Definition & Reality in the General Theory of Political Economy

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Title: Definition & Reality in the General Theory of Political Economy

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*** START OF THE PROJECT GUTENBERG EBOOK DEFINITION & REALITY IN THE GENERAL THEORY OF POLITICAL ECONOMY ***

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
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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 clarifi

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