ECONOMIC POLICY-MAKING SHOULD TAKE ACCOUNT
OF ITS TRUE IMPACT ON SOCIAL WELFARE

Economists like to make policy recommendations and judgements about different policies. Macroeconomics is full of statements about 'welfare losses', 'optimality' and 'golden rules'. The Chancellor of the Exchequer has set a target for the inflation rate. And European Union leaders at their Lisbon summit in March set out to increase EU employment.

Yet as Professor Tony Atkinson noted in a presentation at the British Association meetings in London on Tuesday 12 September, welfare economics, the branch of the subject concerned with the principles by which alternative economic arrangements may be evaluated, has ceased to be an essential part of the curriculum. Economists do not devote a great deal of time to investigating the values on which their analyses are based.

Professor Atkinson explored the foundations for such welfare judgements in macroeconomics. Are inflation targets, golden rules and employment targets an intermediate step on the path to achieving the more fundamental objective of maximising the welfare of citizens? If so, what is the relationship? Alternatively, are these targets based on 'non-welfarist' objectives, that is objectives not directly related to household welfare? If so, what is their rationale?

Are we saving enough?

The presentation took two main case studies. First, the optimal level of capital accumulation: are we saving enough? This is a matter of considerable concern to present and future generations. If we should be investing until the rate of return falls to x per cent, then the determination of x is a critical matter. The textbook account of this issue suggests that it can be resolved straightforwardly, but closer examination shows that there are different ways of formulating the social objective function, giving differing weight to different generations. Generational conflict - the staple of novels and soap operas - cannot be avoided. On one view, we may be saving enough; on another, our capital stock may be far below the optimal level.

The cost of unemployment

Distributional issues arise with the second case: the welfare cost of Europe having higher unemployment than the United States. The quantitative extent of the difference is striking. The excess of European unemployment totalled over the period since 1981 exceeds 100 million person years. But policies to reduce unemployment through cutting back the European welfare state would have distributional effects that cannot be ignored. There would be more people employed, but those in work would face a reduced wage. For the unemployed, there would be a fall in their number, but those remaining unemployed would be worse off. There would be a rise in total profits as employment increases and wages fall, but a reduction on account of the rise in the cost of filling vacancies.

The variety of distributional consequences from varying unemployment may explain why in many continental European countries, the massive rise in unemployment since the 1980s has not been accompanied by a corresponding rise in poverty. Continental European countries have not seen the same large rise in income inequality as the United States and the UK. But it may be that unemployment has costs that are not reflected in measures of financial poverty or income. As Amartya Sen has said, 'the comparative trends in income inequality give Europe an excuse to be smug, but that complacency can be deeply misleading if a broader view is taken of inequality'.

Taking such a broader view may mean looking at indicators such as health, mortality, degrees of social integration, and the progressive loss of skills. Unemployment viewed in terms of loss of employment potential may appear much more serious than when viewed in terms of income loss. This takes us outside the usual framework of welfare economics. It may also provide a more direct rationalisation of the adoption of intermediate objectives, such as employment targets.

These are all challenging issues, Professor Atkinson concluded, but we cannot provide a proper basis for evaluating policy unless the underlying welfare economics is made explicit.

ENDS

Note for Editors: 'The Welfare Basis of Macroeconomics' by Professor Tony Atkinson was presented to the British Association for the Advancement of Science's Annual Festival at Imperial College, London on 12 September. Atkinson is Warden of Nuffield College, Oxford.

For Further Information: contact Tony Atkinson on 01865-278519 (email: tony.atkinson@nuf.ox.ac.uk); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).

During the conference (11-12 September): contact Romesh Vaitilingam on 07768-661095.

NOT ENOUGH ECONOMIC SAGES

The boom in popular science books has bypassed economics completely. You only see textbooks, business guides and the occasional polemic against market capitalism. The subject is not seen by the public as an exciting growth area and the public may be right. But as Samuel Brittan noted, speaking at the British Association meetings in London on Monday 11 September, subjects can be important and affect people without being exciting, e.g. the Common Law.

Headline questions about prosperity, growth and poverty are likely to remain politically contentious. But Brittan put forward 13 economic ideas that might be of value to people with no particular interest in mastering techniques or passing exams and which ought to command a wide consensus.

He also offered a novel defence of more mathematical economics. Ideally, insight, intuition and common sense matter more. But one cannot rely on there being a sage like Keynes or Milton Friedman (or even Alan Greenspan!) on the spot. The main virtue of formal training is to limit the scope for disastrous error by fallible run-of-the-mill leaders.

Among Brittan's own economic pointers:

Business leaders who amass far more wealth than they can possibly use may be driving themselves into an early grave, but the rest of us benefit from their irrational fetish.

Far from consumption being a vulgar indulgence it is the sole purpose of production. If you don't have much desire to consume, you can work less and enjoy your leisure!

As Adam Smith pointed out, people will benefit their fellow creatures more if they follow their self-interest than if they consciously strive to trade in the public interest. But the self-interest doctrine depends on many background conditions, such as the rule of law. We only discover these when they are absent, as in many post-communist countries.

Self-interest is not the same as selfishness. It can include trying to satisfy feelings of altruism.

Ignorance of the circular flow of income is probably the most important single source of perverse policies. What will happen once India and China are able to produce cheaply products that are now made in the west? Few people who ask this go on to ask what Chinese and Indians will do with their export receipts.

Next most important is ignorance of comparative advantage in international trade. Not one person in a hundred appreciates that it still pays to trade even if one country is more efficient at making all products.

If total spending rises too quickly, the result will be inflation. But a sudden unexpected drop in such spending is likely to produce not merely lower inflation but recession and unemployment. These two assertions taken together embody the main element of truth in both monetarism and Keynes. Unfortunately, too many macro-economists prefer to confuse the public with more detailed controversial propositions rather than emphasise these essential truths.

When private institutions are working badly, look at the structure of property rights. The absence of property rights to the seabed leads to overfishing.

Look also for price mechanism remedies. Bypass the unprofitable arguments between environmentalists and growth-first businessmen by putting a price on activities with undesirable overspills.

Opportunity costs matter. Take a museum on a weekday morning. The extra resources we have to sacrifice to admit a few more people are tiny. Take the same museum with a popular exhibition on a Sunday afternoon. The cost of every extra visitor can be very high indeed. Here is the way to unlock the irritating debate on museum charges.

The boring textbook rules about demand and supply still matter. If the price of a service becomes higher, less of it is bought. This would be an utterly trivial proposition except for the frequency with which it is denied. On the left, it is often denied that if you pay workers more there will be fewer jobs. On the right, it is denied that if you impose congestion taxes on people who take cars into town centres in busy periods, more people will stay at home or use public transport. If a higher price is offered for a service, more will be supplied. If nurses' pay were doubled, the Health Service would be able to get as many new nurses as it could use. This does not mean it should be.

ENDS

Note for Editors: 'Some Useful Economic Ideas' by Sir Samuel Brittan was presented to the British Association for the Advancement of Science's Annual Festival at Imperial College, London on 11 September. Brittan is a columnist at the Financial Times. His home page is www.samuelbrittan.co.uk.

CONFLICTS OF INTEREST:
ECONOMISTS AND ECONOMIC POLICY-MAKERS CANNOT AVOID MAKING ETHICAL JUDGEMENTS IN EVERYTHING THEY DO

Economics is a branch of ethics, argued Professor John Broome, speaking at the British Association meetings in London on Monday 11 September. At least, the practical side of economics is: whenever economics tries to determine how the economy ought to be structured or managed, it is making an ethical judgement. On every occasion where an economist concludes that something ought to be done, the conflicting interests of different people will be involved. For example, if the Bank of England decides to raise interest rates, that is good for some people in the South and bad for others in the North. Conflicting interests take us squarely into the domain of ethics.

Yet economists like to avoid ethical commitments. They are self-effacing creatures, and feel it is beyond their station to take an ethical position. Often they conceal from themselves the ethical content of their opinions by concealing the inevitable conflicts of interest. Macroeconomists conceal conflict by dealing with broad aggregates, and microeconomists by pretending that improving economic 'efficiency' is a goal without conflict - good for everyone. But the truth is that there are always conflicts of interest, and hence there are always ethical questions.

When they recognise the ethical questions, economists like to answer them in a way that avoids ethical commitment on their own part. They try to derive their ethics from the people. They do this by founding their conclusions as far as possible on people's preferences. Information on preferences is collected from the market, in focus groups, by questionnaires, or in other ways. Then it is fed in as the basic data from which an economist draws his or her ethical conclusions.

The aim is to avoid ethical commitments, but in practice this procedure implies ethical commitments of its own, and also reveals confusions. One implied commitment is the `preference-satisfaction theory of well-being', the view that a person's well-being consists in the satisfaction of his or her preferences. The theory is that if you prefer one thing to another, then the former is better for you than the latter.

This theory is not credible when your preference is itself derived from a personal belief about what is better for you. It is not credible that, if you believe something is better for you, this belief makes it better for you. That would mean the belief makes itself true. Consequently, the preference-satisfaction theory cannot credibly be applied to preferences that derive from judgements of 'betterness'.

But very many preferences are of this sort. If you prefer organic to inorganic carrots, that may well be because you judge them better for you but it does not mean they necessarily are better for you. Confusion is compounded when the judgement is itself an ethical one. If you would prefer Britain to be more equal, your preference undoubtedly derives from an ethical judgement that greater equality would be better. You may not think it would be better 'for you'.

When economists try to avoid ethical theory, they fail, Professor Broome concluded. They need ethical theory. But how can economists be justified in imposing their own ethical theories on others? They cannot and should not try to impose their theories nor claim absolute authority for their views. But that does not excuse them from forming the best judgements they can on the basis of the best ethical theory they can find. They should offer their own best judgements about what ought to be done, which will then enter the ordinary intellectual and political debate, along with whatever arguments can be mustered for them.

No one can do more than this; we can only offer and defend our own best judgements. We can also hope that good judgements will fare better than bad ones.

ENDS

Note for Editors: 'Ethical Theory and Welfare Economics' by John Broome was presented to the British Association for the Advancement of Science's Annual Festival at Imperial College, London on 11 September. Broome is Professor of Moral Philosophy at the University of St Andrews, Fife KY16 9AL.

LACK OF UK INVESTMENT IN SPARE CAPACITY
CARRIES INFLATIONARY DANGERS

The Bank of England's Monetary Policy Committee places great emphasis on labour market and earnings behaviour in its efforts to predict and control inflation. But just as important, argued Professor Ciaran Driver in a presentation at the British Association meetings in London on Tuesday 12 September, is the role of physical capital, which prevents inflationary bottlenecks. Capital investment improves productivity - output per person hour - thus allowing higher wages without threatening inflation. It also reduces capacity utilisation, lessening the power of firms to raise prices without constraint.

But according to Driver's analysis, this means that there is a potentially serious problem in the UK. First, it is difficult to find a stable long-run pattern in UK investment. But second, looking at the data, it is clear that there has been an upward shift in the ratio of output to capacity both absolutely and in relation to other European economies. What this indicates is that manufacturing is now running with less spare capacity to meet sudden upsurges in demand and that this has been the case since the early 1980s. This creates the possibility of a self-reinforcing spiral of low growth as:

• Firms underinvest causing capacity shortage
• Inflation rises
• Government responds by reducing demand directly or by higher interest rates
• Expected output and investment both fall

The implication of the decline of spare capacity is that investment and, indirectly, growth is being constrained by firms because they have raised the profitability they require. Under these circumstances, it is not surprising that it difficult to find a stable long-run equilibrium relationship for investment in the UK: the underlying target rate of return has also apparently been unstable. Analysing why this is so takes us to the boundaries of economics and other disciplines since movement in target rates of return seem to depend to a large extent on cultural and institutional factors as many cross-country studies show.

Driver argued that investment should be a prime focus for policy because it is capricious - the normal functioning of markets does not necessarily induce the appropriate amount that would be implied by profit-maximising in well-behaved markets. In economics, equilibrium relationship are presumed to exist that would always hold were it not for the constant buffeting of shocks and the effect of constraints that prevent the system quickly adjusting.

Very often these equilibrium relationships rest on an arbitrage condition, that is, if they didn't hold, some activity would take place to correct this. In the case of fixed investment, we are dealing with limited arbitrage possibilities, partly because investment goods are irreversible so mistakes are not easily corrected, partly because a lot of information is private to firms themselves and partly because some desired information is unknowable.

The difficulty of modelling investment in a simple way underscores its importance in a policy context, Driver concluded. Firms make long-term decisions in the face of possible regime changes and high uncertainty. Inevitably, they fall back on conventional thinking or simple rules until these break down and are replaced by alternative conventional responses.

ENDS

Note for Editors: 'Can Economic Theory Predict Long-Term Capital Investment in UK Manufacturing?' by Ciaran Driver was presented to the British Association for the Advancement of Science's Annual Festival at Imperial College, London on 12 September. Driver is Professor of Economics at Imperial College Management School. His latest edited volume with Paul Temple develops some of the arguments in this presentation: Investment, Growth and Employment (Routledge 1999).

For Further Information: contact Ciaran Driver on 020-7589-5111 x713 (email: c.driver@ic.ac.uk) or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).

During the conference (11-12 September): contact Romesh Vaitilingam on 07768-661095.

LIVING WITH UNFAIRNESS: THE LIMITS OF EQUALITY
OF OPPORTUNITY IN A MARKET ECONOMY

Equality of opportunity is an idea advocated by many economists and social thinkers nowadays. It resonates with two major themes in modern thought: a wish to expand everyone's range of choice as far as possible; and an insistence on fairness. Yet as Professor Robert Sugden argued in a presentation at the British Association meetings in London on Tuesday 12 September, the concept overlooks the tension between these two themes. The market processes that provide us with the rich opportunities we want also - and inescapably - generate unfairness. Professor Sugden concluded that if we want the opportunities that markets give us, we have to live with this unfairness.

The central problem with the idea of equality of opportunity is that however hard we try to ensure starting-line equality, we can never guarantee equal reward for equal effort. As a result of the surprises that markets spring on us, some people will be better rewarded than others as a result of circumstances beyond those individuals' control.

For example, an individual's success in her career often depends on whether she happens to be in the right place at the right time. In choosing which career to pursue, what training to undergo, which job offer to take up and so on, an individual effectively bets on her own judgements about her talents and on how the economy will develop. This in turn depends on what other people choose to do in the future.

Through no fault of their own, individuals' best efforts may fail because of unanticipated changes in the economic environment. Think of the wholesale destruction of white-collar jobs by information technology; or the vulnerability of Rover car workers to the volatility of consumer's perceptions of brand names.

For many modern thinkers, equality of opportunity means more than the classical liberal idea of the absence of discrimination or 'careers open to talent'. It is stronger in two ways. First, opportunity - or effective freedom - is interpreted as a measure of the range of options that is accessible to a person. The ideal is that every person should have an equally rich range of options from which to choose the life he actually leads. To achieve equality of opportunity in this sense, it is not enough to eliminate unfair discrimination; it is also necessary to redistribute resources.

Second, at least for some writers (including the distinguished American economist John Roemer), equality of opportunity is taken to require that individuals who make equal efforts should receive equal rewards. On this view, a fair society is seen as a kind of handicap race. There is starting-line equality: when people enter the competition of social life, no one is disadvantaged relative to anyone else. As Roemer puts it: 'there is, in the notion of equality of opportunity, a "before" and an "after": before the competition starts, opportunities must be equalised, by social intervention if need be, but after it begins, individuals are on their own'.

In addition, there is equal reward for equal effort: as a result of the competition, those individuals who try hardest receive the largest rewards. Quoting Roemer again: 'The rock-bottom view behind equality of opportunity [is] that autonomously taken effort should be rewarded'. This ideal of fairness is seen as a way of reconciling egalitarianism with principles of freedom and responsibility. On grounds of justice or fairness, it is said, each person can legitimately demand the same amount of opportunity as other people enjoy, but what he does with those opportunities is up to him. Because people make different choices, there may be significant differences in the rewards they ultimately receive; but there should be no differences in rewards that are attributable to circumstances beyond the control of the individuals concerned.

But this account of equality of opportunity has a fatal flaw, Sugden pointed out: it is incompatible with a market economy, even the kind of social market economy that its proponents favour. It fails to take account of the problem of the division of knowledge, first pointed out by Friedrich Hayek in the 1930s in his critique of the then-fashionable ideas of 'market socialism'.

The knowledge that is necessary to co-ordinate the economic actions of millions of people does not and cannot exist in any one mind or database. It is divided among all those individuals. In a market economy, each of us makes use of our own knowledge; through the process of everyone acting on their own knowledge, important components of that knowledge become encoded in market prices and made public.

Because this flow of knowledge is part of the workings of a market economy, we cannot know the outcomes of market processes before those processes take place. Thus, no one has the knowledge necessary to turn economic life into a fair handicap race. To do that, we would need to know in advance which circumstances are advantages and which are disadvantages; but that requires us to know how economic events will unfold in the future.

ENDS

Note for Editors: 'Living with Unfairness: The Limits of Equality of Opportunity in a Market Economy' by Professor Robert Sugden was presented to the British Association for the Advancement of Science's Annual Festival at Imperial College, London on 12 September. Sugden is in the School of Economic and Social Studies at the University of East Anglia, Norwich NR4 7TJ.

For Further Information: contact Robert Sugden on 01603-593423 (email: r.sugden@uea.ac.uk) or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).

During the conference (11-12 September): contact Romesh Vaitilingam on 07768-661095.