Lionel Robbins Memorial Lectures

Economic Freedom and Public Policy: Economics

as a Moral Discipline
Lord Turner
Chairman of the Financial Services Authority, the Climate Change Committee and the Overseas
Development Institute

Howard Davies
Chair, LSE
 Lionel Robbins Memorial Lectures
Economics after the crisis: Objectives and means

Lecture III
Economic Freedom, Public Policy and the Discipline
of Economics

Adair Turner

London School of Economics

13 October 2010

1
Starting Point: The Instrumental Conventional Wisdom

Free Allocative Human

Growth
markets efficiency happiness

Free
markets Inequality: Justified because it helps deliver growth

2
 Happiness and income per capita in the USA

Source: Bruno Frey & Alois Stutzer, Happiness and Economics, Princeton University Press, 2002
3
Income and Human Contentment:
Possible stylised pattern over time

Pre-industrial societies The Great Transformation

Income / Contentment

Income
Developed
economies

Human wellbeing
contentment / happiness

China

Africa

Economic and technological

progress

4
 Three distinct reasons why relative income matters

1. Rising
expenditure on Concern for relative
fashion and status in itself
branded goods Higher
relative
income
increases
Happiness
2. Increased competition Relative income happiness a function
for inherently limited influences absolute of others’
supply positional goods living standard income as
well as
own

Rising average incomes

3. Congestion externalities degrade quality of some
forms of consumption

5
 “Distributive” versus “creative” activities

“Creative” Increasing the net real

income available for
consumption

“Distributive” Winning increasing

income at expense of
others

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

6
 Health and social problems

Income Inequality

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

7
 USA debt as a % of GDP by borrower type

300%

250% Corporate

200%
Household
150%

100%
Financial
50%
10%
1971
1965

1977
1983
1990
1959

1996

2002
1929
1935

1947

1953

2007
1941

Source: Oliver Wyman

8
 Global issuance of Collateralised Debt Obligations:
Cash and synthetic

300
Synthetic
250 Cash

200
$bn

150

100

50

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: IMF Global Financial Stability Report, 2006

9
Complete markets as a route to…
… efficiency
Credit derivatives “enhance the
transparency of the markets’
collective view of credit risks..
[and thus]… provide valuable
information about broad credit
conditions and increasingly set
the marginal rice of credit.
Therefore, such activity improves
market discipline”
IMF, Global Financial Stability Review, April 2006
… and stability
“There is a growing recognition
that the dispersion of credit risk
by banks to a broader and more
diverse group of investors has
helped make the banking and
overall financial system more
resilient …
The improved resilience may be
seen in fewer bank failures and
more consistent credit provision”.
10
 Share of the financial industry in US GDP

%
9
8
7
6
5
4
3
2
1
0
1850 1910
1850
50 70 90 1910
10 30 50 70 90

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

11
 Historical 'excess' wage in the US financial sector

'Excess' wage
0.5

0.4

0.3

0.2

0.1
+

0.0 -

1910 2000
0.1
1910 2000
Source: Philippon,10
11
T12
13
15
16
and17
18
20
21
22
23
25
Reshef 26
27
A2830
31
32
33
35
36
(2009). 37
38
40
41
42
Wages43
45
46
47
48
and 50
51
52
53
55
Humal56
57
58
60
61
62
63
65
Capital 66
in67
68
70
71
the 72
73
US75
76
77
78
80
81
82
83
85
Financial8687
88
90
91
92
9395
Industry: 96
97
98
00
01
02
03
05 NBER Working
1909-2006,
Paper No 14644.A. Resh (As referenced by Andrew Haldane in The Future of Finance, LSE Report, 2010)

12

Growth not the objective but by-product of other
desirable objectives

Policy implications

Implications for the discipline of economics

13
The case for growth

Growth in low and middle income countries

The poor in rich countries

Economic regression in absence of markets

The journey, not the destination

Economic freedom as an end per se

+
Avoidance of involuntary unemployment

14
The internally contradicted argument

Economic growth in rich countries still matters because it

matters to poorer citizens

Economic growth is maximised by significant inequalities /

incentives

Therefore don’t worry if economic growth is combined with

increasing inequality

15
The case for growth

Growth in low and middle income countries

The poor in rich countries

Economic regression in absence of markets

The journey, not the destination

Economic freedom as an end per se and avoidance of

involuntary unemployment

16
Keynes, The General Theory

“There is social and psychological justification for

significant inequalities of incomes and wealth…
… dangerous human proclivities can be canalised into
comparatively harmless channels by the existence of
opportunities for money-making and private wealth
which, if they cannot be satisfied in this way, may find
their outlet in cruelty, the reckless pursuit of personal
power and authority, and other forms of self-
aggrandisement. It is better that a man should tyrannise
over his bank balance than over his fellow citizens.”

(Chapter 24)

17
The case for growth

Growth in low and middle income countries

The poor in rich countries

Economic regression in absence of markets

The journey, not the destination

Economic freedom as an end per se and avoidance of

involuntary unemployment

18
Happiness, income and changing aspirations

Aspiration 1

Aspiration 2
Happiness

2 3 Aspiration 3
1
Flat line of long-term happiness

Income

19
The case for growth

Growth in low and middle income countries

The poor in rich countries

Economic regression in absence of markets

The journey, not the destination

Economic freedom as an end per se and avoidance of

involuntary unemployment

20
Amartya Sen, “Development as Freedom”

“… the freedom of people to act as they choose in

deciding where to work, what to produce, what to
consume…”

“The merit of the market system does not lie only in

its capacity to generate more efficient culmination
outcomes but also in the processes by which those
outcomes are achieved”

(Chapter 1, The Perspective of Freedom)

21

Growth not the objective but by-product of other
desirable objectives

Policy implications

Implications for the discipline of economics

22
Four clear policy implications

Maximise stability and minimise downsides

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

Maximise public choice: especially at local level

Minimise positional goods competition

• Welcome population stabilisation

23
Happiness, already achieved income, and changing
aspirations

Plus:
Happiness

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

Income

24
Do we “need to grow” to afford public expenditure?

Health In general no, if main cost is

salaries which rise proportionally
with average GDP per capita

Education

Debt servicing Yes, if macro-instability or fiscal

profligacy generate high stock of
debt relative to GDP

25
Costs and benefits of higher capital and liquidity standards

Possible costs to GDP growth

• Long-term? Vs Benefits of reduced probability
• Transitional of negative setbacks

Standard evaluation techniques

• Compare costs & benefits using a discount rate which accords
equal weight (in any given year) to costs and benefits

Consequence: will undervalue stability and over-value minor

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

26
 Estimating GDP

Measured value of

Long-term trends and
financial services?
cross-country
comparisons between
Distributive rent rich countries have
extracting versus
Lionel Robbins:
uncertain meaning
“creative” activities “both the concept of
world money income
and of national
Increasing % of money income have
income devoted to
Annual or quarterly strict significance
housing house changes are crucial only for monetary
prices increase: guide to inflation theory”
inflation or real targeting and
income? economic stabilisation

27
Four clear policy implications

Maximise stability and minimise downsides

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

Maximise public choice: especially at local level

Minimise positional goods competition

• Welcome population stabilisation

28
Growth in UK living standards: with 80% emissions cut

GDP per capita 2006=100

300
338

225 1.0 – 2.0%

lower

150

75
100

0
2006 2020 2030 2040 2050
Business as usual
80% emissions cut

29
Costs of climate change

Conceptually clear – but difficult to quantify, e.g.

changes in agricultural yields

Inherently uncertain
• Contingent social and political responses

Small probability catastrophic losses

30
The impact of discount rates

Assuming 2% per
£1000 in 2150 annum growth: 100 %
Discounted is worth of GDP in 2150 is worth

 at 4% real £3.67 today 6% of GDP today

 at 2% real £59 today 100% of GDP today

31
 Discount rate and declining marginal utility

r = η (g) + δ

η = the elasticity of the marginal

utility of consumption

Utility
g = growth rate

δ = the rate of pure time Consumption

preference

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

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

32
Happiness already Achieved Income and Changing
Aspirations

Plus:
Happiness

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

Income

33
Three problems with the standard discount rate approach

Losers in future may be Discount rate should be

poorer than rich big negative
emitters today

Small probability of Discount rate applied to

catastrophic losses those losses should be
negative

Losses of
environmental goods – Gains of economic income
species, beauty, cannot offset environmental
diversity – valued in losses
themselves

34
Four clear policy implications

Maximise stability and minimise downsides

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

Maximise public choice: especially at local level

Minimise positional goods competition

• Welcome population stabilisation

35
Four clear policy implications

Maximise stability and minimise downsides

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

Maximise public choice: especially at local level

Minimise positional goods competition

• Welcome population stabilisation

36
 Population growth and stabilisation: UN medium projections

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

9.5 9.2
9.0 8.8 600

8.5 8.3 500

8.0 495 513 519 520 515
7.7 400
7.5
7.0 300

6.5 200
6.5
6.0
100 60 65 68 70 72
5.5
5.0 -
2005 2020 2030 2040 2050 2005
2005 2020
2020 2030
2030 2040
2040 2050
2050

Source: UN Medium Projections

37
 Four clear policy implications

Maximise stability and minimise downsides

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

Maximise public choice: especially at local level

Minimise positional goods competition

• Welcome population stabilisation

Overall Objective: Creating a stable environment in which freedom to choose

can be allowed expression while minimising downside consequences and
setbacks
38
Two unclear issues

1. Are some goods / services more important to human

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

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

39
 Different marginal utility of different “goods”

Utility / Happiness

Utility / Happiness
Utility / Happiness

Income Income Income

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

40
41
Sub-optimal consumption choices

Goods consumed as a result of public choice

Social mores, herd-like fashion, and advertising

Congestion and environmental externalities

42
Two unclear issues

1. Are some goods / services more important to human

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

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

43
How much inequality?

The instrumental Inequality is justified because and to the extent that it

justification delivers growth which delivers wellbeing; low taxation
rates incentivise effort and entrepreneurship

The reality

Relative income matters

Standard responses inadequate
– Growth
– Skills
– Opportunity

Relative status competition invalidates standard incentive theory

Economic freedom, and even perceived fairness, imply significant
inequality

44

Growth not the objective but by-product of other
desirable objectives

Policy implications

Implications for the discipline of economics

45
 Economics in the dock

Prosecution Defence

Assumption of rationality
Always recognised

imperfections

Mathematicisation: “physics
envy”
Never monolithic

Focus on market completion • Mirrlees, Stiglitz, Akerlof
and equilibrium • Kahneman

Lack of enquiry about end • Sen

objectives
Never said growth (rather
than welfare) was objective
Prosecutors:
Robert Skidelsky, Keynes: “The Return of the Master”
John Cassidy: “How Markets Fail”

46
From Arrow-Debreu to the Washington Consensus:
Three simplifications

Downplay of severity of market imperfections

From Pareto equilibrium to good outcome – even

without redistribution

From equilibrium to growth as the objective

47
Economics for the real world, not for ease of modelling

Objectives

Is happiness the objective? Or welfare? Or freedom?

How are they related to each other, and to income?

Can we measure happiness or welfare?

Means

Inherent failures of complex markets

Consequences of human mental processes – part
rational, part instinctive

Inherent irreducible uncertainty, not mathematically
modellable probability distributions

48
Keynes on economics

“economics is a moral and not a natural science”

***
“no part of man’s nature or his institutions must be
entirely outside [the economist’s] regard”

***
The economist should be “mathematician,
historian, statesman and philosopher in some
degree”

49
“Economics deals with ascertainable facts: ethics with
valuations and obligations. The two field of enquiring are not on
the same plane of discourse”
(Lionel Robbins, On the Nature and Significance of
Economic Science, 1932, P.132)

“As against Robbins, Economics is essentially a moral science.

That is to say, it employs introspection and judgement of value”

(John Maynard Keynes, Letter to Roy Harrod)

50
 Lionel Robbins: Essay on the Nature and Significance of
Economic Science

“Both the concept of world money income and of national income

money have strict significance only for monetary theory”

***
“There is no penumbra of approbation around the theory of
equilibrium. Equilibrium is just equilibrium”

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

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

51