of economics and the method of studying it — a
difference which is not recognized in the Keynesian definition.

The question whether economics is really a science cannot be answered
easily. Astronomy, chemistry and physics have spoiled us with their
split-second accuracy and such infallibility of prediction that we are
inclined to look with disdain at the social sciences. Biology has not
scored the successes credited to the physical sciences, but it still
outpaces economics by a good deal. If, however, science is thought of
as an attitude, a willingness to put aside prejudice, self-interest,
and the unverified wisdom of the authority, then economics will fare
moderately well.”

This ends the longer quote.

Gambs and Komisar themselves state: “The economist’s job in our society
- as it would be in simpler societies - is to study all of our
decision-making forces, practices, and traditions, and to decide
whether they are promoting the general welfare.” (p14)

My own notes on all of this: (1) Keynes’s quote likely refers to the
‘science’ claim for economics, and has less to do with its subject
matter. See the discussion on Hicks in chapter 19. (2) Robbins’s
definition, though popular as it is - since it focusses on a clear
phenomenon that can be frequently seen - thus is inadequate on the
whole. It is an engineering’s definition, a rephrasing of ‘efficiency’.
It is useful to highlight some aspects, but no more. It neglects policy
stagnation that causes a state of inefficiency to endure. It neglects
evolution and power that for example affect the income distribution.
Robbins’s definition is like defining a map as ‘a piece of paper that
contains street names’, forgetting all the other useful things that map
makers provide.

Mankiw (1998:4) defines: “Economics is the study of how society manages
its scarce resources.”

This again mixes ‘economics’ (the approach) and ‘political economy’ (a
subject). I am not in favor of this, see the introductory discussion.
The ‘10 principles’ that Mankiw himself provides in his first chapter
give a nice view on the economic approach to problems - quite like
Keynes’s definition - but do not tell us much yet about the management
of the state.

Piet de Wolff (1911-2000) introduced the distinction ‘macro-economics’
and ‘micro-economics’, in his 1941 article on elasticities, in The
Economic Journal. His distinction is plain technical, and his
‘macro-economics’ appears to be just another word for ‘aggregate’. I
surmise that the economics profession quickly adopted the word
‘macro-economics’ since it sounds more professional and less political
than ‘Political Economy’. It sounds as a distinction that can be made
within economics, without having to visit the other sciences. The
problem with equating macro-economics with Political Economy however is
that Political Economy also is interested in distributional aspects -
while macro-economics by definition looks at the aggregate only. A
problem with publishing a book on micro-economics (and using that word
as the title) is that good micro-economics of course also includes the
macro-economic feedbacks and constraints. So my suggestion is to use
the ‘macro’ and ‘micro’ words as technical terms only (better sounding
than ‘aggregate’ and ‘disaggregate’), and not write books with those
titles or create professorial chairs on those ‘subjects’.

Biographical note on Montesquieu

Quoting from
http://www.geocities.com/Athens/Acropolis/6681/montesqb.htm:

“Montesquieu, Charles Louis de Secondat, Baron de la Brede et de
(1689-1755), French writer and jurist, born in the Chteau of la Brède,
and educated at the Oratorian school at Juilly and later at Bordeaux.
He became counselor of the Bordeaux parliament in 1714 and was its
president from 1716 to 1728. Montesquieu first became prominent as a
writer with his Persian Letters (1721; trans. 1961); in this work,
through the device of letters written to and by two aristocratic
Persian travelers in Europe, Montesquieu satirized contemporary French
politics, social conditions, ecclesiastical matters, and literature.
the book won immediate and wide popularity; it was one of the earliest
works of the movement known as the Enlightenment, which, by its
criticism of French institutions under the Bourbon monarchy, helped
bring about the French Revolution. The reputation acquired by
Montesquieu through this work and several others of lesser importance
led to his election to the French Academy in 1728. His second
significant work was Considérations sur les causes de la grandeur et de
la décadence des Romains (Thoughts on the Causes of the Greatness and
the Downfall of the Romans, 1734), one of the first important works in
the philosophy of history. His masterpiece was The Spirit of Laws
(1748; trans. 1750), in which he examined the three main types of
government (republic, monarchy, and despotism) and states that a
relationship does exist between an area’s climate, geography, and
general circumstances and the form of government that evolves.
Montesquieu also held that governmental powers should be separated and
balanced to guarantee individual rights and freedom.”

Note that his original name was Secondat, and that he inherited the
title of Baron from his uncle in 1716. He also was elected to the Royal
Society in 1730. See http://tqd.advanced.org/3376/Monty2.htm

Sir Isaiah Berlin: “Montesquieu advocated constitutionalism, the
preservation of civil liberties, the abolition of slavery, gradualism,
moderation, peace, internationalism, social and economic justice with
due respect to national and local tradition. He believed in justice and
the rule of law; detested all forms of extremism and fanaticism; put
his faith in the balance of power and the division of authority as a
weapon against despotic rule by individuals or groups or majorities;
and approved of social equality, but not the point which it threatened
individual liberty; and out of liberty, but not to the point where it
threatened to disrupt orderly government.” (“Against the Current”)
(Also taken from the internet.)

The Spirit of Laws can actually be read on the internet at
http://www.constitution.org/

I’ve read the introductory parts, and find them still quite readable.
One notes that Montesquieu refers to the ‘laws of the material world’,
and one cannot but think that Newton (1642-1727) has some influence
here.

It is interesting too what Montesquieu has to say on economics (Book
XX.7):

“Other nations have made the interests of commerce yield to those of
politics; the English, on the contrary, have ever made their political
interests give way to those of commerce. They know better than any
other people upon earth how to value, at the same time, these three
great advantages -- religion, commerce, and liberty.”

Also interesting is what he writes on taxes:

“12. Relation between the Weight of Taxes and Liberty. It is a general
rule that taxes may be heavier in proportion to the liberty of the
subject, and that there is a necessity for reducing them in proportion
to the increase of slavery. This has always been and always will be the
case. It is a rule derived from nature that never varies. We find it in
all parts -- in England, in Holland, and in every state where liberty
gradually declines, till we come to Turkey.” (Book XIII.12)

Also:

“Thus, in the Roman world, as at Sparta, the freemen enjoyed the
highest degree of liberty, while those who were slaves laboured under
the extremity of servitude.

While the citizens paid taxes, they were raised with great justice and
equality. The regulation of Servius Tullius was observed, who had
distributed the people into six classes, according to their difference
of property, and fixed the several shares of the public imposts in
proportion to that which each person had in the government. Hence they
bore with the greatness of the tax because of their proportionable
greatness of credit, and consoled themselves for the smallness of their
credit because of the smallness of the tax.

There was also another thing worthy of admiration, which is, that as
Servius Tullius’s division into classes was in some measure the
fundamental principle of the constitution, it thence followed that an
equal levying of the taxes was so connected with this fundamental
principle that the one could not be abolished without the other.”
(Book XI.19)

He discusses exemption of taxes for whole provinces.

18. Of an Exemption from Taxes. The maxim of the great eastern empires,
of exempting such provinces as have very much suffered from taxes,
ought to be extended to monarchical states. There are some, indeed,
where this practice is established; yet the country is more oppressed
than if no such rule took place; because as the prince levies still
neither more nor less, the state becomes bound for the whole. In order
to ease a village that pays badly, they load another that pays better;
the former is not relieved, and the latter is ruined. The people grow
desperate, between the necessity of paying for fear of exactions, and
the danger of paying for fear of new burdens. (XIII.18)

On exemption we also find something like a ‘basic income’ for nobles:

“We find in Xenophon’s Banquet a very lively description of a republic
in which the people abused their equality. Each guest gives in his turn
the reason why he is satisfied. “Content I am,” says Chamides, “because
of my poverty. When I was rich, I was obliged to pay my court to
informers, knowing I was more liable to be hurt by them than capable of
doing them harm. The republic constantly demanded some new tax of me;
and I could not decline paying. Since I have grown poor, I have
acquired authority; nobody threatens me; I rather threaten others. I
can go or stay where I please. The rich already rise from their seats
and give me the way. I am a king, I was before a slave: I paid taxes to
the republic, now it maintains me: I am no longer afraid of losing: but
I hope to acquire.”” (Book VIII.2)

Price inflation and wage growth in Holland 1950-2002

Table 20: Price inflation and wage growth in Holland 1950-2002

Source: Central Planning Bureau (January 2003)

_Year_

_% change_

_1951=100_

_dlog P_

_dlog wi_

_P_

_wi_

1950

8.7

1951

11.1

10.4

100

1952

0.3

5.4

100

105

1953

-0.7

4.2

100

110

1954

4.0

9.2

104

120

1955

1.7

8.9

105

131

1956

2.1

8.6

108

142

1957

5.5

10.8

113

157

1958

1.6

4.4

115

164

1959

1.2

2.4

117

168

_dlog P_

_dlog wi_

_P_

_wi_

1960

2.3

8.2

119

182

1961

2.1

7.2

122

195

1962

2.6

5.9

125

206

1963

3.8

9.0

130

225

1964

6.5

14.9

138

258

1965

3.6

11.1

143

287

1966

5.3

11.

151

319

1967

2.9

8.8

155

347

1968

2.5

8.9

159

377

1969

6.2

13.4

169

428

1970

4.4

12.8

176

483

1971

7.9

13.6

190

548

1972

8.3

12.6

206

617

1973

8.5

15.8

223

715

1974

9.5

15.6

245

826

1975

10.1

12.8

269

932

1976

9.0

10.9

293

1034

1977

6.1

8.7

312

1124

1978

4.5

7.2

326

1205

1979

4.3

6.1

340

1279

1980

6.9

6.1

363

1357

1981

6.3

4.2

386

1413

1982

5.3

6.3

407

1502

1983

2.8

3.8

418

1559

1984

2.1

0.5

427

1568

1985

2.2

1.8

436

1597

1986

0.2

2.1

437

1630

1987

-0.2

1.4

436

1653

1988

0.6

1.1

439

1672

1989

1.6

0.8

446

1685

1990

2.5

3.0

457

1735

1991

3.1

4.4

471

1811

1992

3.2

4.1

486

1886

1993

2.6

2.9

499

1940

1994

2.7

2.4

512

1987

1995

2.0

1.3

522

2013

1996

2.1

1.1

533

2035

1997

2.2

2.3

545

2082

1998

2.0

4.0

556

2165

1999

2.2

3.1

568

2232

2000

2.6

5.0

583

2344

2001

4.5

4.8

609

2455

2002

2.5

4.2

625

2559

Income distribution in Holland 1950 and 1988

Rijken van Olst (1969:97) provides the Dutch income distribution for
1950. Here income is measured in Dfl thousands (thousand guilders) of
1950, and the observed frequency concerns males with tax obligations. A
Dfl is about 0.5 €.

The Centraal Bureau voor de Statistiek (1991:47) provides an income
distribution for 1988, in Dfl thousands of 1988, and the observed
frequency concerns the ‘active’ population with an income, i.e.
exclusive of fulltime benefit recipients, but, in this case, also
exclusive of independents.

Table 21 contains both distributions. Income class _c_[_i_] means that
incomes from _c_[_i-1_]_ < c_[_i_] are considered, so that _c_[_i_]
itself is excluded. With _f_[_c_] the frequency observed for class _c,
_we can compute the frequency density as _f_[_c_[_i_]]
/ (_c_[_i_] - _c_[_i-1_]) or the frequency adjusted for
the range concerned.

Table 21: Dutch income distribution for 1950 and 1988

1950

1988

Class
(Dfl 1000)

Frequency
(1000)

Frequency
density

Class
(Dfl 1000)

Frequency
(1000)

Frequency
density

< 1

343

< 2

334

167

544

185

909

192

618

197

261

193

136

181

163

151

138

149

173

221

110

267

134

100

288

144

100

294

147

291

146

302

151

289

144

237

118

224

112

384

257

118

100

150

200

These data are not comparable, and some aspects are a bit less relevant
for our objectives. Apart from the difference in independents, the 1950
distribution excludes females, and the 1988 distribution contains
parttimers while the number of parttimers has strongly increased
compared to 1950. In both cases it are incomes, and not just labour
earnings. However, we can see how far we get.

Table 22 contains a summary review, with both the numbers of persons
involved, the total and average income (in currency of the relevant
year). It appears that by dropping the lowest 8 classes of the 1988
distribution we are better approximating the situation without the
parttimers. This then is used for estimation of the lognormal
productivity distributions that are used in the illustrations in the
body of the text.

Table 22: Summary of the Dutch income distributions
for 1950 and 1988

_ _

_Number of persons_

_(thousands)_

_Total income_

_(Dfl million)_

_Average income_

_(Dfl thousand)_

1950

3096

10993

3.5

1988 with the first 8 classes excluded

4081

154120

37.7

1988

5677

165460

29.1

Program used in the analysis on exposed and sheltered sectors

This program uses the Applied General Equilibrium routine of the
Economics Pack (Colignatus (1999)), which routine is based on work of
Asahi Noguchi and Silvio Levy, see the chapter in Varian (1993). It is
nice to show how simple modeling actually can be made.

Needs[“Economics`Pack`”]

ResetAll

Economics[“AGE`”]

SetFunction[withl, shel] =

{Function ( 0.4 (1-q) hs^0.334 + 0.6 (1-q) ms^0.334 + q ls^0.334)^3,

CoefficientList { q 0.1}, Factors {hs, ms, ls} }

SetFunction[withl, expo] =

{Function

(( (c he^(1-1/s2) + (1-c) me^(1-1/s2))^(1/(1-1/s2)) )^(1-1/s) * (1-d)
+

d * le^(1-1/s) )^(1/(1 - 1/s)),

CoefficientList {c 0.2, d 0.01, s 1.2, s2 0.4},

Factors {he, me, le} }

SetModel[NumberOfSectors 2, NumberOfFactors 3, Utility CES,

Production {Sector[1] SetFunction[withl, shel],

Sector[2] SetFunction[withl, expo] } ]

ownpars = {Utility {Scale[Utility] 1, RTS[Utility] 1, S[Utility]
0.6,

FactorE[1] 0.7, FactorE[2] 0.3},

Production {}, Resources {15, 75, 10}}

eq = Equilibrium[ownpars]

AllocationTable[Allocation[ownpars]]

shares = (FactorPrices /. eq) * (Resources /. ownpars)
/ (YEq /. eq)
/
/
cpc23 = CPCDiagram[ownpars, AxesLabel {“Sheltered”, “Exposed”},

AspectRatio Automatic]

ploteq1 = EdgeworthBowley[ownpars, Factor {1, 2}, PlotPoints 50]

(*l = 0*)

SetFunction[withoutl, shel] =

{Function ( 0.4 (1-q) hs^0.334 + 0.6 (1-q) ms^0.334 + q ls^0.334)^3,

CoefficientList {}, Factors {hs, ms} } /. {ls 0, q 0.1}

SetFunction[withoutl, expo] =

{Function (( (c he^(1-1/s2) + (1-c)
me^(1-1/s2))^(1/(1-1/s2)) )^(1-1/s) * (1-d) +

d * le^(1-1/s) )^(1/(1 - 1/s)) /. {le 0, s 1.2, s2 0.4} //
PowerExpand,

CoefficientList {c .2, d 0.01}, Factors {he, me}}

SetModel[NumberOfSectors 2, NumberOfFactors 2, Utility CES,

Production {Sector[1] SetFunction[withoutl, shel],

Sector[2] SetFunction[withoutl, expo] } ]

pars22 = {Utility {Scale[Utility] 1, RTS[Utility] 1, S[Utility]
0.6,

FactorE[1] 0.7, FactorE[2] 0.3},

Production {}, Resources {15, 75}}

eq22 = Equilibrium[pars22]

AllocationTable[Allocation[pars22]]

shares22 = (FactorPrices /. eq22) * (Resources /. pars22) / (YEq /.
eq22)

cpc22 = CPCDiagram[pars22, AxesLabel {“Sheltered”, “Exposed”},

AspectRatio Automatic]

ploteq4 = EdgeworthBowley[pars22, Factor {1, 2}, PlotPoints 50]

cpcfin = Show[cpc23, cpc22]

ebfin = Show[ploteq1, ploteq4,

FrameLabel {“Total high pr. labour”, “Total middle pr. labour”}]

A note on Hayek

Writing this book got me to read some of Hayek (1984) - finally, and
after great misgivings. As a rule, a student of economics should always
read up on the Nobel laureates, but Hayek never inspired me. What I
read about his work made it uninviting. In Skidelsky’s biography of
Keynes he is reduced from a critic of Keynes to someone whom Keynes,
exasparated from lack of progress in communication, took along to go
and buy old books. Later Hayek got a following of ‘libertarians’ and
that was equally unattractive (not to be confused with ‘librarians’
(;-)).

I likely agree with Mark Blaug (1985:90): “In short, everyone agrees
with what Hayek means in general but there is a large spectrum of
answers to what he means in particular. It will take another generation
to fully digest Hayek’s many and multifaceted contributions to
economics and indeed social science as a whole.”

What I finally got to read of Hayek actually made me better appreciate
part of his work, though the feelings remain mixed.

For starters, it appears that Hayek considers himself to be a ‘whig’
like Gladstone and de Tocqueville, and that he was not too happy with
the ‘libertarians’. This is quite a relief to read, and I am sorry that
I have entertained such a prejudice for so long. (And: Why can’t
reporters be more accurate ?)

Secondly, Hayek is known in current economics for his early comments on
the relevance of ‘knowledge’. My hesitation on this remains, though.
This hesitation derives from the consideration that he apparently
didn’t advance beyond Walras’s solution of assuming tatonnement, and
similarly I find it hard to believe that other early economists
disregarded knowledge. (Keynes for example emphasised ‘expectations’.)
But ‘knowlegde’ is an issue.

Subsequently, though, I was jolted by Hayek’s discussion of the
philosophical consequences of his theory of knowledge. Some of his
thoughts are precisely the same as mine ! Notably (I could not have
said it better!):

“The sense data, or the sensory qualities of the objects about which we
make statements, thus are pushed steadily further back; and when we
complete the process of defining all objects by explicit relations
instead of by the implicit relations inherent in our sensory
distinctions, those sense data disappear completely from the system. In
the end the system of explicit definitions becomes both
all-comprehensive and self-contained or circular; all the elements in
the universe are defined by their relations to each other, and all we
know about the universe becomes contained in those definitions. We
should obtain a self-contained model capable of reproducing all the
combinations of events which we can observe in the external world, but
should have no way of ascertaining whether any particular event in the
external world corresponded to a particular part of our model. Science
thus tends necessarily towards an ultimate state in which all knowledge
is embodied in the definitions of the object with which it is
concerned; and in which all true statements about these objects
therefore are analytical or tautological and could not be disproved by
any experience. The observation that any object did not behave as it
should could then only mean that it was not an object of the kind it
was thought to be. With the disappearence of all sensory data from the
system, laws (or theories) would no longer exist in it apart from the
definitions of the objects to which they applied, and for that reason
could never be disproved.” Hayek (1984:230-231)

Clearly, a fully ‘self-contained model’ might take a million years to
make - and I doubt whether sense input can be really fully eliminated -
but the Definition & Reality approach of using a ‘reduced form of
stylized facts’ is quite along the same tracks, and differs only in
digits of accuracy.

Thirdly, Hayek (1984) discusses constitutional reform. I’d rather not
use this space to comment on those particular thoughts, especially on
those of constitutionally allocating younger women to older men, since
I would digress on my subject. But it remains useful to note, then,
that more economists have taken up the issue of the constitution. (And
to be clear about it: I write these lines with lots of laughter.)

It appears (more soberly) that Hayek is mentioned a number of times by
Sen (1999a) “Development as freedom”. Sen even states: “(…) my
admiration for Friedrich Hayek and his ideas (he has contributed more
than perhaps anyone else to our understanding of constitutionality, the
relevance of rights, the importance of social processes, and many other
central social and economic concepts) (...)” (Sen:257) !

Sen’s “freedom” is Hayek’s “liberty”, see in particular p289-292 where
Sen clarifies that ‘income’ has been and is a useful indicator but
tends to be overvalued and mistaken for the true objectives relating to
freedom. See the discussion of Sen’s book above.

Sen however rightly criticises Hayek’s misuse of the argument of
‘unintended consequences’ against social change, and in fact makes fun
of it:

“The idea that unintended consequences of human action are responsible
for many of the big changes in the world is not hard to appreciate.
Things often do not go as we plan. Sometimes we have excellent reason
to be grateful for this, whether we consider the discovery of
penicillin from a leftover dish not intended for that purpose, or the
destruction of the Nazi party caused by - but not intended in -
Hitler’s military overconfidence. One would have to take a very limited
view of history to expect that consequences match expectations as a
general rule.” (Sen:254)

“If it is, as Hayek puts it, a “profound insight,” then there is
something wrong with profundity.” (Sen:257)

Sen concentrates on the difference between ‘unintended’ and
‘unpredictability’. I think that the argument can even be stronger than
that, but, don’t pursue that reasoning here, since it is not the topic
of discussion.

Fourthly, it appears that Hayek in “Road to serfdom” argues in favour
of a ‘guaranteed minimum income for everyone’ - which would be called a
‘basic income’ nowadays. This is actually a fairly decent approach to
the poverty problem - though I would suggest that workfare at a living
wage would be more appropriate. It is interesting to see that Keynes
recommended that book and supported it for its ‘ethics and philosophy’
(though not explicitly for its economics).

Fifthly, Hayek (1984)’s chapter on Bernard Mandeville is advised
reading.

A note on Barrow’s “Impossibility”

John D. Barrow (1998) “Impossibility” gives a nice introduction into
some of the topics that we encounter when developing the Definition &
Reality methodology. I have taken a useful quote from one of his pages
to emphasise a main point. A point of consideration however is that
Barrow only provides an introduction and a starting point, and there is
need for more discussion and refinement of the argument. Some points of
warning are:

1. Barrow uncritically adopts Arrow’s explanation for his
impossibility theorem - and we have shown that this explanation is
erroneous.

2. On the logical paradoxes (e.g. Epimenides’ Liar paradox [142])
I have presented a ‘logic of exceptions’ that changes the argument.
(Not in this book.)

3. See our discussion on non-Euclidean geometry in the main body
of the text.

4. On p23 Barrow suggests that at small dimensions ‘concepts’
like velocity and position can only exist with ‘limited sharpness’ -
which is a very strange thing to say.

5. Barrow p22 states: “There have occasionally been attempts to
find mental consequences of Heisenberg uncertainty, but the general
opinion is that the effects are too small on the scale of neurons to
have any significant effect upon the human thinking process.” Well,
Schrödinger gave his cat-example that quantum mechanics can extend into
the macro world. (We don’t seem to have that mechanism in our head
though, but there can be equivalent ones.)

6. We should be more critical about how physicists deal with
their ‘measurement problems’ in general.

A constitutional amendment for an Economic Supreme Court

As an economic expert I advise to a parliamentary enquiry and a public
debate on this issue. It are the present powers in government that must
grow convinced of the need for a better balance of powers. The evidence
will likely convince them, if only they study it.

The following is a text that may serve as a concept for a
constitutional amendment. The text assumes the common Trias Politica.
It uses the term “Parliament” for the legislative branch (e.g. US
Congress), and “President” for the executive branch (e.g. the UK
Cabinet). It then adds the Economic Supreme Court. The given size,
terms and other properties of the Economic Supreme Court seem best to
create a balance for group decision making, openness, stability and
change.

This text has essentially been posted on the internet in 1996. The
major current change with respect to that text is a result of Frank
Sulloway’s “Born to rebel” (1996) and the subsequent reports - Van den
Berg (2004) refers to _Nature_ - that these findings are not accurate.
Sulloway argues that first-borns tend to be less open to new ideas but
more likely to have responsible positions. This causes the idea that,
since the court should be sensitive to new discoveries and be critical
to abuse of authority, it would seem wise to have some test on
open-mindedness. This needs to be investigated upon. Since this is a
constitution, we should formulate a general rule, and we should leave
it to the practical times and state of scientific inquiry how this is
implemented, by first-bornnesss or by some other verifiable criterion.

The nation has an independent and scientific Economic Supreme Court of
equal status next to Parliament, the President and the Supreme Court.

1. The task of the Court is to scientifically check the economic data,
assumptions, analyses and projections underlying the government’s
budget and its draft statement, and then possibly veto the official
adoption and publication of the budget, if the Court finds that the
information used and presented, and in particular the estimates for the
deficit and national debt, are not scientifically correct. The Court
will publish its findings both for Parliament and for the scientific
community.

2. Members of the Court are appointed by the Court itself, subject to a
veto by a normal majority in Parliament.
The Court will inform Parliament about the name and credentials of the
candidate for appointment. Parliament will have 50 days to discuss and
possibly veto an appointment. The appointment of the candidate becomes
effective when Parliament does not veto the appointment.

3. The Court consists of 7 members. At least 5 members have a high
likelihood of open-mindedness, by criteria generally accepted in the
scientific community.

4. Term rules are:

a) Each member serves a term of 7 years. Each year the member with the
longest term resigns, and a new member is appointed.

b) Terms run from May 1st till April 30st, 7 years later. If a
member resigns before the end of the term, then the replacement will
concern only the remainder of the term.

c) Members may only serve for two terms, which terms need not be
consecutive. A part term will not count if its duration is less than 4
years.

d) All 7 members participate in the selection of a candidate for
appointment.

e) The Court chooses its chairperson from among its members.
Non-eligible are the newly appointed and the resigning member, so that
only 5 members are eligible.

f) The Court determines its modus operandi further by itself.

5. Parliament may, if the occasion arises, decide to dismiss an
existing Court and reappoint a new one, which decision requires a
majority of two-thirds. Parliament may not override a veto by the
Court, by any majority. It is up to the newly installed Court to decide
if a wronged veto is repealed.

6. The means of the Court are as follows:

a) The Court can appoint a staff of maximally 150 persons. Minimally
50% of the staff shall have an appointment as scientist, and they shall
operate under both common scientific standards and a special statute
that has precedence. This special statute shall be established and
published by the Court.

b) The Court can instruct the President to provide information.
The President may refuse information only if national security is at
stake. Information that the President regards as confidential will be
treated as confidential by the Court and its staff too, unless the same
information can be received via independent other channels too.

c) When State governments within the Federation install their own
Economic Courts, then possible disputes shall be settled by the
Economic Supreme Court.

d) The Court can install a council of economists and other
specialists from the academia. The Court can install chambers of
special competence.

e) The Court shall have a budget that compares favourably to the
average budget of scientific research institutes of the same size.

A parallel argument on the Central Bank

The analysis about the Economic Supreme Court and the ‘natural
monopoly’ argument about economic policy advice, actually finds a
parallel with respect to the Central Bank. Reading Galbraith (1998)
made me aware of this situation.

Let us regard the situation that market forces determine the rate of
interest to a large extent, but that the Bank is not without some power
and will use its influence on rates to control inflation.

· Theory dependence: The Bank decides on its policy while using an
economic model that contains a mechanism for the determination of the
rate of interest - for example the rate of interest will contain
anticipated inflation. Hence policy is directly dependent upon the
state of economic theory.

· Self-reference (reflexiveness): Since interest rates are sensitive to
Bank policy, Bank policy would be part of the model. Popular thought
has it that a good Bank would target at zero inflation, but Bank policy
generally would be different. For example, a true zero target would
require that a period with inflation is followed by deflation, and
Banks generally don’t do that. Also, the true price level should
include inventories and capital stocks, but inflation generally is
measured as the CPI, which is something totally different. These
details, and Bank policies on them, should be put into the model (with
error terms to allow for possible discretion).

· Conflictive self-reference: Clearly, one can conceive the situation
that the Bank announces a policy while the true scientific forecast
shows that the policy is untenable and will be repealed later. Hence
there is an internal source of conflict - the worst kind, not a
dysfunctional person, but a logical knot.

· General conflict of interests: The Central Bank may not only have the
objective to control inflation but also other objectives, like for
example supporting and supervising the financial system. For example,
the US Fed is not purely a governmental body, but it is rooted in the
financial system and it is influenced by private interests therein. See
Galbraith (1998:221-231) for a discussion on the conflict of interests
- for example on the ‘credit crunch’ - and read also Krugman on the
Savings & Loans debacle.

Hence, along the ‘TP & ESC’ line of argumentation, we can clearly see a
need for reform in existing Central Banking, and the direction that it
would need to take. Interestingly, where economic policy of the state
would have to be co-ordinated with the policy of the Central Bank (that
should best remain independent), there arise questions of structure and
priority. My suggestion is to first create the Economic Supreme Court,
and have it advise on how to position the Bank or its separate
functions.

About the US Council of Economic Advisers

This appendix consists of two large quotes from the White House
internet site in January 2000, with my comments added.

From the “Employment Act of 1946”

“There is hereby created in the Executive Office of the President a
Council of Economic Advisers (hereinafter called the “Council”). The
Council shall be composed of three members who shall be appointed by
the President, by and with the advice and consent of the Senate, and
each of whom shall be a person who, as a result of his training,
experience, and attainments, is exceptionally qualified to analyze and
interpret economic developments, to appraise programs and activities of
the Government in the light of the policy declared in section 2, and to
formulate and recommend national economic policy to promote employment,
production, and purchasing power under free competitive enterprise.

It shall be the duty and function of the Council--

1. to assist and advise the President in the preparation of the
Economic Report;

2. to gather timely and authoritative information concerning
economic developments and economic trends, both current and
prospective, to analyze and interpret such information in the light of
the policy declared in section 2 for the purpose of determining whether
such developments and trends are interfering, or are likely to
interfere, with the achievement of such policy, and to compile and
submit to the President studies relating to such developments and
trends;

3. to appraise the various programs and activities of the Federal
Government in the light of the policy declared in section 2 for the
purpose of determining the extent to which such programs and activities
are contributing, and the extent to which they are not contributing, to
the achievement of such policy, and to make recommendations to the
President with respect thereto;

4. to develop and recommend to the President national economic
policies to foster and promote free competitive enterprise, to avoid
economic fluctuations or to diminish the effects thereof, and to
maintain employment, production, and purchasing power;

5. to make and furnish such studies, reports thereon, and
recommendations with respect to matters of Federal economic policy and
legislation as the President may request. ”

Martin Feldstein on the US Council of Economic Advisers

Quoted from _The Economic Journal, 102 (September 1992),_ “The Council
of Economic Advisers and Economic Advising in the United States”, by
Martin Feldstein.

The Structure of the Council of Economic Advisers

Although the term ‘Council’ conjures up the image of a large committee,
the CEA actually consists only of a chairman and two members. The
chairman is legally responsible for establishing the positions taken by
the Council. The other two members direct research activities of the
Council in particular fields, represent the Council at meetings with
other agencies, and generally work with the chairman to formulate
economic advice.

In addition to the chairman and two other members, the CEA has a
professional staff that is both small and unusual. A group of about ten
economists, generally professors on one- or two-year leaves from their
universities, act as the senior staff economists. They in turn are
assisted by an additional ten junior staff economists, typically
advanced graduate students who also spend only a year or two at the
CEA. Four permanent economic statisticians assist the economists in the
interpretation and identification of economic data.

The academic nature of the staff and of most CEA members distinguishes
the CEA from other government agencies. It generally assures a higher
level of technical economic sophistication and of familiarity with
current developments in economic thinking. Members and staff also use
their strong links in the academic community to obtain advice on
technical issues throughout their time in Washington.

There is of course a price to be paid for this reliance on academic
economists, especially at the staff level. They often come to the CEA
without the institutional knowledge of some of the issues with which
they will deal and without any experience in the bureaucratic process
of decision-making. My experience however was that most of the senior
staff economists learned quite quickly to be effective participants,
and made an important contribution to the policy debates because of
their ability to apply economic analysis to the issues being discussed,
and to develop new economic proposals that had not occurred to
non-economist participants from the agencies.

How Advice Is Given

The CEA chairman gives advice directly to the President and to the
senior members of the administration. There is also a broader role of
trying to shape public understanding of the economic issues. The CEA
members and staff participate directly in the inter-agency process, in
which policy options are evaluated and recommendations developed for
presidential decisions.

The specific organization of advice-giving undoubtedly differs from
administration to administration, reflecting the overall form of
economic policy making and the particular style and interest of the
president. I can only describe my own experience.

In the Reagan administration, the cabinet as a whole rarely met.
Instead, economic policy issues were discussed through a series of
cabinet councils with more specialized responsibilities. These included
a cabinet council on commerce and trade that was chaired by the
Secretary of Commerce, a cabinet council that dealt with labour and
social insurance issues, a cabinet council that dealt with regulatory
and legal issues, and a general cabinet council on economic affairs
that was chaired by the Secretary of the Treasury. Each of the
interested departments was represented at the council by the secretary
of that department. Occasionally the deputy secretary or
under-secretary substituted for the secretary at those meetings. I
generally represented the CEA, although occasionally one of the members
took my place at the table. Vice President Bush usually attended these
meetings.

The councils generally met without the president. Roughly twice a month
the president participated in council meetings when there was a
specific issue that required a presidential decision or, occasionally,
a broad area that seemed appropriate for general cabinet-level
discussion with the president.

Any major proposal for legislative action, whether originated by a
department or from Congress, would be assigned to an appropriate
cabinet council for consideration to develop an official administration
position. Initial meetings would be held at a staff level, with the CEA
represented by the senior staff economist with the relevant expertise.
Often discussion at this level would be sufficient to dispose of the
idea, usually with the conclusion that the proposal was well-meaning
but misguided and would not accomplish its stated purpose or would do
so only at an unacceptable economic cost. This would quietly bury an
internal departmental proposal or lead to a formal administration
position to oppose a Congressional initiative.

When there was disagreement about the proposal that could not be
resolved unanimously at the level of this working group, a higher-level
meeting would be held. Each interested department would be represented
at a sub-cabinet level, generally by an assistant secretary. The CEA
would be represented by a member or senior staff economist, since with
only two members it was often true that the CEA only had the expertise
at the senior staff level and preferred to send a real expert rather
than, as in the other departments, to send a more senior official who
was ‘briefed’ but who did not really understand the issues himself.

Once again, if this group could not reach a consensus the issue would
be passed up to the full cabinet council, where the departments were
represented at the top level and the CEA by the chairman. If this group
reached an agreed recommendation, its conclusion would be sent to the
President. When there was disagreement, a summary of the different
positions would be prepared by the staff of the council for submission
to the president for his decision. These decision memos were carefully
prepared so that each side could object to any spurious arguments put
forward by others. On some occasions, when it was felt that such
written summaries were inadequate, the group would meet with the
president to present opposing views.

This process gave the CEA an opportunity to influence both the specific
decisions and the way that members of the administration thought about
particular issues. This was true at every level from the departmental
senior staff that interacted with the CEA economists to the cabinet
level.

In addition to these relatively large group meetings with the
President, there were also smaller meetings dealing with specific
subjects. A central organizing set of meetings each year dealt with the
budget. Here the only regular participants, in addition to the
president and the vice-president, were the Secretary of the Treasury,
the Director of the Office of Management and Budget (OMB), the Chairman
of the CEA, and a small number of senior White House staff. The series
of budget meetings began with a five-year economic forecast prepared by
the CEA. Technical staff discussions and meetings between a CEA member,
a Treasury assistant secretary and an associate director of the OMB
would review the evidence on which a forecast would be based. In
insisted, however, that the CEA alone was responsible for the final
forecast in order to avoid a repetition of earlier experience in which
the forecast was widely (and correctly) criticized as over-optimistic,
and therefore as leading to a substantial underestimate to future
budget deficits. Needless to say, this was a source of friction and
contention.

Other such small meetings with the president included preparation for
the G-7 economic summits, for his televised national press conferences,
and for discussions of special subjects like social security reform.

The Secretary of the Treasury and I also met roughly every two weeks
with the president and a few senior White House staff to discuss
subjects of our choice. The Treasury Secretary frequently used these
sessions to discuss monetary policy or issues currently under
development at the Treasury. I frequently discussed the budget deficit
but also talked about things like the character of unemployment, the
nature of the trade imbalance, and other types of general ‘background’
information. These were not intended as decision-making sessions.

In addition to these meetings, I also sent the president brief memos on
particular issues. Occasionally these would be my thoughts on some
issue being discussed in the administration. There were also almost
daily brief memos telling the President how to interpret important
economic statistics that would be released the next morning so that he
would not be caught unaware of the information (by the press or other
visitors) or uninformed about the significance (or lack of
significance) of the particular statistic.

The CEA also serves as a source of professional economic advice to
other departments and agencies. In some cases, this serves to reinforce
the advice being given by that department’s own economist. In other
cases, it fills a gap where the department does not have an economist
or where the CEA can bring better analysis to a particular problem. As
chairman I also met on an individual basis with the department heads to
discuss policy issues relevant to their department or more general
issues like the budget situation.

A weekly breakfast meeting with the Treasury Secretary and the OMB
Director -- the so-called Troika or T-t group -- provided an important
opportunity to discuss economic issues with complete candour and
without fear of leaks to the press. This small group was occasionally
joined by Secretary of State George Shultz and on some rare occasions
by Federal Reserve Chairman Paul Volcker.

These breakfast meetings were just about the only time during my time
at the CEA when the Fed Chairman participated in a discussion inside
the administration. He met privately of course with the Secretary of
the Treasury and with various financial regulators. I had breakfast
with him every other week and on those occasions we discussed the state
of the economy, the direction of monetary policy, banking regulation,
and such issues as the developing country debt problem, in which the
Fed worked closely with the administration.

As the senior economist in the administration, the CEA chairman is
frequently called upon to discuss economic policy issues in public.
These include testimony to congressional committees, speeches to a wide
array of audiences, occasional television interviews and frequent
discussions with the press. I always regarded these as opportunities to
teach economics. An important challenge was to explain why the dollar
had soared and how that, rather than protectionist policies abroad, was
responsible for our trade deficit. Until the recovery was firmly
established, I would explain why an expansionary fiscal policy was
unnecessary and later I spent endless hours explaining how to assess
the structural budget deficit and why reducing it was important.

The Council of Economic Advisers produces an annual report which
discusses broad issues of economic policy for a general audience. This
report is widely read by the economic press, by Congressional staff and
by academic economists and students.

How the CEA Advises Presidents

_“I think our unique system of placing a professional economist in the
White House to report directly to the president works well. I hope that
future presidents continue to use this policy.”_

The principle of comparative advantage suggests that I, as a former
chairman of the Council of Economic Advisers, convey my knowledge of
this unique and little understood agency. I emphasize the word “unique”
because I believe the CEA is really quite different from advisory
institutions in other countries.

During my time as chairman (1982 through 1984), I had the opportunity
to talk with the senior economic officials in many countries. I never
found one that institutionalized our combination of characteristics: a
professional economist who has direct access to the head of the
government and who participates as an equal in all cabinet-level
discussions.

In other countries, the top economic official is either an economics
minister (i.e., a politician selected from the Parliament who may or
may not be a professional economist) or a professional economist who
reports to the minister of finance or some other cabinet minister.
There are also some special situations in which individual economists
are influential advisers to the heads of government, but these are
personal arrangements that have not been institutionalized in the way
that the CEA has been.

One reason why the American system for giving economic advice differs
from those abroad is that, in our presidential system, it is the
president rather than the minister of finance or budget minister who
has ultimate responsibility for all economic matters. In other
countries, the prime minister or president is less involved with
economic issues and the responsible cabinet member has a political
standing and legitimacy in his own right. In the United States, the
cabinet is in the last analysis an advisory and management body while
all true decision-making authority of the executive branch is vested in
the president.

The role of the CEA and its chairman undoubtedly differs over time
depending on both the chairman and the president. The differences can
be quite profound even within the same set of legal rules. For example,
during the Nixon administration there was a period when George Shultz
served simultaneously as budget director and as counselor to the
president with responsibility for overall coordination of economic
advice. But I have not researched the history of the CEA and will
therefore focus my comments on the period of 1982-1984 that I know from
firsthand experience.

I began by saying that the council is “little understood” because I
have frequently discovered that people are quite surprised when they
learn how small the council is and how it actually operates. The term
“council” seems to conjure up the image of a dozen or more people
sitting around a conference table voting on recommendations of economic
policy. In fact, the CEA has only a chairman and two additional
members.

Since the days of the Arthur Burns’ chairmanship in the Eisenhower
administration, there has been an official executive order vesting all
of the executive authority for the council in the chairman. In
practice, that means that the three members have informal discussions
but do not take votes. It also means that when a formal recommendation
from several agencies is sent to the president, the position taken by
the CEA reflects the judgment of the chairman just as the position of
the Treasury reflects the view of the Treasury secretary. In giving
direct advice to the president, I always spoke for myself rather than
on behalf of the Council.

The CEA has a small but high quality professional staff of about twenty
economists and four economist statisticians. The statisticians are
permanent civil servants who understand the construction of official
economic statistics and do their best to save the economists from
erroneous use of these data. Because the senior staff economists come
fro universities for a one- or two-year period, they keep the CEA up to
date on the best academic thinking on a wide range of subjects.

Although the CEA is physically as well as operationally part of the
White House complex (CEA offices are in the Old Executive Office
Building adjacent to the White House and within the same security
cordon), the economic staff functions in a completely professional and
nonpartisan way. My very able and distinguished staff included Larry
Summers, who was prominent as chief economic adviser to presidential
candidate Michael Dukakis.

The tradition of professionalist is so strong that even in a
presidential election year the CEA chairman appoints members of the
staff for the coming academic year with the clear understanding that
they will continue to serve even if the party in power loses the
presidential election. I might just add in this context that, unlike
the practice in some countries, the members of the CEA and their staff
work full-time at their CEA responsibilities. Indeed, in December and
January of each year, the pressure of working simultaneously on the
Economic Report of the President, the budget, and the issues to be
presented in the president’s state of the union message seemed like
much more than a full-time job.

The CEA was created by the Employment Act of 1946 with a Keynesian
heritage and an expectation that it would give advice about the use of
fiscal policy to achieve and maintain full employment. Needless to say,
there has been a profound change in the economics profession’s thinking
about macroeconomic policy in the past forty years.

Commenting on this

Above description of the US CEA shows that it is very close to the
Executive. There is ‘professionalism’ - and we may willingly interprete
that to mean that one keeps a distance to political scheming and the
illusions of the day - but still, this is not auditing, this is not
verification for verification’s sake, this is not vetoing David
Stockman, this is not sticking to one’s own perception of what the
right model is regardless of what the President likes to think. If
there would be an Economic Supreme Court, then, indeed, the President
would still have need for advice as currently provided by the CEA. One
would imagine that CEA staff members would frequent the Court’s
offices, and such. But the constitutional powers would be
institutionally separated.

We can see that the CEA is so understaffed and so preoccupied with its
duties of ‘running about for the President’, that it failed to pick up
an important analysis. In April 1993, I sent a major piece of my work
to the CEA. And got no reply.

In August 1993, I actually visited the US Treasury, but with little
success. See the appendix on presenting the analysis to the US National
Press below, and the autobiographical appendix as well.

At the end of August, 1993, President Clinton announced a major
increase in the Earned Income Tax Credit (EITC) - see next appendix. I
don’t think that my paper and visit contributed to that. If it has,
they should have replied - and could have gone much further. (But I do
think that the Clinton EITC measure helped, as one factor, to create
the subsequent the long boom in the US economy. There was more
competition on the labour market, and this helped to reduce wage
growth.)

To prof. Blinder

& prof. Stiglitz

Council of Economic Advisers

White House

Old Executive Office Building

Washington DC 20500

Verenigde Staten van Amerika

April 16 1993

Concerning: unemployment and inflation

Dear professors,

It takes time to get things published, so I overcome my hesitations and
send you enclosed paper. It is one of the fruits of 15 years of
econometric research, including long term projections with 2000
equations models.

The paper gives a structural analysis of unemployment, regardless the
state of inflation. The analysis can be extended on the time path of
inflation.

You should read it with a good intuition of the importance of
heterogeneous labour and a reduced form analysis.

I am glad to answer any questions.

Kind regards,

Drs. Thomas Cool

Rotterdamsestraat 69

2586 GH Scheveningen

Holland

Enclosed: paper “On the political economy of employment in the welfare
state”
[Chapters 39 and 40 of this book]

Presentation for the National Press in Washington 1993

The following is a bit of an ambarrasment, but modern courage is not
fighting wild animals but facing such possible views in public opinion.
Anyway, in 1993 my Class of ’73 (of Burbank Highschool, California)
had, guess what, a 20 year reunion. I took the opportunity to visit
Washington, visit the US Treasury, and also present my analysis at the
National Press Building. When I arrived there on August 17, it appeared
that almost everyone had taken their holiday, following President
Clinton to Martha’s Vineyard. My appointment with the Treasury lasted
only some 20 minutes, and my host was too much involved in the Health
Plan and showed no interest in my analysis. The journalists
subsequently must have been at the beach - or in Europe - since nobody
showed up. Perhaps my press release was uninviting too - judge for
yourself, below. I took care that it was distributed to all agencies -
which was another bill to pay. The idea remains: people have had the
opportunity. Note 1: Had I still been at the CPB, then my possibility
frontier with US officials of course had been larger. Note 2: My
foreign exchange year at Burbank High and participation in the US
National Forensics League apparently rubbed off, and I got some editing
help from an American friend: so that my presentation was All American.

Clinton administration EITC plans for 2000

(The following is quoted from the White House internet site.)

THE WHITE HOUSE
Office of the Press Secretary

For Immediate Release

January 12, 2000

PRESIDENT CLINTON PROPOSES TO EXPAND THE EARNED INCOME TAX CREDIT IN
ORDER TO INCREASE THE REWARD FOR WORK AND FAMILY

Today President Clinton Will Announce, in his Address to the Democratic
Leadership Council, A New $21 Billion Plan to Expand the Earned Income
Tax Credit -- A Key Part of His “New Opportunity Agenda.” The
President’s proposal would expand the Earned Income Tax Credit (EITC)
to provide tax relief for 6.4 million hard-pressed working families.
The expansion will cost about $21 billion over 10 years.

Building on the Successes of the 1993 EITC Expansion. In 1993, the
President signed into law the largest EITC expansion ever to provide a
tax cut for 15 million working families while rewarding work and
family. Today, the success of the EITC in reducing poverty and
encouraging work is clear:

· 4.3 Million People Directly Lifted Out of Poverty by the EITC in 1998
-- more than double the number lifted out of poverty in 1993.

· 2.3 Million Children Directly Lifted Out of Poverty by the EITC in
1998. This includes 600,000 African-American children and 600,000
Hispanic children..

· Largest Drop in Poverty and Child Poverty in Over Three Decades. The
poverty rate has fallen from 15.1 percent in 1993 to 12.7 percent in
1998 -- the lowest since 1979. At the same time, the child poverty rate
fell from 22.7 percent to 18.9 percent -- the lowest child poverty rate
since 1980.

· More Single Mom’s Are Working Than Ever Before. The percentage of
single mothers who work and receive no welfare has risen from 60.9
percent in 1992 to 75.0 percent in 1998.

The President’s Proposal Increases the Reward to Work and Family in
Four Ways:

· Expand the Maximum Credit for Working Families with Three or More
Children By $500. This would provide a tax break for 2.1 million low-
and moderate-income working families. This expansion is targeted at the
highest concentration of child poverty: in 1998 the poverty rate for
children in families with three or more related children was 28.5
percent -- more than twice the 11.9 percent poverty rate for children
in families with one or two related children.

· Expand the Credit for Married, Two-Earner Couples. This would benefit
over 1.3 million married filers. For married, two-earner couples, this
provision by itself would provide an average tax break of $250.

· Increase the Reward to Work While Expanding the Credit for Families
with Two or More Children. This would provide an additional tax break,
and an additional incentive to work, for families with two or more
children by lowering the phase-out rate to give more rewards to
families struggling to work their way into the middle class.

· Encouraging Savings Through Simplification. Currently, when a working
family contributes to a 401(k) they may see their EITC reduced. This
proposal encourages savings and simplifies the calculation of earned
income for the purposes of the EITC.

Here is How These Changes Would Increase the Reward to Work for
American Families:

THE PRESIDENT’S PROPOSED INCREASE IN THE EARNED INCOME TAX CREDIT

Pre-1993 Law

Current Law

Proposal

Increase

Married*; 2 children; $20,000 earnings

$1,438

$2,524

$2,940

+$416

Individual; 3 children; $15,000 earnings

$2,331

$3,577

$4,116

+$538

Married*; 3 children; $23,000 earnings

$902

$1,892

$2,867

+$975

*Both spouses must earn at least $725 to qualify for the additional
credit for a married couple.

DETAILS OF THE PRESIDENT’S PROPOSAL

The President’s Proposal Would Expand the Earned Income Tax Credit to
Provide Tax Relief for 6.4 Million Hard-pressed Working Families. The
average increase for families with three or more children is $544 and
some married couples with three or more children could see as much as
an additional $1,155 tax credit. The expansion will cost about $21
billion over 10 years. The four major provisions of President’s EITC
expansion are:

Expand the Maximum Credit for Working Families with Three or More
Children By $500. The President’s proposal would add a “third tier” to
the EITC to expand benefits for families with three or more children.
Very low-income families will get 45 cents for every additional dollar
they earn -- compared to 40 cents under current law. This higher credit
rate will increase the maximum credit for a family with three children
in 2001 from $3,992 to $4,491 -- a roughly $500 increase. This proposed
new “tier” of the EITC is important because 60 percent of all poor
children -- 7.7 million children -- are in families with three or more
children. Adding a third tier to the EITC would provide a tax break for
2.1 million low- and moderate-income working families.

Expand the Credit for Married, Two-Earner Couples. The President’s
proposal would allow married couples to earn an additional $1,450 more
before beginning to have their EITC phased out. For example, in 2001 a
married, two-earner couple with children would be able to earn up to
$14,480 and still receive the maximum EITC, as compared to the $13,030
threshold under current law. The result of this provision would be to
provide an additional $250, on average, for married, two-earner
couples. This provision would benefit over 1.3 million married filers.

Increase the Reward to Work While Expanding the Credit for Families
with Two or More Children. The third provision of the President’s
proposal would provide an additional tax break, and an additional
incentive to work, for families with two or more children. Under
current law the EITC for these families is reduced by 21.06 percent for
each dollar they earn above the maximum threshold. The President’s
proposal would lower this phase-out rate to 19.06 percent -- a tax
break for 5.4 million of America’s hard-pressed working families.

Encouraging Savings Through Simplification. Under current law, 401(k)
contributions and other forms of nontaxable earned income are counted
as income in computing the EITC. For many families this means that if
they increase their contributions to a 401(k) then they will see their
EITC reduced. The President proposes to encourage savings for poor
people by eliminating nontaxable earned income from the calculation of
the EITC. In addition to encouraging savings, this step will simplify
the EITC, and continue to increase compliance.

THE PRESIDENT’S 1993 EITC EXPANSION HAS CONTRIBUTED TO THE LARGEST
REDUCTION IN POVERTY IN OVER THREE DECADES

In 1993, the President Signed Into Law the Largest EITC Expansion Ever.
The President’s policy provided a tax cut for 15 million working
families. For every dollar a very low-income working parent with one
child earns, the EITC was increased from 23 cents to 34 cents (25 cents
to 40 cents for two plus children). The maximum credit was increased by
over $1,500. The income limit on eligibility was increased by about
$3,700.

Nearly 19 Million Families Claim the EITC. In FY 1999, the total cost
of the program was $30.5 billion. In 2001, the average credit for all
claimants will be $1,680 and for claimants with children it will be
$1,990. [Source: U.S. Department of the Treasury]

In 1998, the EITC Was Directly Responsible for Lifting 4.3 Million
People Out of Poverty -- Twice the Number Lifted Out in 1993. Census
Department statistics show that the EITC was directly responsible for
lifting 4.3 million people out of poverty in 1998 – more than twice the
number lifted out of poverty in 1993. The indirect contribution of the
EITC to poverty reduction may be even greater given the evidence that
the EITC provides a powerful incentive to work. [Source: Calculations
using data from the U.S. Census Bureau.]

In 1998, the EITC Was Directly Responsible for Lifting 2.3 Million
Children Out of Poverty. The 2.3 million children lifted out of poverty
by the EITC include 600,000 African-American children and 600,000
Hispanic children. [Source: Calculations using data from the U.S.
Census Bureau.]

Expanded EITC and Higher Minimum Wage Has Led to Large Real Income
Growth For Hard-pressed Families. A working parent with two children
earning the minimum wage in 1993 made $10,559 with the EITC (in 1998
inflation-adjusted dollars) -- well below the poverty line. With the
1993 increase in the EITC and the 90 cent increase in the minimum wage
in 1996 and 1997, a similarly situated family in 1998 was above the
poverty line -- making $13,268 -- a 26 percent inflation-adjusted
increase in their standard of living.

Poverty Rate Fell To 12.7 Percent in 1998 -- Its Lowest Level Since
1979. The poverty rate has declined from 15.1 percent in 1993 to 12.7
percent in 1998 -- that’s the largest five-year drop in poverty in
nearly 30 years (1965-1970). There are now 4.8 million fewer people in
poverty than in 1993. (In 1998, the poverty threshold was $16,660 for a
family of four.) [Source: U.S. Census Bureau]

The Largest Five-year Drop in Child Poverty in More than Three Decades.
While the child poverty rate remains too high, between 1993 and 1998,
the child poverty rate has declined from 22.7 percent to 18.9 percent
-- that is the lowest child poverty rate since 1980 and the largest
five-year drop in nearly 30 years (1965-1970). [Source: U.S. Census
Bureau]

The Poverty Rate for Children in Families with Three or More Children
is More than Double the Poverty Rate for Children in One or
Two-Children Families. Although the poverty rate for children in
families with three or more related children has fallen from 32.3
percent in 1993 to 28.5 percent in 1998, this is still more than twice
the 11.9 percent poverty rate for children in families with one or two
related children. 7.7 million children in families with three or more
children were growing up in poverty in 1998. [Source: Calculations by
the Department of the Treasury using data from the U.S. Census Bureau.]

THE EVIDENCE IS OVERWHELMING THAT THE EITC ENCOURAGES WORK

More Single Mothers With Children Are Working Than Ever Before. After
staying essentially constant in the 1980s and early 1990s, the
percentage of singe mothers aged 16 to 45 who work and receive no
welfare has risen from 60.9 percent in 1992 to 75.0 percent in 1998.
The percentage of single mothers who worked rose from 73.7 percent in
1992 to 86.6 percent in 1998. [Source: Calculations by Professor
Jeffrey Liebman using data from the Bureau of Labor Statistics’ March
Current Population Surveys.]

According to One Study, More Than 60 Percent of the Increase In the
Employment of Single Mothers Has Been Due to Expansions of the EITC.
Bruce Meyer and Dan Rosenbaum find that 63 percent of the change in the
employment of single mothers between 1984 and 1996 can be explained by
the expansions of the EITC. [Source: “Welfare, the Earned Income Tax
Credit, and the Labor Supply of Single Mothers.” National Bureau of
Economic Research Working Paper No. 7363. September 1999.]

Another Study Predicted That the 1993 EITC Expansion Would Induce
516,000 Families To Move From Welfare to Work. Stacy Dickert, Scott
Houser, and John Karl Scholz found that the 1993 EITC expansion would
induce 516,000 families to move from welfare to work. [Source: “The
Earned Income Tax Credit and Transfer Programs: A Study of Labor Market
and Program Participation.” Tax Policy and the Economy No. 9, MIT
Press: Cambridge, 1995.]

Another Study Shows that Increasing the Reward to Work, Increases Labor
Force Participation. Nada Eissa and Jeffrey Liebman found that the EITC
significantly increases labor force participation among single mothers,
especially less educated women. [Source: “Labor Supply Response and the
Earned Income Tax Credit.” Quarterly Journal of Economics 111(2),
1996.]

Comment January 2000, that still stands in 2004: These are still
relatively small effects. In that sense we should not overestimate the
impact of the 1993 EITC change on the increase in competition on the
labour market and the US booming economy. And having a higher gross
minimum wage does not help - the Card & Krueger argument does not
convince for the general situation. /TC

Summaries of additional papers

There are two papers that have not been included for brevity’s sake. It
is useful to include their summaries however. Both papers are available
on the internet.

(1) Colignatus (1996d) “An institutional explanation of structural
unemployment of low income labour”, presentation for the Dutch “7th
Research Day of the Social Sciences”, Amsterdam, ewp-oth/9605001. The
idea of this paper is to use results of social psychology to identify
the real forces implied by the reduced form theorems. The paper’s
summary is:

“Structural unemployment of low income labour has causes in
institutional settings. Directly, there is a systematic error in the
co-ordination of employment policy and tax policy. Indirectly, the
system of co-ordination shows a deficiency in its capacity to repair
systematic errors.

Many people see the cause of mass unemployment in technology and
‘globalisation’, which are factors on the demand side. Others see the
cause in high benefit levels or in low levels of education or
educationability, which are factors on the supply side. These
explanations allow little room for policy making, especially when the
benefit level is regarded as social subsistence. There however is a
third explanation, one that has been put forward by employees of the
Dutch Central Planning Bureau (CPB), first Van Schaaijk in 1983, then
Bakhoven in 1988 and Colignatus in 1989-1996. In this approach the
cause of unemployment must be found in policies on taxes and social
security, an area where policy can do a lot. In this third approach,
technology and trade have reduced the problem of unemployment, since
they have boosted productivity. Since the problem lies with labour
costs and the demand for labour, supply factors like the benefit level
are less relevant. This third approach does not attract much attention.
The three authors are little known, even though they at the time worked
at a renowned institute.

This paper intends to raise the attention level towards asking the
proper questions about current stagnation. The best way to tackle
stagnation likely is the institutional approach. The economy and its
management can be regarded as a _system, _which system comprises the
community of economists, officials, politicians, journalists and ‘the
general public’. This paper then proceeds by using Aronson’s book on
social psychology to discuss various properties of the system and
relations within it, and the behaviour of the participants in the
collective decision making on this complex issue. The discussion
results into a number of questions for further research.”

(2) Colignatus (1998c), “On the paradox of efficiency improvement at
the micro level and Productivity Slowdown at the macro level: The case
of Efficient Inventory Control”, ewp-get/9805003. The summary is:

“Last decades show a Productivity Slowdown at the macro level, while at
the micro level we have seen a huge attention for business economics
and operations management - and we now have a decade of booming stock
markets. This paper tries to tackle that paradox by singling out the
issue of Efficient Inventory Control. This seems to be the part of the
business process that comes closest to the problem of the Productivity
Slowdown. Namely, when inventories are reduced, then this normally
means that part of demand is serviced from inventories, and this means
lower production. Estimating stylized relationships for the US, we find
that inventories in 1997 are 25% lower than they would have been
otherwise, and the level of production is 0.56% lower at an annual
basis. However, real GDP growth is not really affected, since the
annual change in inventory is a very small percentage of GDP. Thus,
business success stories that are based upon inventory reduction -
which is regarded as efficiency improvement at the micro level - can be
reconciled with stagnation at the macro economic level.”

A note on the New Economy (2000)

(The following note was written in 2000 and it still stands in 2004.)

The US economy has shown steady growth from 1992 till 2000, and people
have been talking about a New Economy. The stock exchange has
exploded, the Productivity Slowdown seems to be over, unemployment has
been dropping below the CWIRU (NAIRU) while prices have remained
stable, an Asian Crisis that might have turned into a big depression
did not do that: and economists have been looking all over to find
causes. The New Economy answer would be that the Volcker - Reagan years
have created a stable environment, and that technology now is causing
all kinds of revolutions. Computers, the internet, biology, a better
understanding of economics and capital markets, you name what, the
interaction of all these: they all cause a wholly different world. And
billionaires to prove it.

My view on this issue is sensibly guarded.

Yes, the internet indeed has interesting properties, vide Shapiro &
Varian (1999). I have been using computers intensively since 1972, have
my own software on the internet - see Colignatus (1999). Yes, on
biology and other technologies the possibilities are huge, and man can
be a creative animal.

No, it all is plain old economics. Shapiro & Varian (1999) make that
clear too. Also: (a) It should be obvious by now that my own analysis
on unemployment and inflation already provides much of the answers.
Many causes why the CWIRU dropped can be identified - e.g. the EITC
increase (labour cost reduction) in 1993, and the abolishing of
‘welfare as we know it’. Society has started to accept a lower
subsistence level - which is a dubious origin of growth for the rich.
(b) Lower taxes for the rich gives them more money e.g. to invest in
the stock market. (c) Americans have been borrowing. (d) The fact that
1970-1992 was a low period in post-War US history does not mean that
the current ‘high’ is so high. I think that the basic foundation was
given by FDR, and hence the creative human energy was provided with a
stable environment to prosper. The 1970-1992 period fouled up the FDR
heritage. Getting back to that heritage is important - but not
something ‘new’. (e) Of course there still are many people in poverty,
and many are seduced to crime which ends them up in prison. (f) The New
Economy is much coloured by Wall Street, the Jones’s driving up the
property price of the Jones’s. The financial system still needs
reworking.

I think I could go on, but I’d rather stop. The basic idea is that if
there is a new kid on the block then this does not mean that the block
has changed. In particular when the kid is someone old who everybody
has forgotten about. In economics, though, perceptions are important -
and the New Economy idea might be relevant for that.

On the 2005 edition of this book

This 2005 edition of this book is virtually the same as the 2000
edition. This note discusses the points of consideration.

(1) The major change seems to be that I now use the name Colignatus
for my scientific work for better distinction from political or
commercial work. I remain of course a single individual but the papers
and books can be usefully labelled differently. In some archives you
will have to keep searching on the name “Cool”.

(2) Unfortunately, I have not been able yet to extend the discussion
as indicated in chapter 32 on dynamic optimality. The prime cause is a
new job in a new field that required much new study.

(3) The book now uses euro’s. I didn’t use the latest data but use
those of Colignatus & Hulst (2003) for consistency. The Enlargement of
the EU from 15 to 25 member states on May 1 2004 caused some changes in
the data and text however. A discussion with Henk Folmer (Wageningen
University) caused an update on OECD data and papers, clarification of
some points in the argument, and the longer Abstract below.

(4) Colignatus (2001) “Voting theory for democracy” is my
implementation of the theory on social choice within _Mathematica_. An
earlier suggestion of (1990c) for an algorithm was developed in more
detail, which caused me to find a name for it: this became the “Borda
fixed point” approach. Further reflection caused the paper Colignatus
(2002) “Without time no morality” that now has been adapted to a new
chapter in this edition. The total enriches the analysis on Arrow’s
Theorem with a practical social choice algorithm.

(5) The chapter with notes on ethics has been added.

(6) The chapters on the reduced form have been re-united into Book
IX again. In the earlier paper Colignatus (1992b, 1995a) they already
formed a unity, but in the first edition of this book they got
separated for a reason that appeared unconvincing.

(7) Since Coligatus (1990) had in its title “After 20 years of mass
unemployment”, I could write (2004) “After 35 years of mass
unemployment”, and this has been included as a chapter. Since the
(1990) paper was hit by censorship and the intermediate years have seen
no resolution of that matter, I now advise to a boycott of Holland till
that censorship is resolved. Please study the chapter closely.

(8) The following comments can be included at this very spot:

(a) Much of current policy focus is on the EU Lissabon Strategy and
issues like pensions. This book does not explicitly discuss these but
it would be a mistake to conclude that this book would not be relevant
for those topics. The point is that this book already had that long
term approach to start with. Lissabon and pensions are new kids on the
block and one should rather study this book before proceeding with new
policy making.

(b) Advised reading is Skidelsky (2000), the third part of his
biography of Keynes.

(c) Lomborg (2001), “The skeptical environmentalist. Measuring the
real state of the world”, gives an impressive review of the problems in
this subject. As an economist and non-ecologist it is difficult for me
to say anything about his comments on the state of the ecology. Three
statements in the realm of political economy are:
(b1) Lomborg does not yet take account of the argument by Hueting
(1980) and Van Ierland et al. (2001). Statistical measurement of
national income derives from the economic theory of social welfare. To
approximate the social welfare function we use the income hyperplane
that is tangent to it. Market prices for the environment will not
suffice since there are market failures.
(b2) In his discussion on the ‘double dividend’ Lomborg relies on
economic papers that do not take into account both the analysis by
Hueting and the analysis provided in this book on the Trias Politica,
unemployment, the tax void and dynamic marginal rates.
(b3) The case for an Economic Supreme Court appears enhanced. Human
flourishing requires proper environmental protection, and monitoring of
the information about the environment then requires proper safeguards.

(d) Shiller (2003), “The new financial order. Risk in the 21st
century”, discusses how the market with proper government regulation
can give rise to new risk instruments. Part of what I try to do with
the constitutional amendment for an Economic Supreme Court, he tries to
do with ‘macro-markets’, i.e. financial instruments based upon macro
variables: namely, getting better information. My impression is that
both approaches have merits of their own, and that it helps to
disentangle what the instruments are intended for precisely. Similarly,
the analysis in this book on unemployment cannot be replaced by an
insurance on the distribution of income. Yet, when these more basic
reforms on the Economic Supreme Court and unemployment have been
implemented, Shiller is right that welfare can be improved by novel
risk instruments.

(e) Gould (2000:294-297) discusses Sulloway (1996) with sympathy.
This seemed relevant given the importance of the latter for the draft
constitutional amendment for an Economic Supreme Court. However, Van
den Berg (2004) in Dutch NRC-Handelsblad reports that the validity of
Sulloway’s finding is seriously questioned in _Nature_.

(f) I reread Ayer (1936, 1978), “Language, truth and logic”, and
was struck by his discussion of Poincaré. Ayer, page 115: “For a
well-chosen definition will call our attention to analytic truths,
which would otherwise have escaped us. And the framing of definitions
which are useful and fruitful may well be regarded as a creative act.”
In the “definition & reality methodology” the idea is that definitions
concerning stylized facts are “useful and fruitful”. Williams (2002),
“Truth and truthfulness”, is advised reading. What I take from it is
that people have a ‘sense’ what is true or not, whether they are right
or not, and that society can benefit from giving proper way to this
‘sense’. Now, what would be a proper way ? My approach is to give more
attention to science and the scientific attitude.

(g) Colignatus & Hulst (2003) is a Dutch booklet that summarizes the
scientific argument in this book for the Dutch lay public. This booklet
also relates to the murder of the Dutch politician Pim Fortuyn in 2002.
There is a peculiar streak in Dutch society that is wildly at odds with
its reputation for tolerance. Namely, the Dutch can react strongly to
someone who threathens their view of the world. A similar phenomenon
can be observed in other cultures too, but it is strong in Holland. My
inclination is to link this phenomenon to the observation in
Cavalli-Sforza (2000:184) of different mentalities in France: “Hervé Le
Bras and Emmanual Todd [1981] have recently refined ideas by the French
sociologist Fredericq Le Play. They believe three major types of
families exist in France. (…) have proposed a controversial but
stimulating hypothesis that says family structure influences political
structure”. These types are related to the history of Celts,
proto-Basque and Franks. My impression is that Dutch society is
similarly subject to some cultural mentality.

(h) When I discussed the consequences of the CPB censorship for
public health, this caused developments that led to my dismissal in
August 2004 from the Erasmus MC Dept. of Public Health. This is another
breach of the integrity of science. Dutch readers are referred to my
website. All this is too fresh to include it in this book.

(i) November 2, 2004, Holland saw Theo van Gogh murdered. He is a
grandson of Vincent van Gogh’s brother Theo (the elder). The younger
Theo is said to have been a talented though controversial film
director. The Van Gogh family had donated its collection of paintings
to the state and Theo van Gogh had trouble finding funds to develop his
talent. When he was murdered he was completing his film 0605 of the
murder of Pim Fortuyn. Van Gogh’s murderer of Moroccan decent expressed
his delusion of the 9-11 ideology. This is a new element in Dutch
society that can only be understood with the input of the Bush policy
on Iraq. It must be noted though that Theo van Gogh protested regularly
to that other original streak in Dutch society referred to above,
namely that Holland is not as tolerant and open as it may seem. One can
summarize the situation as that a truly tolerant Holland would have had
no fertile ground for that 9-11 ideology, while the resulting criminal
extremist killed the critic of that intolerant streak.

(j) There are some Dutch books that deserve an English
translation. Here I only translate the titles. Klever (1990), “Pure
economic science”, takes his position in Spinoza and argues that
economic science should be developed from first principles in a
deductive fashion. This strikes me as quite similar to the “definition
& reality methodology”. Mathematical economics already had the
deductive approach, and econometrics assumed that only statistical
approximation was feasible, but we can do better if we can find
definitions that fit stylized facts. Klever also recovered Franciscus
van den Enden (1665, 1992), “Free political theses”. That author was a
teacher of Spinoza and his book argues that democracy is the only form
of government that can safeguard stability and general welfare. Klever
(1981), “Dialectic thinking”, must be mentioned for a better
understanding of the deductive method. His discussion of Poincaré and
his pupils, for example, clarifies the creative element in mathematics.
Guépin (1985) “Civilization” and Guépin (1994) “The difference in
opinion” defend classical rhetorics as the essence of civilized
mentality. These books provide a wealth of information and are a useful
antidote to expecting too much from deduction only. He highlights the
tension between rhetorics and deduction by criticizing Socrates that it
is rather easy to impress people by goading them into inconsistencies
when they have not first defined their terms properly. (Rhetorics
cannot make fun of rule based inference if the only goal of rhetorics
is to get better inference.) Guépin also highlights that deduction
thrives with dichotomy but hesitates with the _sorites_, i.e. the
problem of accumulating grains of sand until the mountain moves.

Autobiographical note

This book completes a project that started in 1989 and that is closely
related to the Fall of the Berlin Wall in that year.

At that time in 1989, and in fact from 1982-1991, I was employed as a
‘economic scientific researcher’ at the Dutch Central Planning Bureau
(CPB), which institute can be compared to the US Council of Economic
Advisers. The CPB provides the executive branch with economic
projections and with evaluations of policy proposals. In 1989 I was
involved in test runs for a study of the economy for the long run till
2015, later published as the CPB (1992a&b) “Netherlands in Triplo” and
“Scanning the future”. The test runs showed continued economic
problems, and this caused me to consider some points. If the Bureau
would publish bad weather projections, then these might cause the
government to enact economic reforms that would self-unfulfill the
projections. Secondly, my CPB colleagues Van Schaaijk (1983) and
Bakhoven (1988) had presented a solution approach to unemployment that
did not get the attention that it deserved. Thirdly, when the Wall
fell, it was obvious that continued unemployment in Western Europe
would be detrimental to economic recovery in the East, and this
suddenly made unemployment much more important than it had been before.
So in November I wrote an internal memo Colignatus (1989) proposing
various economic reforms that might be considered as research projects
not only for the final version of the long run study but also for the
medium run.

Then, in December, in deciding on the annual pay rises, the CPB
directorate withheld part of the normal raise for me, and my section
chief informed me that it would have been better if I had not written
that memo. Apart from the bizar sensation that a hundred billion dollar
invention was being punished instead of rewarded, I also experienced
the sensation that comes when the dime drops or when the pieces of a
puzzle fall together. I could not escape the conclusion that I was
confronted with a particular piece of evidence of stagnation in policy
making, and that improper means were being used to influence scientific
discourse. Taking stock: my career position was blemished, my creative
contribution was branded as weird instead of simply creative, and I was
apparently supposed to no longer judge ideas on their own value but on
some line that was decided by the directorate. If these methods were
used, I could understand why colleagues Van Schaaijk and Bakhoven had
become silent on their important contributions to the solution
approach, or had left the Bureau altogether.

So in December 1989 I easily envisaged a book that would explain both
the solution to the current mass unemployment in OECD countries and the
stagnation in policy making that causes it. It was my perception at
that time that under normal conditions it might take ten years before
this analysis would be accepted by ‘the relevant circles’, i.e. some
years to write the book, some years to allow my fellow economists to
digest it, and some years for the percolation into public and political
discourse.

But life is not such that if a scientist decides that a book should be
written, that his environment will let him do it. Instead, there was
the pressing need to find a proper answer to the abuse inflicted on me,
and to collect and safeguard the evidence of that abuse. Given the
triad of Voice, Exit or Compliance (‘compliance’ since ‘loyalty’ is the
precondition - and the Exit and Compliance options already used by my
two colleages) I decided to Voice. I filed an appeal, and started
writing a paper where I clearly stated my conclusion as a scientist
that the return to full employment could be much speedier if Parliament
would have an enquiry in the policy making process. Not quite to my
surprise, I saw myself moved to a separate room in April 1990, and my
paper was blocked from circulation. Only after some trouble it was
allowed to appear as an internal note Colignatus (1990ac), but was
further blocked from internal discussion and eventual publication. And
I was finally fired in October 1991. And neither quite to my surprise,
the courts allowed the directorate to do all this. The court deemed it
an abuse of power that the directorate had moved me to a separate room,
but the dismissal was deemed acceptable. The legal position of a
scientist within the government is not that strong, the popular stories
to the contrary.

These lines clarify that this book has not been written under the
conditions that benefit science. I have been mauled by the bureaucracy,
I have been on the run from one short temporary job to another, always
job hunting, a longer while unemployed and in dire financial straights.
But I was happy that I had kept my integrity, and it was a joy to
occasionally read some economics again and to write a piece of the
analysis. I published a collection in 1992 and another collection in
1994. I discovered _Mathematica_, January 1993, and there was hope
again. The internet became accessible to me, and I was able to enter my
papers in the Economics Working Papers Archive (EconWPA) at the
Washington University in St. Louis.

One factor that caused a shift in the plan of the book was that I no
longer had the resources of the CPB at my disposal. No database, no
model, no easy access to the literature, no participation in
professional discussion, and no professional position that would give
easier access to the other research institutes and organisations like
the OECD, World Bank or IMF. It was curious, to say the least, not to
have access to the model that I had helped designing and that I in fact
normally maintained and had sitting at my computer. My situation caused
me to rethink methodology. What could I prove, if I did not have the
means that I had grown accustomed to ? But by 1991 I had solved that
problem and life became a bit more agreeable. But of course, it took
longer, much longer, to work it all out.

Please be aware that it was not all misery and gloom. Over these 15
years I could go to 7 Dutch economics ‘research days’, visit 3 European
Economic Association congresses and visit the occasional colleague and
professor. There are also nice events that happen when you approach
people with some novel ideas. I still enjoy the tour of Cambridge that
Richard Layard gave to Assar Lindbeck and me; this was in 1991 when
Layard, Nickell & Jackman (1991), “Unemployment”, had just appeared.
Mr. Emile van Lennep, former head of the OECD, then retired as Minister
of State but still at the Dutch Treasury, agreed to talk to me, and
afterwards helped me to get an interview at the US Treasury in the
Summer of 1993: but to no avail, the person that I talked to was too
absorbed by the Clinton Health Plan, and said something like ‘Well, if
Europe wants to adapt its constitution, be my guest’. It also appeared
that the OECD did not have information on tax exemption in the member
states. It was worth a try, and fun to do. I also have had great fun
developing my “Economics Pack”, applications for _Mathematica_. It is
good software, it brings me in contact with interesting economists all
over the world, and of course it includes, amongst other projects, also
some of the material of this book - which should do something for the
spread of the ideas as well.

So now the book is here. It collects and combines the various articles
written since 1989, and gives the final twists that come from
integration.

Note that I as a researcher claim ‘novel results’, while I at the same
time say, at the risk of an inconsistency, that ‘_either_ governments
already knew how to solve unemployment and then neglected human
suffering, _or_ they could find out how to do it and then at least
failed in co-ordination’. ‘Novelty’ and ‘it was known’ are at risk of
being inconsistent. I have removed this risk (a) by making the novel
results available since 1990, which was 10 years ago at the first
edition of this book in 2000 and now in 2005 is 15 years ago, (b) by
gathering information about the abuse afflicted on myself, and making
this information available to others, and (c) by showing that important
parts of the whole analysis (without my contributions) were already
known before. Cohen Stuart in 1889, and policy makers in the 1950s
already knew that tax exemption should be at the subsistence level. One
does not really need a CWIRU concept to see that. While this was known,
my novel contribution then has become to analyse the ‘loss’ of this
information as an institutional and Public Choice problem - or bad
co-ordination between the Treasury and the Ministry of Labour. As a
‘novel contribution’ it has its limits - though in the 1980s it took me
a decade of eliminating other causes before I discovered, and indeed
with surprise, how dumb and insensitive these bureaucrats can be. But
other novel insights have a more enduring character, and that is a
relief.

Yes, some friends have advised not to tell all of this, others have
advised to do so. I once entertained the thought to skip my Dutch
examples, and concentrate on, say, the US. This might enhance the
argument, since readers would be less inclined to think that I am
partial to the argument. I hesitated doing that, since (a) I am not
partial anyway, and (b) it would eliminate that very example of the
current structural deficiencies in economic policy making.

What is new in this analysis ?

‘New’ is taken here in comparison to others, and thus includes points
also made in my earlier publications on this analysis. New is:

1) clarification that if you don’t index subsistence for average
income, then you create poverty

2) clarification that minimum ‘income’ is not an ‘income’ but a
mechanism (with multiplier)

3) the concept of the Tax Void

4) the dynamic marginal tax rate, and its relation to labour supply and
macro-economics

5) these explanations for the shift of the Phillipscurve:

a) by the minimum wage and tax void, or poverty

i) directly, and caused by differential indexation of exemption and
subsistence

ii) indirectly, by the crowding out effect, shifting of the tax burden
etc.

b) by misguided macro-economic policy (not understanding taxes,
fighting inflation with the wrong means)

6) clarification that ‘there is no poverty trap’

7) suggestion for a simple nonlinear tax function, clarification for
households

8) suggestion of a possibly ‘dromedary shaped’ labour supply

9) clarification on the concept of a ‘free lunch’

10) proper definitions of risk and uncertainty

11) clarification for the impact of the minimum wage (tax void) on
sheltered and exposed sectors

12) clarification on the Definition & Reality methodology

13) the theorem on the possibility of full employment, via the
reduced form

14) integration of deontic logic with preference theory

15) the proper interpretation of Arrow’s Theorem

16) the Borda Fixed Point method

17) the theorem on the possibility of co-ordination, via the reduced
form

18) description of actual bureaucratic processes on these subjects,
so that we better understand how the Great Stagflation came about
(comes about)

19) the concept of the Economic Supreme Court, in its political and
historical relation to both the Trias Politica and economic science,
and a draft constitutional amendment to start thinking about

20) clarification of the moral imperative with regards to Russia and
Eastern Europe

21) positioning this analysis with respect to a standard small macro
model and the work of other authors.

Abstract

The prime conclusion of this book is that Western democracies are
well-advised to install an Economic Supreme Court. This volume includes
a draft constitutional amendment that shows that such a measure can
indeed enhance democracy.

The fundamental structure for current policy making in a democracy is
Montesquieu’s model of the separation of powers, i.e. the Legislative,
Executive and Judicial branches that form the “Trias Politica”. It
appears that this structure still allows room for economic policy
making that is detrimental to the life and liberty of the citizens of
the state. The key issue appears to be that there is no independent
protection of the quality of information. With all the social, economic
and political interests involved, the current process of economic
policy making allows the current constitutional powers too much room
for distortion of the information. Economic theory then suggests the
creation of an Economic Supreme Court as a separate constitutional
power with the task of the scientific management of information. The
legislative and executive branches would still decide on policy targets
and policy execution, but they would lose the power to interfere with
the scientific handling of information. This argument can be developed
purely theoretically. The economic experience of the last century shows
that the argument is also practically relevant.

Political Economy as a science has the general objective of explaining
and advising the management of the state. Two hallmark reference points
exist in the _General Theory _by Keynes (1936) and the analysis by
Tinbergen (1956) on the principles and design of economic policy
making. These studies show that the state can be subject to long
periods of economic recession and even depression if not properly
managed. Since the end of World War II, application of these ideas has
allowed spectacular economic growth while depression has been prevented
indeed. However, the economic record especially since the 1970s is
mixed, with issues like stagflation, problems with the welfare state
and continued poverty and also with the issue of sustainable
development and protection of the environment. It can be shown beyond
reasonable doubt that economic policy has been detrimental to the life
and liberty of many of its citizens while this came about by
mismanagement of the available information.

An element of self-reference arises when economic policy uses economic
theory itself, so that theory should include theory. Increasingly over
the years, economic theory has gotten a role in the management of the
state, and developments in the real economy cannot be properly
understood without reference to the economic ideas adopted for national
policy. Since economic theories give conflicting advice, part of the
management problem of the state is the selection of the appropriate
theory, and this selection is more and more the key management problem.
At the next higher level of abstraction, the process of selection
becomes the focus of attention. The problem then becomes what that
process is, what criteria of transparancy and fairness it satisfies,
and how the process itself affects the economy. The current structure
gives too much room for political elites and bureaucrats to neglect the
basic rights of the population at large. The criterion to judge an
optimal improvement in the structure of economic policy making is not
just economic growth but can be taken in the concept of democracy
itself and the citizen’s right to be properly informed.

Keynes’s _General Theory_ can be generalised even further by the
inclusion of endogenous government in the model, and in particular
economic policy making itself as that is guided by economic theory.
Keynes clearly anticipated this line of thinking, where he wrote:
“Practical men, who believe themselves to be quite exempt from any
intellectual influences, are usually the slaves of some defunct
economist. Madmen in authority, who hear voices in the air, are
distilling their frenzy from some academic scribbler of a few years
back.” (GT:383) The new point now is that this does not only concern
“practical men” but economists themselves too, and the whole
institutional framework for economic advice. When economic policy
making itself is part of the model, economic stagnation can be
explained as stagnation in that realm, and the solution for economic
stagnation can be found there too.

OECD nations had full employment in the 1950-1970 period, and Japan and
Sweden had it much longer. So it would seem that full employment at
least is feasible. However, after the period of full employment, all
nations showed the phenomenon of stagflation, which is a worsening
trade-off between inflation and unemployment (represented as the shift
of the Phillipscurve), frequently associated with stagnating growth.
Instead of full employment and a steady growth of welfare, OECD nations
suffered a long period of insecurity from 1970-2005.

This volume analyses the different periods and finds the likely cause.
The fundamental cause is the common Trias Politica structure of
economic decision making that all OECD nations share over time and
space. At an operational level, stagflation can be explained by the tax
policy that OECD nations have in common as well.

The common tax policy is based upon a particular economic theory that
has become the conventional economic view of our time. This
conventional theory sees tax as a penalty on work effort and holds that
statutory marginal rates have major disincentive effects. Marginal tax
rates are a useful penalty on (inflationary) wage claims in
wage-bargaining, but the conventional view is that the disincentive
effect dominates. Following this theory, policy has been to reduce
marginal rates at the cost of lower exemption. Another measure was to
switch from the income tax to a Value Added Tax (VAT) that has no
exemption at all.

The common tax policy has static and dynamic components. Statically,
exemption is low. Dynamically, there is the tendency of reducing
exemption even further. The low and ever lower exemption causes rising
tax levels and hence either poverty or higher labour costs in the lower
wage brackets, causing unemployment, and causing higher taxes to pay
for the benefits. What is crucially wrong about current policies is the
phenomenon of differential indexation. Exemption is indexed on
inflation, while subsistence, by social psychological causes, rises
with inflation and real income. This differential indexation causes
ever increasing problems with poverty and unemployment.

The OECD countries have been pursueing this policy now for more than
three decades, and rather little is being achieved. It is time to
seriously wonder whether policy is on the right track. This book shows
where the conventional theory goes wrong.

A first feature is the tax void. The tax void is the region of
productivity and income between the net minimum wage and the gross
minimum wage. The difference between net and gross is normally called a
‘tax wedge’, but this term is inadequate since a wedge is commonly
thought to apply _at_ a particular level while the void is a _range_.
The income range between the net and gross minimum wage is a void since
there are official tax statutes for that range but no true revenues.
People are not allowed to work below the gross minimum and thus cannot
pay taxes there (that is, for full timers). Ideally, as in the 1950s,
the net minimum should be equal to the gross minimum so that the void
is zero, and so that such workers can start earning their own living
without paying taxes. Because of the current practices for tax
indexation, the tax void has grown over time so that the gross minimum
wage has risen much more than the net minimum wage. By result, more and
more low wage workers are subject to that excessively high gross
minimum and are effectively removed from the labour market. The shift
of the Phillipscurve can be explained partly by this growing component
of minimum wage unemployment. This analysis also points to a solution.
For the tax void, no taxes are collected (on full timers), thus
abolishing such void taxes will not cost anything. The argument is not
quite that lowering the minimum wage will create new job opportunities,
but rather that not raising the gross wage costs so excesssively would
not have destroyed the opportunities that already existed. This
argument designs an experiment at no cost.

The tax void causes needless unemployment for millions of people all
over the world and its plain bureaucratic stupidity is a blow to naive
ideas about democracy (that the current democratic structure would be
adequate and provide adequate information).

The second feature in the new analysis concerns the dynamic marginal
tax rate. Marginal tax rates are important - since economic theory
indeed assumes optimising economic agents - but these marginal rates
should be properly computed. This analysis not only considers the
partial effect, assuming other things constant, but rather considers
the total effect that includes all simultaneous changes. A change in a
marginal tax rate is usually accompanied by a change in exemption, and
both generally happen at the same time, either annually or in computer
policy simulations. Private and national income change at the same time
too. Individuals are frequently aware that their own fortunes are
linked to the fortunes of the national economy and they will be
sensitive to their relative position in the distribution of income.
Work incentives may be more guided by the average tax rate rather than
the statutory marginal tax rate. Hence, ‘incentives’ may not be a
convincing argument against higher marginal tax rates, even though
policy makers have been advancing that argument forcefully. That, in
fact, the converse is true, fits perfectly with the experience of the
last decades. The reduction of the statutory marginal rates, as the
policy was, appears to have had little incentive effects, since the
true incentive effect depends more on the average tax over time, and
this average has remained high due to the problems of unemployment,
poverty and lower growth.

This book concludes that macro-economic policies in OECD nations have
not countered stagflation but have actually increased it. Current
policies add to labour costs, reduce incentives, fuel forward shifting
of the tax burden, and worsen the trade-off between inflation and
unemployment.

The new analysis points directly to a policy that will be successful
and that will allow a return to full employment under stable prices
like in the the 1950s. If exemption is put at subsistence, then jobs
can be created at the low end of the labour market, which would save
benefits and reduce average taxes, which again would increase
incentives. The alternative structure and policy would also be
beneficial for inflation. If low productivity labour has a stronger
position in the labour market, then the risk of unemployment is spread
more evenly, and trend-setting high productivity labour will be
cautious about wage claims.

A welfare state is defined as a state that doesn’t let people die and
thus provides benefits for the lowly productive _anyway_. The welfare
state can be run more efficiently by using those resources, instead of
going into benefits, to instead reduce labour costs and to price the
lowly productive into jobs. The analysis on inflation and unemployment
thus results into the proposition that, since the present situation is
inefficient, an improvement is possible from which everybody can
benefit.

This book provides theorems in mathematical economics to prove its
points. The central questions in the political economy of employment in
the welfare state are: _can _one solve unemployment, does one _know
_how, and does one _want _to ? The book presents a model that satisfies
the stylized facts and thus serves theoretical and empirical uses.

· The first result is a possibility theorem (_can_) that there are two
regimes of either full employment or unemployment.

· The second theorem explains the choice by _know_ and_ want _causes.
Full employment results from conscious choice or chance (while lacking
knowledge). Unemployment results from conscious choice or wrong
co-ordination (where a Pareto optimising change is blocked only by lack
of knowledge - and a lack of knowledge not by the economists but by the
incompetent or insensitive policy makers).

The analysis shows mathematically that democratic goals indeed can be
blocked by special interests or neglect, for example within the
bureaucracy. A policy conclusion is to improve informational (planning)
procedures.

The discussion of taxes, unemployment and inflation is basically just a
minor point of the book. The major point of the book concerns the
co-ordination problem. Western democracies apparently allow long
periods like the Great Depression or the Great Stagflation that are
detrimental to the economic well-being and security of large sections
of their populations. Ideas of economists that point the way to
recovery are only slowly accepted. Key examples are the ideas of
Tinbergen and Keynes: for them it took World War II before they got
listened to. Eventually, the political powers of that time accepted
that they had to redesign the structure of economic policy making, and
they gave more room to the scientists, but did not dare to give up
their ultimate power to meddle with the information. Currently, the
world faces the challenge of the growth of the world population from 6
billion people around 2000 to likely around 8 billion people around
2025. To manage this process, mankind would benefit from a structure of
economic decision making that is both democratic and that respects the
citizen’s right to know.

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Index

Acceleration, 116, 120, 121, 225

Adriaansens, H., 311

Albeda, W., 263, 311

Alm, R., 232, 242, 243, 244, 245, 246, 314

Ancot, 311

Animal spirits, 218

Annan, K., 233

Aoki, 125, 311

Arminius, 78, 80

Aronson, E., 70, 72, 107, 298, 311

Arrow, K., 27, 31, 84, 158, 159, 160, 161, 162, 163, 164, 165, 166,
168, 169, 170, 171, 172, 173, 174, 175, 176, 180, 183, 206, 234, 278,
300, 306, 311, 313, 314, 317, 319, 320

Ash, T.G., 259

Ashenfelter, O., 96, 99, 311

Ashton, 94, 96, 318

Auerbach, A., 94, 311

Bacon, 17

Bakhoven, A., 206, 298, 303, 311

Balkenende, J.P., 258

Barndorf-Nielsen, 78, 311

Barro, R.J., 22, 98, 100, 110, 233, 311

Barrow, J., 71, 75, 76, 278, 279, 311

Barten, A., 15, 32, 311

Basic income, 127, 138, 272, 278

Basic insurance, 110, 127

Bean, 313

Beatrix of Orange, 279

Beckerman, W., 13, 311

Beenstock, M., 94, 311

Begg, D., 311

Beld, C.A. van den, 150, 311

Bellman, R., 224, 311

Bentham tax, 45, 49, 50, 54, 55, 93, 109, 112, 115, 128, 131, 139, 140,
141, 142, 145, 146, 147, 204

Berg, P. van den, 314

Berg, R. van den, 33, 279, 301, 311

Bergeijk, P. van, 28, 187, 312

Berlin, 3, 18, 22, 31, 35, 66, 68, 197, 260, 271, 303

Bernholz, 313

Bernstein, 197, 219, 312

Besseling, P., 312

Blair, T., 56, 258, 259

Blanchard, O., 13, 28, 40, 94, 312

Blaug, M., 276, 312

Blinder, A., 218, 288

Bochenski, 82, 312

Bochove, van, 312

Booker, C., 259

Boone, J., 97

Borda, 173, 175, 177, 178, 179, 180, 181, 183, 300, 306

Borjas, G., 41, 42, 94, 95, 97, 108, 312

Bos, W., 258

Boskin, 245

Boumans, M., 15, 312

Bovenberg, L., 312

Braband, van, 319

Brandsma, A., 312

Brittan, S., 312

Britton, 318

Broeder, G. den, 96, 264, 312

Broer, P., 37, 97, 312

Bron, J., 312

Bruno, M., 28, 30, 93, 225, 237, 312

Buchanan, 14

Buitenhuis, P., 312

Buridan, 166

Burns, A., 287

Bush, G.H.W., 284

Bush, G.W., 158, 178, 254, 302

Cairncross, 30

Card, D., 297

Carter, J., 237

Cavalli-Sforza, L.L., 184, 185, 301

Centraal Bureau voor de Statistiek, 43, 274, 312, 313

Central Bank, 24, 59, 92, 222, 225, 237, 238, 281

Central Planning Bureau, 13, 14, 20, 28, 32, 37, 38, 40, 43, 69, 86,
94, 96, 97, 135, 138, 139, 150, 151, 158, 172, 206, 250, 251, 252, 253,
254, 255, 260, 261, 262, 263, 264, 272, 289, 298, 302, 303, 304, 311,
312, 313, 314, 315, 316, 319, 320

CEPS, 313

Chaos, 64, 81, 85, 168, 229

China, 22, 217, 234

Chirac, J., 178

Clemence, 316, 317

Clinton, W.J., 56, 288, 289, 293, 304

Cnossen, S., 186, 187, 313

Coase, R., 13, 113, 187, 239, 313

Coats, A.W., 313

Cohen Stuart, 56, 57, 62, 109, 204, 305

Colander, D., 313

Colignatus, Th., 1, 2, 13, 26, 37, 59, 70, 72, 86, 94, 99, 129, 137,
151, 156, 159, 171, 172, 179, 181, 184, 195, 206, 212, 221, 251, 254,
255, 260, 261, 262, 275, 298, 299, 300, 301, 303, 304, 313, 314, 316,
320

Competition, 41, 58, 62, 67, 68, 72, 116, 141, 149, 185, 223, 230, 239,
240, 288, 297

Computer, 69, 78, 83, 152, 181, 209, 264, 304, 309

Condorcet, 27, 165, 166, 169, 170, 173, 177, 178, 179, 180, 183

Congress, 15, 17, 130, 219, 235, 238, 279, 284

Congressional Budget Office, 97, 314

Constitution, 3, 12, 13, 14, 16, 18, 25, 26, 29, 30, 33, 35, 68, 85,
159, 160, 161, 162, 163, 165, 167, 168, 170, 171, 172, 206, 232, 256,
260, 271, 272, 277, 279, 288, 301, 304, 306, 313, 318

Consumer Price Index, 150, 218, 245, 246, 281

Cool, Th., 2, 289, 300

Council of Economic Advisers, 13, 14, 22, 24, 25, 68, 85, 110, 208,
251, 256, 282, 283, 284, 285, 286, 287, 288, 303

Cox, W.M., 232, 242, 243, 244, 245, 246, 314

Crouch, E.A.C., 197

Crowding out, 36, 122, 123, 126, 213, 236, 305

Csikszentmihalyi, M., 184

Cullis, J., 314

CWIRU, 84, 117, 118, 119, 120, 121, 122, 128, 135, 207, 218, 299, 305

Dahl, R., 314

Dam, M. van, 258

Danthine, 313

Darwin, Ch., 11, 78

Dasgupta, P., 12, 218, 231

Deficit, 25, 42, 67, 87, 92, 110, 113, 280, 285, 286

Definition & Reality, 3, 83, 85, 86, 198, 212, 277, 278, 306, 313

DeLong, H., 73, 314

Delors, J., 259

Depression, 3, 14, 17, 18, 19, 23, 24, 26, 30, 31, 34, 64, 66, 67, 156,
192, 224, 299, 307, 310, 317

Dewey, J., 269

Diamond, J., 184

Differential indexation, 43, 48, 56, 57, 62, 126, 132, 145, 236, 238,
305, 308

Dilnot, A., 247

Doel, J. van den,, 314

Don, F.J.H., 200, 251, 261, 314

Dopp, 314

Dornbusch, R., 13, 28, 87, 311, 314

Draper, D., 312

Drèze, J., 314

Driehuis, W., 150, 311, 315

Drissen, 207, 315

Duisenberg, W., 59, 98

Dukakis, M., 287

Dutch Disease, 149, 150

Dylan, B., 254

Earned Income Tax Credit, 248, 249, 250, 288, 293, 294, 295, 296, 297,
299

Eatwell, J., 196, 315, 321

Economic Supreme Court, 3, 11, 12, 14, 16, 22, 24, 25, 26, 28, 29, 31,
32, 33, 66, 72, 85, 97, 232, 234, 238, 256, 260, 264, 279, 280, 281,
288, 301, 306, 313

Economist, The, 12, 94, 130, 187, 321

Edgeworth-Bowley, 153, 189, 190, 191

Eenhoorn, 258

Ees, van, 318

Eijgenraam, C., 264

Eijk, van, 315

Eisenhower, I., 287

Enden, F. van den, 302

Epimenides, 173, 279

Equilibrium rate (ERU), 117, 118, 119

Erasmus MC, 261, 302

Erlang, 78

Euclid (geometry), 73, 75, 76, 279

Europe, 3, 18, 22, 23, 31, 35, 37, 38, 41, 45, 56, 58, 59, 60, 61, 62,
64, 66, 68, 97, 124, 125, 150, 156, 218, 220, 223, 229, 231, 234, 238,
239, 244, 246, 251, 258, 259, 260, 263, 270, 289, 303, 304, 306, 312,
313, 314, 318

Ewijk, C. van, 186, 187, 313

Executive, 3, 12, 16, 17, 25, 279, 282, 286, 287, 288, 303, 306

Exemption, 45, 47, 48, 49, 50, 51, 52, 53, 54, 55, 56, 57, 59, 62, 63,
82, 99, 108, 109, 124, 125, 126, 127, 128, 129, 130, 131, 133, 135,
137, 138, 139, 140, 141, 142, 143, 146, 202, 203, 204, 206, 215, 246,
272, 304, 305, 308, 309

Falsification, 72, 76, 77

Fase, M., 150, 311, 315

Federal Reserve Bank, 218, 237, 238, 281, 285, 316

Feldstein, M., 283

Ferguson, Th., 197, 315

Feynman, R., 315

Fischer, S., 13, 28, 40, 87, 94, 311, 312, 314

Fitoussi, J.-P., 247

Flanning, C., 14

Folmer, H., 264, 300

Fortuyn, W.S.P., 256, 257, 258, 259, 260, 262, 301, 302

Freeman, R., 124, 311, 315

Friedman, M., 40, 94, 121, 241, 315

Gainous, J., 160

Galbraith, James K., 26, 27, 98, 223, 232, 235, 236, 237, 238, 239,
240, 241, 242, 281, 315

Galbraith, John K., 260, 315, 319

Gambs, J., 267, 269, 315

Gastel, L. van, 264

Gelauff, G., 28, 94, 96, 97, 98, 135, 140, 241, 315

Gill, J., 160

Gill, R., 78, 80, 81, 194, 261, 311, 315

Gillingham, J., 259

Gladstone, 277

Globalisation, 31, 37, 42, 57, 58, 61, 62, 68, 221, 236, 239, 298

Gödel, K., 164

Gogh, Th. van, 302

Gogh, V. van, 253, 302

Gomarus, 78, 80

Gorbachev, 22

Gordon, R.J., 240, 321

Gore, A., 158, 178

Gould, S.J., 11, 86, 301, 315

Graaf, T. de, 257

Graafland, J., 14, 97, 155, 241, 315, 316

Grafstein, R., 316

Grandmont, J.-M., 14, 204, 316

Graybill, F., 315

Green, J., 165, 175, 318

Greenspan, A., 238

Groot, H.de, 99, 316

Guépin, J.P., 302

Hadjimichalakis, M., 237, 316

Hahn, F., 311

Halberstadt, V., 93, 320

Hall, R.E., 316

Hansen, 316, 317

Harrington, 319

Harrod, R., 19

Hartog, H. den, 150, 151, 311, 315, 316

Hayek, F., 26, 83, 232, 235, 276, 277, 278, 316

Hebden, J., 40

Heck, A., 264

Heilbroner, R., 12, 219, 220, 221, 227, 230, 231, 314, 316, 319

Heinlein, R., 186

Helliwell, 316

Hendry, D., 27, 316

Hersoug, T., 97, 155, 241, 316

Herwaarden, van, 98, 317

Hicks, J.R., 13, 14, 26, 32, 83, 93, 269, 316, 318

Hillier, F., 316

Hofstra, H., 56, 109, 316

Hornby, 193, 196, 316

Hotz, V.J., 247, 248, 249, 250

Hueting, R., 156, 218, 301, 316

Hughes Hallet, 311

Huizinga, F., 97, 155, 312, 316

Hulst, H. and A. Hulst, 252

Hulst, H. en A. Hulst, 137, 254, 261, 262, 264, 300, 301, 314, 316

Hum, 96, 317

Ierland, E. van, 156, 301, 311, 317

ILO, 219, 241, 318, 321

IMF, 22, 65, 304

India, 217, 218, 234

Inequality, 235, 236, 238, 239, 241, 242, 256

Inflation, 14, 18, 19, 27, 31, 36, 37, 38, 39, 40, 41, 42, 48, 49, 51,
52, 53, 55, 56, 57, 58, 59, 60, 61, 62, 63, 82, 89, 90, 91, 92, 96, 97,
104, 109, 115, 116, 117, 118, 119, 120, 121, 123, 125, 126, 127, 130,
132, 133, 139, 143, 144, 146, 198, 207, 218, 219, 223, 225, 229, 230,
237, 238, 239, 245, 272, 281, 288, 289, 299, 306, 307, 308, 309, 310,
313, 314, 316, 321

Institutions, 14, 26, 86, 126, 158, 207, 220, 232, 238, 262, 263, 270,
283, 286, 298, 305, 313, 316

Insurance, 93, 107, 110, 126, 127, 135, 238, 284, 301

Interest rate, 36, 92, 121, 223, 237, 281, 316

IS-LM, 11, 13, 14, 32, 84, 87, 89, 93

Jackman, R., 28, 94, 304, 318

Jacobs, D., 124, 317

Janus, 79, 80

Japan, 58, 62, 67, 69, 85, 198, 239, 307

Johansen, L., 160, 317

Johnson, H. G., 245, 317

Johnson, L.B., 245, 317

Johnston, J., 317

Jones, Ph., 314

Jongen, E.L.W., 97

Jorgenson, D., 161, 317

Jospin, 56

Judiciary, 16, 29

Jupp, 78, 311

Kalecki, M., 26

Kam, C. de, 98, 317

Kant, I., 163

Keizer, M., 317

Kennan, G., 68

Kennedy, D.M., 17, 19, 20, 23, 317

Keuzenkamp, H., 76, 99, 316, 317

Keynes, J.M., 3, 11, 13, 14, 15, 18, 19, 20, 26, 27, 28, 32, 33, 34,
59, 63, 66, 67, 83, 95, 96, 106, 107, 142, 156, 183, 192, 197, 208,
216, 218, 219, 224, 226, 239, 241, 268, 269, 270, 276, 277, 278, 301,
307, 310, 312, 316, 317, 319, 320, 322

Keynes, M., 19, 320

Klamer, A., 317

Klein, L., 227

Klerk, R. de, 320

Klever, W.N.A., 302

KNAW, 261

Knegtmans, P.J., 317

Knight, F., 196, 197

Knoester, A., 311, 317, 318

Köbben, A.J.F., 252

Kohl, H., 223

Kok, W., 56, 156, 256, 257, 258, 260, 262, 321

Komisar, J., 267, 269, 315

Koopmans, L., 112, 317

Korliras, P., 317

Kotlikoff, L., 94, 311

Koyck, L.M., 251

Kromhout, F., 264

Krueger, A., 297

Krugman, P., 13, 14, 27, 28, 29, 66, 67, 68, 98, 156, 192, 219, 220,
221, 222, 223, 224, 225, 227, 230, 231, 235, 236, 238, 242, 254, 255,
256, 281, 314, 315, 317

Kruiderink, 22

Kuhn, T., 78, 318

Kuipers, S., 318

Kuttner, R., 29

Laffer, 227, 318

Laidler, 318

Lakatos, I., 318

Lambert, P.J., 102, 318

Lawrence, 227, 314

Layard, R., 28, 41, 94, 96, 304, 311, 318

Le Bras, H., 302

Le Pen, 178, 257, 258

Le Play, F., 302

Legislative, 3, 12, 16, 279, 284, 306

Leontief, W., 318

Leube, 316

Levy, S., 264, 275

Lieberman, G., 316

Lincoln, 68

Lindbeck, A., 41, 304, 318

Lindblom, 314

Lissabon Strategy (EU), 157, 300

Lomborg, B., 301

Long, H., 23, 228

Lubbers, R., 256

Lucas, R., 27, 41, 121, 122, 208, 227, 318

Luce, 160, 318

Luenberger, D., 318

Madison, 113, 114, 174, 217

Magaziner, I., 98, 236

Mahony, D.O, 14

Majority, 182

Mäler, K.-G., 218, 314

Malinvaud, E., 313

Mankiw, N.G., 13, 15, 17, 27, 28, 94, 95, 216, 217, 218, 219, 237, 270,
318

Marcott, C., 34

Marginal rate, 45, 54, 55, 63, 69, 94, 96, 97, 98, 99, 126, 127, 128,
129, 137, 138, 140, 141, 142, 143, 145, 146, 147, 148, 157, 202, 203,
206, 217, 222, 223, 225, 301, 308, 309

Markowitz, H., 195

Marsden, M., 246

Marshall, A., 3, 11, 17, 33, 216, 266, 268, 318

Mas-colell, A., 175, 318

Maslow, 243

McCloskey, D.N., 184, 317, 318

McCrae, J., 247

Meade, J.E., 13, 318

Meidner, R., 150

Melkert, A., 257, 258, 262

Methodology, 3, 14, 15, 33, 70, 72, 82, 83, 85, 86, 198, 206, 212, 278,
301, 302, 304, 306

Michielsen, P., 68

Milberg, W., 219, 220, 221, 230, 316

Mill, J.S., 216, 268

Milosevic, S., 22

Minford, P., 94, 96, 318

Minimum wage, 37, 38, 41, 43, 44, 45, 46, 47, 48, 50, 52, 53, 56, 57,
58, 59, 60, 61, 69, 74, 84, 88, 99, 103, 104, 105, 106, 108, 109, 119,
120, 121, 122, 123, 124, 125, 126, 130, 131, 132, 133, 134, 135, 136,
137, 141, 145, 146, 148, 149, 151, 152, 155, 199, 200, 208, 219, 227,
236, 237, 247, 253, 262, 296, 297, 305, 306, 308, 313

Mirowski, 78, 318

Mitchell, W., 268

Monetarism, 26

Monopoly, 29, 72, 239, 281

Montesquieu, 16, 17, 21, 28, 34, 234, 270, 271, 306, 318

Mooij, R.A. de, 14, 97

Mudde, C., 258

Mueller, 28, 158, 171, 318

Muller, 315, 316, 318

Mundell, R., 15, 27, 227

Musgrave, 318

Mussolini, 258

Muysken, J., 318

Nádas, P., 260

Nader, R., 158, 178

Nafziger, E.W., 21, 318

NAIRU (_see_ CWIRU), 84, 116, 122, 226, 227, 229, 237, 240, 241, 299

Natural rate (_see_ NAIRU), 84, 121, 122, 218, 226, 241

Negative income tax (NIT), 138, 139

Nentjes, A., 318

Neubourg, C. de, 318

New Deal, 19

New Economy, 299, 300

Newton, I., 17, 175, 271

Nibbelink, A., 97

Nickell, S., 28, 41, 94, 253, 304, 318

Nieuwenhuis, A., 140

Nishiyama, 316

Nixon, R., 287

Noguchi, A., 264, 275, 319

North, R., 259

Nypels, 317

OECD, 23, 37, 42, 43, 48, 62, 63, 69, 85, 98, 120, 125, 126, 127, 130,
151, 155, 200, 224, 246, 247, 300, 303, 304, 307, 308, 309, 313, 319

Oers, F.M., 97

Oil crisis, 90, 149, 150

Okroi, L.J, 319

Okun, 40

Okun, A., 24, 94, 319

Oort, 98, 131

Oplatka, A., 68

Opstal, R. van, 319

Ormerod, P., 219, 220, 221, 228, 229, 314, 319

Palgrave, The New, 160, 171, 196, 315, 321

Palley, Th., 235, 319

Pareto, V., 21, 57, 74, 102, 162, 182, 183, 206, 212, 215, 220, 225,
232, 309

Parks, B., 264

Parliament, 25, 29, 33, 65, 85, 98, 183, 261, 279, 280, 286, 304

Patinkin, D., 95, 319

Pearce, D.W., 160, 314

Pearson, M., 247

Pechman, J.A., 319

Pelkmans, J., 319

Pen, J., 100, 319

Perry, G., 93

Phelps, E., 28, 40, 94, 121, 122, 219, 220, 221, 222, 224, 225, 226,
227, 229, 247, 314, 319

Phillips, A.W., 40, 41, 93, 99, 121, 125, 320

Phillipscurve, 14, 38, 40, 83, 84, 90, 91, 94, 96, 97, 106, 115, 118,
120, 122, 124, 198, 221, 225, 230, 305, 308

Pigou, C., 33, 34, 96, 109

Pikkemaat, A., 319

Piore, 208, 319

Ploeg, F. van der, 312, 317, 320

Plurality, 177, 178

Political Economy, 3, 11, 12, 13, 14, 26, 34, 82, 183, 184, 198, 212,
216, 222, 231, 235, 237, 252, 266, 267, 268, 270, 289, 301, 307, 309,
311, 312, 313

Popper, K., 76

Postma, R., 259, 260

Poverty, 3, 17, 18, 21, 26, 33, 34, 37, 38, 42, 45, 56, 57, 58, 60, 61,
62, 84, 124, 125, 185, 216, 217, 220, 227, 230, 234, 243, 244, 245,
246, 247, 253, 260, 264, 265, 272, 278, 293, 295, 296, 299, 305, 306,
307, 309, 316, 318

Praag, B. van, 93, 320

President, 13, 14, 24, 25, 29, 33, 59, 68, 85, 109, 143, 158, 180, 183,
245, 251, 253, 270, 279, 280, 282, 283, 284, 285, 286, 287, 288, 289,
293, 294, 295, 314, 321

Probability, 24, 65, 80, 81, 96, 104, 116, 194, 195, 197, 215, 315, 317

Productivity, 12, 27, 37, 41, 42, 58, 60, 61, 62, 63, 89, 93, 97, 99,
100, 102, 106, 107, 116, 123, 124, 125, 126, 129, 133, 134, 135, 138,
139, 145, 150, 153, 155, 156, 198, 200, 201, 204, 213, 218, 222, 223,
227, 239, 241, 246, 275, 298, 308, 309

Progression factor, 112, 113, 114, 127

Public Choice, 12, 14, 207, 250, 305, 318, 320

PvdA, 257, 258, 312, 322

Pythagoras, 72, 73, 74, 75, 76, 78

Quah, 99, 100, 320

Queen, 215, 279

Raiffa, 160, 318

Random, 78, 79, 80, 81, 82, 85, 118, 215, 229

Rastogi, 318

Rational Expectations, 118, 121, 191, 208

Reagan, R., 143, 156, 227, 284, 299

Reijn, van, 320

Reuten, G., 320

Ricardian vice, 82

Rijken van Olst, H., 273, 320

RIVM, 261

Robbins, L., 186, 268, 269

Roebroek, 320

Roosevelt, F.D., 17, 19, 23, 234, 246, 299

Roscher, W., 268

Rosenmöller, P., 257, 258

Roskamp, 320

Rostow, W., 320

Russell, B., 164, 173

Rutten, F., 317, 320

Saari, D., 175, 177, 179, 180, 181

Sachs, J., 28, 93, 225, 227, 237, 312

Sala-i-Martin, X., 100, 311

Samuelson, P., 13, 14, 15, 255, 320

Saramago, J., 254, 256

Sargent, Th., 318

Scarpetta, S., 247

Schaaijk, M. van, 150, 151, 155, 206, 212, 298, 303, 320

Scholz, J.K., 247, 248, 249, 250

Schor, J., 108

Schrijver, 320

Schröder, G., 56

Schrödinger, 78, 81, 279

Schultze, 314

Schumpeter, A., 82

Schuyt, C., 320

Scitovsky, 311

SCP, 261, 320

Segers, H., 252

Sen, A., 13, 21, 22, 158, 160, 171, 172, 174, 175, 217, 218, 232, 233,
234, 235, 278, 320

Shapiro, C., 299, 320

Shone, R., 320

Shultz, G., 285, 287

Siebrand, J., 264

Simpson, 96, 317

Skidelsky, R., 13, 19, 20, 183, 276, 301, 320

Skinner, A., 17, 320

Slesnick, D., 245

Smith, A., 11, 17, 78, 99, 109, 184, 216, 232, 233, 234, 320

Snower, D., 41, 187, 225, 318

Social Security, 36, 93, 108, 110, 139, 154, 207, 208, 219, 232, 238,
285, 298, 315

Soest, A. van, 317

Solow, R., 83, 93, 109, 226, 317, 320, 321

Speth, J.G., 20

Stagflation, 3, 18, 24, 30, 31, 36, 38, 40, 57, 93, 94, 96, 97, 106,
120, 126, 128, 135, 157, 198, 224, 230, 235, 236, 242, 250, 306, 307,
308, 309, 310, 312, 316

Standing, G., 126, 175, 321

Stappershoef, E. van, 264

Statistics, 25, 38, 44, 79, 80, 81, 82, 86, 197, 214, 235, 243, 244,
245, 285, 287, 295, 311, 315

Steuart, J., 267, 268

Stevers, Th., 321

Stiglitz, J., 29, 288

Stiphout, H. van, 321

Stockman, D., 27, 67, 288

Subsistence, 45, 46, 49, 52, 59, 106, 107, 109, 154

Sudgen, R., 321

Sulloway, F., 33, 279, 301, 321

Summers, L., 287, 321

Suppes, P., 81

Swank, O., 321

Sweden, 198, 307, 321

SWF, Social Welfare Function, 79, 151, 152, 158, 162, 172, 188, 189,
190, 207, 209, 211, 212, 213, 215

Szenberg, M., 321

T[.], general tax function, 45, 49, 102, 109, 111, 112, 123, 125, 128,
140, 141, 142, 143, 199

Tajuddin, I., 321

Takayama, A., 321

Tax Void, 43, 47, 48, 51, 53, 83, 138, 139, 186, 305, 308

Tax[.], special nonlinear, 45, 129, 133, 134, 137, 142, 143

Technology, 12, 31, 37, 42, 57, 58, 61, 62, 104, 135, 176, 221, 227,
231, 236, 239, 242, 298, 299

Teigen, R., 314, 320, 321

Theeuwes, J., 96, 264, 321

Theil, H., 241, 251, 321

Thorn, R., 317

Throgmorton, 34, 321

Thurow, L., 231

Tinbergen, J., 15, 32, 33, 59, 63, 67, 83, 100, 208, 216, 221, 222,
224, 233, 250, 251, 252, 307, 310, 311, 312, 313, 317, 319, 320, 321

Tintner, G., 70, 76, 82, 321

Tobin, J., 41, 106, 107, 160, 170, 254, 321

Tocqueville, de, 277

Todd, E., 302

Trevithick , J., 322

Trias Politica, 12, 14, 16, 17, 20, 21, 24, 25, 28, 30, 35, 220, 224,
225, 230, 264, 279, 301, 306, 308, 313

Tullock, G., 14, 27, 321

Tyrväinen, T., 246

Unemployment, 3, 14, 15, 18, 19, 22, 23, 26, 27, 31, 34, 35, 36, 37,
38, 39, 41, 42, 43, 44, 47, 48, 53, 56, 57, 58, 60, 61, 62, 63, 64, 65,
66, 68, 70, 74, 80, 84, 86, 89, 90, 92, 93, 95, 96, 97, 98, 99, 103,
104, 105, 106, 109, 115, 116, 117, 118, 119, 120, 121, 122, 123, 124,
125, 126, 133, 138, 139, 141, 149, 150, 151, 152, 155, 156, 186, 187,
198, 199, 200, 201, 203, 204, 205, 206, 207, 208, 211, 212, 213, 214,
218, 219, 220, 221, 225, 226, 227, 229, 230, 231, 234, 236, 237, 238,
239, 240, 241, 244, 247, 250, 251, 252, 253, 254, 256, 259, 262, 264,
285, 288, 289, 298, 299, 300, 301, 303, 304, 305, 307, 308, 309, 310,
312, 313, 314, 315, 316, 317, 318, 319, 320, 321

Uno, 321

US Federal Reserve Bank, 238, 285

US, USA, 3, 13, 14, 15, 17, 22, 23, 25, 27, 37, 38, 58, 61, 62, 67, 69,
98, 108, 110, 124, 125, 129, 158, 212, 218, 219, 231, 235, 236, 238,
239, 241, 242, 246, 248, 249, 251, 255, 279, 281, 282, 283, 288, 289,
297, 299, 303, 304, 305

Value Added Tax (VAT), 53, 54, 127, 135, 204, 308

Varian, H., 275, 299, 319, 320, 321

Veblen, Th., 268

Velthoven, B.C.J. van, 314, 321

Verdoorn, P.J., 251

Verkade, E., 320

Verkerk, D., 264

Visscher, G., 321

Volcker, P., 237, 285, 299

Vromans, M., 264

Walras, L., 202, 241, 277

Wanniski, J., 227

Weddepohl, H., 264

Wemelsfelder, 322

Whinston, M., 175, 318

Wilson, R., 197

Winden, F. van, 207, 315

Wolff, P. de, 251, 270

Wolfram, S., 264, 322

Wolfson, D., 322

Workswick, D., 322

World Bank, 65, 233, 304

Zalm, G., 251, 258

Zijlstra, J., 320, 322

Zoon, C., 254

Zwan, A. van der, 150, 315

Zwezerijnen, 315, 316, 318

End notes

[1] Greek ‘oikos’ = ‘estate, house’, ‘nomos’ = ‘law, custom’ and
‘polis’ = ‘city, community’. The Dutch word for ‘political economy’ is
‘staathuishoudkunde’ - with ‘kunde’ = ‘theory and art’ and ‘huishouden’
= ‘home maintenance’ (with ‘huishoudster’ = ‘cleaning lady’). See
chapter 7 below and the appendix on the definition of ‘economics’.

[2] Gould (1980) recalls that Charles Darwin was also inspired by Adam
Smith.

[3] An example is the debate between Heilbroner and Dasgupta, see P.
Dasgupta (1998). Heilbroner regards ‘economics’ as Political Economy
only, and hence neglects the other fields of economics. Dasgupta
emphasises the validity of normal economics, and replies: “Economics
does not encompass the whole of the social and moral sciences.” His
argument apparently is that science arises from cutting up knowledge in
specific approaches. But this neglects the problem of integration.

[4] The Economist February 19 2000 (p74) gives a review of Mancur Olson
“Power and prosperity” (2000) that develops the same line of thought.

[5] Though I might remark that ‘management’ itself already implies some
influence of some people on others - it is a recipe for stress if there
would be responsibility but no influence.

[6] Holland: Centraal Planbureau (Central Planning Bureau, CPB),
France: Commissariat du Plan, Germany: Sachverständigenrat. The UK
apparently relies on the Treasury.

[7] Keynes here most likely borrowed Einsteins distinction between the
special and general theory of relativity. See also Skidelsky
(1992:487).

[8] Though see Hicks (1983:374).

[9] Remarkably, also the JEL codes have ‘Keynesian’ next to
‘neoclassical’.

[10] Vide Keynes’s very definition of ‘effective demand’: what
businesses expect to sell and thus are willing to currently produce,
after taking account of already available stocks. ‘Effective demand’
thus is another word for ‘production’. Key Keynesian is seeing
production as an expectational variable.

[11] It must be recalled that more economists in the early 1900s turned
from comparative statics to dynamics. A key figure is Tinbergen, who
used the calculus of variations in his thesis and who presented the
first macro-economic model that the world has seen (see e.g. Boumans
(1992) and Barten (1988)). It may be noted that Tinbergen’s first
national model does not contain a monetary sector. In a sense
understandable, since the model was for Holland, and Holland was on the
gold standard at that time, and we know - with Mundell, who refers to
Tinbergen’s ‘instrument argument’ - that monetary policy in that case
is ineffective. Anyway, Tinbergen clearly was more of a ‘real business
cycle’ analyst, while Keynes had the feeling for monetary issues.
Keynes’s approach appeared more important, primarily since money is a
generic policy instrument for the whole (world) economy.

[12] An illustrative example of the statics vs. dynamics issue, and of
the problems that economists continue to have in making this
distinction, is page 125 of Gregory Mankiw’s 1998 “Principles of
economics” edition. Concerning the payroll tax and the distribution of
its burden over firms and workers, and using a diagram of elastic
demand and supply, he states: “This division of the tax burden between
workers and firms does not depend on whether the government levies the
tax on workers, levies the tax on firms, or divides the tax equally
between the two groups.” Referring to a US Congress effort to allocate
the burden he concludes: “This example shows that the most basic lesson
of tax incidence is often overlooked in public debate.” Well, this
conclusion is only valid for the static analysis, but in dynamics, take
home pay is directly affected by regulations, while wage contracts are
adjusted by quite different bargaining processes. The US Congress may
well have taken a right decision for the medium run.

[13] I will take the position that definitions (and thus tautologies)
can be very important too. I tend to think that Samuelson in fact would
not disagree if the point would be formulated as such. Indeed,
Samuelson has remained more of a theorist himself, and is less known
for work on collecting data and estimation.

[14] Western economies suffer since the early 1970s from mass
unemployment and the threat of inflation. This bad mix of bad
ingredients is called “stagflation” for short. “Stagflation” in fact is
a concatenation of “stagnation” and “inflation”. The word was coined
around 1970 when national income growth stagnated and brought along
unemployment. Since then growth has somewhat recovered, and stagflation
has been redefined and now is properly understood as a bad ‘trade-off’
of both inflation and unemployment. See below.

[15] Note that Kennedy (1999) in his first six pages prominently refers
to Keynes (1919).

[16] UN-WIDER Press Release “40 International Experts and Scholars Meet
in Helsinki to Discuss the Wave of New Emergencies, 6 - 8 October 1996,
at Hotel Marski”.

[17] Interview with Kruiderink, “Progress ? No, it is a black hole.”
Volkskrant Oct. 16 1999

[18] Barro also discusses the relationship between the quality of the
US CEA and US growth.

[19]
http://europa.eu.int/comm/employment_social/employment_analysis/eie/
eie2004_stat_annex_en.pdf

[20] Participation is taken here as the employment rate (employment in
% of the population in the age bracket 15-64) plus the unemployment
rate (age 15+).

[21] Kennedy (1999:241) describes the threat of Huey Long: “Roosevelt
shared that assesment. ‘Long plans to be a candidate of the Hitler type
for the presidency in 1936,’ he told William E. Dodd, his ambassador to
Germany. ‘He thinks he will have a hundred votes in the Democratic
party and put in a reactionary Republican. That would bring the country
to such a state by 1940 that Long thinks he would be made dictator.
There are in fact some Southerners looking that way, and some
Progressives are drifting that way… Thus it is an ominous situation.’
[note] ” Also, the US already had a disputable policy with regards to
its Black population, and no doubt they could be made scapegoats like
the Jews in Europe.

[22] Hayek discussed ‘knowledge’ and ‘constitutional reform’, so that
the current line of thought is not alien to economics - though see the
appendix on Hayek.

[23] There exists still one matter to settle though. Krugman suggests
that Supply-siders were no serious economists. Similarly, Mankiw
(1998:29) calls it ‘fad economics’. But after they got their respective
Nobel Prizes, both Lucas and Mundell told the press that they were such
Supply-siders.

[24] The two major recent revisions in the US, the chained price index
and the redefinition of software as investment (and thus growth), are
just examples.

[25] If the Court would be scientific but would be only an island in an
ocean of neglect, the Court would already be an improvement over the
current situation - but less than optimally so. A wise parliament also
provides for funds for independent research bodies with related
objectives, that then will provide a critical working environment.

[26] The term ‘existing theory’ will be used in this volume for the
tradition of research and results indicated by these references. In
the light of the abundance of schools and attitudes it is a bit
difficult of course to apply that term. However, those who have studied
Krugman’s books and above references, should be senstive to this
suggestion. As a next step, I will present a novel analysis below, that
leaves much of existing economic theory intact, and only supplements
it with some ‘missing links’. With this supplement it becomes even
easier to recognise the ‘existing economics’.

[27] Note that this book quotes Keynes a lot, and in particular the 60
year old _General Theory_, and only refers to modern authors. Some
readers might find this out of balance. However, in the light of the
main argument, about the Trias Politica and the Economic Supreme Court,
I found it rather natural to proceed like this. I think that it
emphasises the enduring quality of economics per se. That, admittedly,
is a matter of taste.

[28] Robert Kuttner, “Peddling Krugman”, American Prospect, 9.96 gives
a nice example: “(…) Joseph Stiglitz, chair of the Council of Economic
Advisors and author of a recent report that, in very delicate wording,
computed that most newly created jobs were in occupations or industries
that had historically paid “above median wages.” This, of course, did
not mean that the newly created jobs actually paid above-median wages.
Stiglitz, threading his way between the administration’s need to paint
a rosy election-year picture and his own professional integrity,
allowed as much.” See http://members.home.net/copernicus/28kutt.html

[29] Note that labour could (actually should) be aggregated with wage
weights, but this normally isn’t done.

[30] Keynes and Tinbergen were both first-borns. Sulloway’s theory
suggests that Keynes’s General Theory is a ‘conservative revolution’.
It gave a theoretical base to existing ideas, helping save capitalism
from the communist threat. Similar for Tinbergen. Tinbergen’s brother
Nico had more radical ideas about ethology. Such interpretations are
hazy of course.

[31] With the necessary proviso that they will not easily sail over the
edge of the world.

[32] Taken from Craig Marcott’s site, who refers to Pigou (1932) “The
economics of welfare” 4th ed. Macmillan 1932; preface. His site is also
advisable for his applications of _Mathematica_ to economics:
http://milkweed.econ.stthomas.edu/~csmarcot/index.html.

[33] See chapter 34 on the notion of a ‘moral imperative’.

[34] This analysis is taken from Colignatus (1990a) and (1994a), and
since then more years have past. CPB researchers Broer c.s. (1999)
recently write: “The high level of unemployment in OECD Europe remains
one of the puzzles of empirical macroeconomics. (…) This is somewhat
surprising in view of the considerable policy effort that has been made
(…) ” See the OECD site: http://www.oecd.org around 1999-2000 contains
such data on stagnation and slow improvement. One assumes the same in
2004.

[35] Taxes in this book are generally inclusive of welfare state
premiums.

[36] Data: US Bureau of Labor Statistics and The Netherlands Central
Planning Bureau. The US is more useful here than Europe, since it has
consistent time series on a single economy.

[37] The Netherlands had a wage explosion in the early 1950s after a
period of wage restraints, but this still allowed a quick return
afterwards to the favourable lower left region.

[38] Data The Netherlands Central Planning Bureau. ‘Not working’
involves the Dutch programs ZW+AAW+WAO+IOAW+IOAZ+WW+Vorstverlet+ABW
(sick leave, disability from birth or later, workers and independents,
welfare relief and unemployment). Welfare relief was intended to be
temporary but can be permanent, for example for the 55+ workers who do
not have to apply for jobs any more.

[39] On p358 they discuss the Lucas supply function _y = _ (_p - p_*)
for GNP _y _and inflation _p_, and remark that this is also Lucas’s
explanation of the Phillipscurve. In chapter 10 they discuss some
‘useful models’, of which in p542-555 the Phillipscurve, starting out
with Tobin’s 1972 discussion of price and wage dynamics.

[40] The ‘insider-outsider theory’ (Lindbeck & Snower (1988)) has the
similar effect that the decisive group shifts the burden. But there the
emphasis is on union membership.

[41] Borjas also states: “(…) the demand for unskilled workers
declined perhaps because of technological change which favors skilled
workers or because of the internationalization of the U.S. economy.”
(p467)

[42] Of course, not all unemployment is caused by the minimum wage. The
25% in the graph is a result of simplifying assumptions. But it is an
acceptable presentation, since Dutch official statistics grossly
underestimate unemployment (and reduce the labour force).

[43] Money is denoted as _MX_. Perhaps unfortunate, but it keeps our
formulas readable.

[44] _B_ for Dutch “Bestaansminimum” (subsistence). English Basic Net
Income or Benefit.

[45] Relation (13.1b) gives the Bentham tax function, that has
exemption _x _and marginal rate _r. _We will write _Bentham_[_y_] for
the Bentham tax, _Tax_[_y_] for a special nonlinear function, and
_T_[_y_] for a general function.

[46] Welfare states commonly distinguish the minimum earning wage and
the minimum on benefit. In Holland the latter is 70% of the former,
thus some _S_ = 0.7 _B_. But then there are subsidies that apply to
people on benefit - and the poverty trap discussion starts. Here it
suffices to take _S _=_ B_. Chapter 39 deals with the argument in
reduced form fashion.

[47] In chapter 28 we will develop the formula for the influence of
indexation on minimum wage _M._

[48] This graph gives the theoretical values for the Dutch minimum
wage, if indexation since 1951 had been rigorously applied with
inflation for exemption and net average income for subsistence. The
actual minimum wage however was different, but within range. OECD
(2000:40) Chart 2.1 graphs the observed real minimum with 1975 = 100
with for example {1970, 77}, {1978, 108}, {1996, 85}.

[49] Common themes in tax theory are merit versus demerit goods and
that one would tax the less mobile factor labour rather than capital.
These themes have less priority than the tax void. The main reason that
remains for a VAT (or a profit tax) is that the government wants to
monitor the economic process.

[50] These are virtual subsidies only: while handed out, they are
immediately cashed in under the tax rule.

[51] Note the bureaucratic mind-set: There is a tax system and thus
people are supposed to pay taxes. Benefits are established at a net
level but are recalculated to a gross level so that the Ministry of
Finance is happy again that it can levy taxes. By consequence it also
seems as if much more is paid on benefits.

[52] In general http://econwpa.wustl.edu. More specifically Colignatus
(1996a, c) at http://econwpa.wustl.edu/months/get/9604.html, and
Colignatus (1998a) at
http://wueconb.wustl.edu/eprints/get/papers/9808/9808002.abs

[53] The OECD (1998) “Employment Outlook” Table 2.3 gives an
international comparison of the level of the minimum wage in relation
to the median wage. The situation in the Netherlands may be a yardstick
to interprete these data. The table shows that the minimum wage in the
Netherlands (in 1997) was 55.9% of full-time median earnings (excluding
overtime and bonusses). Applying that rate to the 2002 values in Table
3 gives an estimate of the 2002 median of € 27,975. However, the proper
subsistence wage should rather be € 12,516, i.e. net of taxes and
premiums. The ratio thus is rather 44.7% than 55.9%. The rate could
even be lower when we consider VAT and other taxes and the possibility
of some employment subsidy, so that 30% could well be attainable. With
this yardstick, the OECD levels of the minimum wage are strikingly
high.

[54] The analysis in chapter 13 holds in theory for full time workers.
In reality, only part of this Tax Void Unemployment will be on benefit,
since a part will substitute for part-time work (at a wage lower than
full-time subsistence). A practical question is also whether the tax
statute really must, and if so can, distinguish properly between
full-timers and part-timers. These questions need to be answered, and
definitely so when a practical run is done with a general equilibrium
model.

[55] This was actually developed in Colignatus (1992b, 1995a). Dutch
readers will benefit from Colignatus (1994b).

[56] See also the appendix on this book.

[57] This was known before, and in fact it is a good hypothesis that
much of Euclid’s geometric knowledge had already been developed in
ancient Egypt. The Greek contribution appears to be the notion of
‘proof’.

[58] Stephen Levinson - interview in NRC-Handelsblad, December 18 1999

[59] See also the appendix on this book.

[60] My understanding of quantum mechanics benefitted much from the
papers on the site of Richard Gill, at
http://www.math.uu.nl/people/gill/ and Gill (1996, 1997a & b), and
Barndorf-Nielsen, Gill and Jupp (1998).

[61] Rutherford seems to have said: “If you need statistics, then you
have the wrong model” (or something to this effect).

[62] Physicists might object to my use of the word ‘understanding’.
Their modern method is to describe the mechanism or process, and to
stay far from other ways of understanding. This is considered to be an
advancement compared to earlier methods, where they apparently lost a
lot of time trying to understand ‘force’ instead of simply modeling and
measuring. But if this is understood, there is no reason to avoid the
word ‘understanding’.

[63] See chapter 34 for deontic logic on this. Note that ‘God on Earth’
would be a situation of for some _T, _with _x_ the vector of
allocations to the agents, both observed and the optimal SWF point.
Since there is no objective SWF, the concept of eternal bliss hangs in
the air as well, though.

[64] There appears to exist a strange miscommunication between physics
and mathematics. Gill quotes Suppes: “For those familiar with the
applications of probability and mathematical statistics in mathematical
psychology or mathematical economics, it is surprising indeed to read
the treatements of probability even in the most respected texts of
quantum mechanics. ... What is surprising is that the level of
treatment in both terms of mathematical clarity and mathematical depth
is surprisingly low. Probability concepts have a strange and awkward
appearance in quantum mechanics, as if they had been brought within the
framework of the theory only as an afterthought and with apology for
their inclusion.” (P. Suppes, 1963). Gill suggests that this is still
the case in 1998.

[65] I would also advice quantum physicists (or journalists) to abstain
from gibberish descriptions of ‘quantum states’. A statement like
“Schrödinger’s cat is both alive and dead, or in a superposition of
life and death, and only collapses to either of these once you open the
box” is nonsense, basically already in terms of logic, but for certain
with the scientific predisposition to determinism.

[66] The NRC-Handelsblad April 4 2000 reports about research by Lene
Hau. The so-called Bose-Einstein Condensation arises at zero Kelvin:
when speed is zero, and thus is known, then apparently atoms ‘merge’
into ‘one amorf collective’, the BEC. Hau says that she can actually
see it, and she uses it to slow down light to human speeds. She
explains that her results are not statistical but ‘honest raw data’.
This approach seems on the right track.

[67] I found, to my surprise, that Hayek has a similar approach. See
the appendix on Hayek.

[68] The importance to recognise a ‘regime switch’ cannot be emphasised
enough. Perhaps the Edmund Burke statement can help here: “Though
nobody can draw a line between the boundaries of day and night, it is
still possible generally to distinguish light and dark fairly well.”
(quoted in Gould (1980) - translated back from the Dutch again).

[69] Real transfer income _TRF_ will later be taken as _B/P U_. In
practice there are also non-unemployment transfers.

[70] Later chapters will re-use _S _for some general supply function.

[71] Note that _M_ is the minimum wage. Our formulas are better
readable this way.

[72] Note that _Y _ is nominal GDP if _NX_ = 0.

[73] Then _LE_ follows from _LE = Y / W, _ and _KE _follows from {_LE,
YR _and the production function}, and _PK_ follows from {_KE _and _KE =
_(1_ - _ )_ Y / _(_i PK_)}.

[74] For example as follows. Regard _LE = Y / W _of above. Substitute
_Y = P YR,_ and rework: _P_ = (_W LE_) / (_ YR) = W _ if labour and
output are proportional.

[75] This means that causality runs from money to inflation, to
unemployment, to the wage.

[76] The short run is defined as the period in which there is no
capacity effect from investments on the stock of capital. After a year
there generally is such an effect. The medium run is about 5 years, and
the long run might be taken as 10 years or more.

[77] This relationship now is dropped from the model, however. While
Graafland & Huizinga (1999) include the marginal tax rate, Broer c.s.
(1999) don’t, and only use the average tax rate. From a personal
conversation with Broer, I understand that this is because their
relationship is to be used in a smaller model that will be used for
policy simulations (and that has to drop some variables in order to be
smaller). This again shows that some choices can be irrational even
though circumstances may make them seem rational.

[78] (I) Professor Oort is indeed related to the discoverer of the
astronomical “Oort cloud”. Perhaps we might speak about an “Oort Cloud”
in economics too: big misconceptions and misunderstandings flying about
in professorial minds, occasionally hitting Earth to great disaster.
(II) A member of the Oort commission was professor dr. C.A. (Flip) de
Kam, who was also an assistant to the social-democratic fraction in
Parliament at the time of the ‘Duisenberg Disaster’, see chapter 14.
Around 1997 we had a chat, and he still didn’t understand the issue -
and thus it doesn’t help to explain it. De Kam is now at the OECD, it
seems in an important position. I highly appreciate some his work, like
De Kam & Van Herwaarden (1989), and I regret his misunderstanding.
Should he once understand it, he would become a welcome and powerful
ally in explaining matters to a larger audience. Still, De Kam’s
omnipresence reminds one of Ira Magaziner’s, vide Barro (1996:xii),
Krugman (1994b:298) and Galbraith (1998:201), to apparently similar
destructive effect.

[79] We don’t perform a statistical test though. We just plot these
graphs, and are satisfied by a rough lognormal approximation. For real
tax experiments, we would use the original income class data.

[80] Lambert (1985:31) mentions that a Pareto distribution - close to
the lognormal - has a nice property with regards to taxes. This should
be investigated.

[81] An alternative interpretation of _ms _and _md _is to take them as
the minimal levels for which the density shows positive values. The
table then remains the same - though of course with a different
interpretation.

[82] Borjas (1996:167) notes that the US minimum wage may have a
noncompliance of 40%.

[83] From discussion with others I understand that Juliet Schor has
made an issue of the high Dutch percentage of parttime work, presenting
it as a social advancement. It likelier comes from the distortions of
the tax system and social laws that force people into less working
hours and lower wages. I have not read Schor, so my comment here is
only a hypothesis, something to be surely checked.

[84] See Barro (1996:96-98) for some entertaining pages. That chapter
also throws some useful light on the US CEA. Curious his statement
however: “(…) we are still waiting for the first sighting of the
Keynesian demand multiplier.” (p111), i.e. curious in the light of the
structure of macro-economic models.

[85] This indeed seems to be happening in Holland 1990-2005.

[86] I have considered to use the word ‘stable’ instead of ‘constant’,
as so many authors write ‘stable inflation’. But again, as
‘accelerating inflation’ is not correct, so is ‘stable’ not correct. A
constant rate of inflation can be the only constant in a sea of
instability. To allow for a later definition of a ‘stable rate’, it is
advisable to pronounce CIRU and CWIRU as KIRU and KWIRU, and not as
SIRU and SWIRU.

[87] In a dynamic setting _u_[-1] will have a greater weight. The
equation used here can be regarded to some extent as a longer run
relation.

[88] Use _* = _, solve (28.2) for _f_[_u_] and solve (28.3) for
_f_[E[_u_]]; and the rhs’s are equal.

[89] Remember that _ = * _in the final equation, and then use (28.1).

[90] Conceivably even, the government uses its instruments such as to
create some surprise element deliberately. However, a statement like
this is a typical result of modeling. Reality is full of surprises, so
the need for governments to create some more does not seem realistic.
The literature on ‘credibility’ similarly has a high academic content.

[91] Which is a nice spot to again emphasise the limitations of the
linear assumption.

[92] In empirical analysis we might approximate demand by next period’s
employment, but then we must be aware that this already includes some
crowding out effect.

[93] Please be aware of the intellectual risk that I am taking here: I
only know (a) the Dutch situation, (b) the OECD (1986) report on
indexation practices, (c) that European minimum wages are quite high
and that the US has more poverty. The rest is a matter of logic and
economics. From this I forecast the foreign situations and these
stylized facts: and it will be fun to hear others confirm these.

[94] Chapter 27 uses _q _for natural public goods, but for lack of
symbols we re-employ _q _here.

[95] See the note above on the Oort Commission: They created this;
though many Dutch nowadays think that it has been around ‘forever’.

[96] In terms of Table 7, we now interprete _ms _and _md_ as the first
values for which the densities have a positive value. Note: we need not
add that _M _ 0 since obviously _B _ 0.

[97] Proponents for the NIT generally don’t understand that home
partners _produce_ something, and could be taxed for that.

[98] My thoughts this were stimulated by Ate Nieuwenhuis’s research on
oligopoly.

[99] Note that this ‘dynamic _M’_ concept differs from the ‘dynamic
marginal’ concept. Note too that these concepts are only defined for
_M_.

[100] Holland provides an empirical example. The real wage index rose
from 1 in 1950 to 3.7 in 1980, and has been stagnant since then. But
there have been tax reductions since 1990.

[101] It is to be noted though that director C.A. van den Beld read
about the vintage approach in a German article, and asked Den Hartog to
further investigate it, already in the years before. The model choice
was not propelled by the Oil Crises, and, indeed, the theoretical link
is weak - if not to say ‘nonexistent’.

[102] Higher fuel costs also translated into a higher CPI and thus
higher wage demands, giving another reason to be worried about wage
costs. But this is another chain of reasoning.

[103] Much of the wage of high salaried persons will derive from custom
and bargaining skill, but there will also be a serious part
‘productivity’.

[104] It is essential to read Hueting (1980) and Van Ierland et al.
(2001) for a proper understanding of the issue of growth.

[105] Vide the ‘proof of God’ paragraph in chapter 19.

[106] This is not without problem, since there are many logics, such as
standard, threevalued, fuzzy, intuitionistic logic, and my own scheme
of ‘the logic of exceptions’ (that I use to solve the liar paradox, and
Russells and Gödels problems). However, here it suffices to presume
standard logic. Note that the earlier version of this chapter (article)
used a ‘quantor free logic’, where the use of a _variable_ indicates
the ‘for all’ quantor, and a _constant _indicates the ‘there is’
quantor. A subtlety is that this distinguishes between “Not _p_ _q_”,
that is equivalent to “_p_0 & ~_q_0”, and “~(_p_ _q_)”, that is
equivalent to “_p_ & ~_q_”.

[107] If we were to put the question to Arrow, my bet is that he likely
prefers incompleteness to inconsistency.

[108] That there should be at least 3 topics is actually an axiom that
we have taken for granted.

[109] Discussion (evaluation and thus eventual publication) of (1990c)
was blocked by the CPB directorate with the comment ‘this issue exceeds
the CPB intelligence’ - which was inconsistent since I worked there.
The EER referee reports of (1997b) are nonsense too.

[110] Thus there is a subtle distinction between:
(A) _The risk,_ that is single (i.e. non-plural), and gives the
expected value of the valued risks
(B) _The risks,_ that thus is plural and gives the list of the the
_oi_ that are losses. For a single outcome, we would have the
difference between _o_ and {_o_} (element and singleton). With a list
of outcomes _O_ = {_o1, o2, ..., on_} we also have lists of prices _P_
= {_P1, P2, ..., Pn_}, and probabilities _Pr_ = {_p1, p2, ..., pn_},
and a utility function _u_. (Continued next page.)

The money valued risks are _X_ = {_x1, x2, ..., xn_} = _O * P_ = {_ P1
o1, _, ..., _Pn on_}.

The utility valued risks are _U_ = {_ u_(_o1_)_,_ .., _ u_(_on_)}. The
expression _U*_ = _u_(_o1_, .., _on_ ) is less appropriate since the
outcomes are mutually exclusive. However, since one might consider
cases where one has some utility about ‘the whole situation’, the _U*_
might still be useful.

[111] Thus stands for the expected value and for the standard
deviation (spread), and the risk. Then, use _R_ for the coefficient
of correlation. Note that the use of ‘spread’ facilitates translation
from learned journals to popular audiences that are less familiar with
‘standard deviation’. Authors that use the word ‘spread’ for the
difference between a futures and a spot price, should relabel to ‘time
premium’.

[112] In a personal discussion, Richard Gill (University Utrecht, KNAW)
had doubts about my shorthand notation, and preferred E[_x_ *
_Ix_<0[_x_]] where _IA_[_x_] is the indicator function with value 1 if
_x A_ and 0 else. Gill’s notation no doubt increases definitory
clarity, but the shorthand is not bad and has the advantage of being
short.

[113] Alternatively, relative risk can be seen as proportional to
another level. What is important in the present discussion is the
distinction with conditional risk.

[114] For (relative) risk we don’t want to use the conditional
distributions. For example, if there would be a small loss with a small
probability _p_, the conditional might turn this in a large ‘risk’,
since 1/_p _is would be a large number. So for risk we have a proper
measure in the ‘probable value’ (loss * probability).

Risk is concerned with one’s _worry_ that bad information _might_
arrive while it may not arrive. The conditional applies only if indeed
new information arrives that the returns will remain below that target
level. (Though the conditional might remain hypothetical.)

[115] If people would work on welfare, we would speak about workfare.
Workfare generally is more efficient, since people on benefit will not
have the utility of idleness.

[116] In a purely mathematical tract, the Lemma would be the theorem,
and the Theorem would be a corrollary.

[117] This is a strong claim of course. Policy makers are overloaded
with data, and they have a hard time turning this into information. But
this is often used as a cheap excuse too. They say ‘I didn’t know’
while they should have said ‘I hired an assistant who knew that he had
to keep sensitive information from me so that I could later say ‘I
didn’t know’.’ The crux of the argument is that policy makers are
responsible, by definition, for structuring the information process
such that they know the relevant facts. It is up to the jury whether
they can be excused for real human mistakes and external errors.

[118] This is a crucial part of the Definition & Reality methodology.
In mathematical economics the theorems depend on axioms that are only
hypothetical. In Political Economy that concerns reality, we also
accept facts. On availability, see also the appendix on the
presentation of the analysis for the US National Press in Washington
1993.

[119] If ‘animal spirits’ is not properly explained, it generates
confusion. As this confusion exists, perhaps I need to provide this
explanation here as well: Medieval philosophy distinguished between
dead matter, plants and objects with a spirit - and the Latin word for
spirit/mind is ‘animus’. So Keynes’s reference is not to wild beasts,
though Mankiw suggests such with his mention of ‘irrationality’ and
‘arbitrary changes in attitude’. As I understand it, Keynes entertains
the consideration that beings with a mind by definition develop
conceptions about reality, and act and take decisions in a state of
uncertainty.

[120] Krugman though allows for a temporary adverse development in
technology. This chapter was basically written as the paper Colignatus
(1997a), and since then Krugman has seen more scope for the technology
argument.

[121] I can understand your misgivings about having to read five books
before allowed to continue. Personally, I already knew most of what
Krugman is writing about, and this may also be the case for you. But it
was a useful refresher, lots of fun reading, and when everybody reads
them then there is some common ground.

[122] That is, most economists don’t know yet, but I do, and thus ‘the
economics profession’ knows it. In the same way, if a murderer knows
that someone in the room knows that he is the villain, he is tempted to
kill all in the room. This someone is going to tell !

[123] It is good to see that James Galbraith (1998) takes up this issue
too. See below.

[124] Note that the reason why I am quite certain about my own approach
is that I have given a mathematical theorem and proof based upon
readily acceptable premisses. I also use a reduced form, but, deduction
beats econometric testing.

[125] In 1997 I also wrote “(…bargaining…) has more to do with the
level of wages than the (inflationary) rate of change.” I have to
retract that statement. I temporarily forgot my very own analysis on
the Phillipscurve ! Yes, I must have been irritated.

[126] And indeed, it must be feared that mainstream economists will not
be interested much in inequality, so that they will also miss out on
the interesting ‘tract’. We may presume, however, that Galbraith will
take another occasion to repair that error.

[127] Palley is assistant director of Public Policy for the AFL-CIO,
and author of a book “Plenty of Nothing”, that I have not read yet but
that seems like a good buy.

[128] Galbraith does not refer to Bruno & Sachs (1985), but it is
useful to note that this B&S analysis would be a major part for the
explanations of the ordeal in the 1970s - which analysis apparently was
insufficiently understood by Carter and Volcker. Also, a reference for
the Volcker years is Hadjimichalakis (1984).

[129] Also Paul Krugman remarks, and expresses regret, that many of the
poor become the victims of the Fed’s anti-inflation policy: but he
doesn’t add that policy can be different.

[130] In May 2004 my employment concerned a cost-effectiveness analysis
of population based screening for cervical cancer and its precursors:
which indicates the job flexibility required.

[131] There were problems of bankruptcy of the distributer Gopher
Publishers during most of 2003-2004, though interested readers could
get the PDF of DRGTPE from my website.

[132] Saramago’s new book speaks about a town where 83% of the
population decides, silently and without any voiced protests, to vote a
blank. The number 83% is a masterly stroke since it sounds much more
realistic than 80% or 75% or 51%. But, is there any link with Fortuyn’s
17% result or is it just coincidence ?

[133] “niet gewoon rechts, maar extreem rechts”

[134] “Hij gaat een grens over die je niet mag passeren. Nederland,
word wakker !” and “Je wordt wakker, en je ziet Le Pen. Je wordt wakker
en je ziet Fortuyn.”

[135] “een gevaarlijk man”

[136] “het leiderstype-Mussolini”

[137] “buitengewoon minderwaardig mens”

[138] “haat en tweedracht te zaaien”

[139] “(…) kan worden gedocumenteerd dat Fortuyn door politici als
Melkert, Rosenmöller en Zalm werd gedemoniseerd.”

[140] In the same way, Tony Blair had his responsibility of leadership
towards Iraq. Where Blair saw danger, he was right to warn for it and
take some action. But Blair said “there are WMD” while he should have
said “I wholeheartedly believe that there are or will be WMD, even
though the current evidence shows there aren’t and will not likely be
there in the future as well”.

[141] A theory laden question, since in Marx’s original theory
socialism required internationalism, while it was the ‘great theorist’
Lenin who dropped that, creating ‘Marxist-Leninism’.

[142] A recent paradox of greater fun is that Queen Beatrix, Dutch Head
of State and Head of the Dutch government, recently stated: “The lie
governs.” She thought of newspapers and obviously did not intend to
refer to herself, but her choice of words allow this interpretation.

This text is made available by the copyright owner as an etext for the
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To professor Michael S. Hart
Founder, LibraryBlog
405 West Elm Street
Urbana IL, 61801-3231, USA

Concerning: grant of rights
March 2 2005

Dear LibraryBlog,
I am the sole copyright holder for the book: Thomas Colignatus,
"Definition & Reality in the General Theory of Political Economy", 2nd
edition, Dutch University Press, January 2005, ISBN 90-3619-172-6.
Please note that "Colignatus" is my preferred name in science. It gives
me pleasure to grant LibraryBlog perpetual, worldwide,
non-exclusive rights to distribute this book in electronic form through
LibraryBlog Web sites, CDs or other current and future formats.
No royalties are due for these rights.
I understand that, minimally, you will include clear notation that the
book is copyrighted by the copyright holder, which is me. The Project
Gutenberg header specifies under what conditions the book may be
distributed while associated with the LibraryBlog trademark. The
format of the text under those conditions may also be referred to as
the "etext" format.
People might remove this header. Since I want to place additional
restrictions (such as no commercial use or resale), I follow your
advice of putting these at the start of the etext as well. Included in
the etext are these additional conditions:

"This text is made available by the copyright owner as an etext for the
LibraryBlog. The PG header specifies under what conditions the
book may be distributed while associated with the LibraryBlog
trademark. Additional conditions are: (a) No commercial use or resale
of the etext is allowed, (b) Hardcopy prints are to be acquired at the
publisher Dutch University Press at http://www.rozenbergps.com or their
designated partners. Please note that the etext uses RTF so that the
etext layout can differ from the official layout."

I have already sent a zip file with the RTF of the etext by email to
dr. Gregory Newby.
Allow me to express my compliments to you and all the volunteers for
the LibraryBlog.

Yours sincerely,

Thomas H.A.M. Cool (Thomas Colignatus)
Scheveningen, The Netherlands
http://www.dataweb.nl/~cool

cc. Mr. Auke van der Berg
Dutch University Press / Rozenberg Publishers / Thela Thesis
Bloemgracht 82hs, 1015 TM Amsterdam, The Netherlands

Book Cover Text

ECONOMICS – POLITICS – LAW

This book explains why the world economy enjoyed a golden period in the
years 1950-1970 and what went wrong since then. Europe in 2005 has a
(hidden) unemployment of 10% and relies on an extensive benefit system
to prevent poverty. The US has less unemployment but at the price of
more poverty – making Europe reluctant to adopt that model. The world
as a whole is a political and economic mess with much and extreme human
suffering. Policymakers explain developments by causes such as
globalisation, technology and welfare state sclerosis. Those
explanations are not convincing however since trade and technology are
sources for welfare, while the only answer to poverty is a well managed
welfare state. This book provides an explanation based upon a new
approach.

When democracies fail to care for their citizens, the cause must be
looked for in the political system. The cause for the present failure
can be found in the Trias Politica structure of national decision
making – the separation of powers of the Executive, Legislative and
Judiciary branches of government. This structure gives too much room
for political elites and bureaucrats to neglect the basic rights of the
population at large. This approach provides an extension and follow-up
to the "General Theory" of John Maynard Keynes. Inclusion of economic
decision making into the analysis gives a truly General Theory of
Political Economy. The theory shows that a constitutional amendment for
an Economic Supreme Court is required – for logical reasons, for the
experience of the whole 20th century, and for an actual improvement of
real democracy which is so much needed for the 21st century.

An example of the policy failure is the curious phenomenon of the Tax
Void. The tax void is the income range between the net and gross
minimum wage. Since people may not work below the gross minimum, those
affected don’t earn income and don’t pay taxes. The taxman intends to
collect taxes in that range, but since there are no earnings there, he
doesn’t collect anything. The tax code only drives up the gross minimum
wage, causing unemployment and the associated benefit burden.
Abolishing that tax code would, since there are no revenues, not cost
anything either – and create jobs. During 1950-1970 net minimum wage
workers were hardly taxed and such taxes were gradually introduced.
Policy makers have been oblivious to this issue and have actually been
neglecting sound economic advice on it.

Historical description of the last decades – Novel contributions to
economics, politics and law – Mathematical theorems and proofs –
Empirical data and charts – Explanations for a larger public – Solution
to Arrow’s Theorem on social choice – Methodological exposition –
Results related to other authors.

Colignatus is the scientific name of Thomas Cool (1954), an
econometrician who has worked at the Dutch Central Planning Bureau
(CPB) where he developed this theory. He has an extensive web site at
http://www.dataweb.nl/~cool. The discussion in this book can be
combined with his _Mathematica_ software, available on that site.

Dutch University Press

ISBN 90-3619-172-6

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