The Economics Book

POST-WAR ECONOMICS 199 See also: The Keynesian multiplier 164–65 ■ Inflation and unemployment 202–03 ■ Saving to spend 204–05 ■ Rational expectations 244–47 situation increases incomes and A man papers his wall with money Milton Friedman has a large, predictable effect on during the German hyperinflation of consumption, restoring the 1923. Friedman thought that state Born in Brooklyn, New York, economy to full employment. intervention to reduce unemployment in 1912, Milton Friedman inevitably led to high inflation. was the son of Hungarian In 1957, Friedman published immigrants. He was taught by A Theory of the Consumption the US’s top economists—at Function, an important work that Rutgers, New Jersey, for his began to challenge the Keynesian bachelor’s degree; Chicago for orthodoxy. Friedman argued that his master’s; and Columbia, people distinguish between New York, for his PhD. At “permanent income”—their stable Chicago he met economics long-term earnings, which they student Rose Director. feel confident to consume—and They married in 1938, and “transitory income”, which is less collaborated throughout their permanent, can be positive or careers. From 1935 to 1946, he negative, and which does not affect worked as a statistician and their consumption. Those with high economist in New York and incomes will have high transitory ❯❯ Washington. From 1946 to 1976, he taught at the The demand for money Government spending University of Chicago. It was can be predicted by looking at cannot reduce there that he became well- known. His fame increased people’s behavior. unemployment below its with the 1980 TV series and natural rate without book Free to Choose. He was causing inflation. an advisor to Presidents Richard Nixon and Ronald The supply of money Inflation damages Reagan. He died in 2006. can be controlled by economic efficiency the government. and should be avoided. Key works Money should grow at a modest, constant rate 1957 A Theory of the in order to keep inflation low. Consumption Function 1963 A Monetary History of Governments should do nothing but the United States, 1867–1960 control the money supply. (with Anna Schwartz) 1967 The Role of Monetary Policy Presidential address to the American Economic Association

200 MONETARIST POLICY Inflation is taxation called “speculative” and hard to pin ANNUAL PERCENTAGE GROWTHand by multiplying this by “T,” without legislation. down. To help prove the quantity the number of transactions, Milton Friedman theory right, Friedman needed to we arrive at the total value of show that the demand for money transactions. Roughly, this income and consume only a small is stable. He had to come up with equation says that if V and T share of their total income; those a testable theory about the are constant then a higher money with the lowest incomes will have demand for money. supply means a higher price level. negative transitory income and In the long run money has no will consume more than their In 1956, Friedman published “real” effects on the economy. income. But if you add all their The Quantity Theory of Money: incomes together, the positive A Restatement. He treated money Natural unemployment and negative transitory incomes as a good, a “temporary abode of The word “monetarism” was largely cancel each other out. purchasing power.” The market first used in 1968, the year that Friedman’s theory seemed to fit the demand for a good depends on Friedman presented a new account evidence well. In a cross-section of people’s overall budget and its of the Phillips Curve (p.203). This the population, consumption did relative price against other showed the supposedly stable not rise much with income. But, competing goods, as well as relationship between inflation and measured over time and looking buyers’ tastes. Friedman thought unemployment, which allowed at the total population (so that that the demand for money would governments to choose between transitory income effects cancelled be influenced by various factors. less inflation with more out), consumption did rise with First, it would increase with the unemployment, or more inflation income. Friedman concluded that general level of prices, since money with less unemployment. Friedman Keynes’s model of consumption is wanted for its purchasing power denied that such a trade-off exists, was wrong. State spending would over real goods. It would also be except in the very short run. He be treated as transitory income influenced by people’s “real” wealth said there is a single “natural rate” and would simply “crowd out” or their permanent income, and the of unemployment, which consists of private spending. Continuing returns on money, bonds, equities, unemployed workers temporarily in slumps caused by inadequate and durable goods. Finally, demand the process of looking for jobs. consumption would not happen. for money would be influenced by In practice the economy is at full “tastes,” which in this context Quantity theory of money means factors such as economic Between 1975 and 1999, the US Friedman aimed to show that uncertainty, which leads people government set yearly targets for monetary policy works: a change to want to hold money. growth in the money supply. However, to the amount of money in the it regularly grew by more than the economy has a predictable effect Given a well-defined level of upper limit of the government target. on total incomes. Keynes had demand for money, an extra supply suggested that this relationship of money would not be required by Actual was unstable because people held consumers: they would already be growth money for different reasons; some holding the money that they of these reasons were what he needed. They would therefore 12 spend any extra cash. Prices do not Upper adjust instantly in the short run, so target this would lead to higher output. But in the long run, prices would 9 adjust, and the only effect of the extra money would be higher 6 prices. Friedman’s approach can Lower therefore be seen as a revival of the quantity theory of money, a 3 target formula that states MV = PT, where “M” is the money supply and “V” 0 1980 1985 represents how quickly money 1975 YEAR circulates. “P” is the price level,

POST-WAR ECONOMICS 201 In 1973, Chile became the first easy to misread what is happening Attention then focused on the country to implement monetarist in the economy. They should follow narrow monetary base, namely policies. Under dictator Augusto a simple rule: ensure that money, notes, coins, and reserves held at Pinochet, a radical program of cuts however it is defined, increases by the central bank. This was easier and privatizations was carried out. a constant amount—2–5 percent to control but did not seem to enjoy (depending on the definition of a stable relationship with so-called employment when unemployment money chosen) annually. broad money. is at this natural rate. If governments spend money The new classical Monetarist experiments were to reduce unemployment below macroeconomics school, led by largely unsuccessful, but the the natural rate, pushing up US economists Robert Lucas and impact of monetarism was inflation, wage earners will further Thomas Sargent, put forward a significant. It grew from a policy inflate their wage demands. revised version of this argument prescription about the money Two things can then happen. based on rational expectations of supply to a program aimed at Unemployment can return to the future economic policy. Friedman’s reducing government involvement natural rate, at the new, higher model treated expectations as if in all aspects of the economy. Few inflation rate. Or the government they only adapted to past mistakes. today would disagree that “money tries to maintain the lower Lucas and Sargent argued that matters.” Monetary policy receives unemployment level, but at the cost people’s expectations are forward- as much attention as fiscal policy of a spiral of accelerating inflation. focused. People can see what and is usually aimed at controlling governments might plan, so any inflation. But the purest form The conclusion was clear: it is government attempt to reduce of monetarism and its policy futile for governments to try to unemployment below the natural implications rely on controversial stabilize employment through fiscal rate will lead immediately to higher assumptions: that there is a policy. Increasing the money supply inflation. In other words the predictable demand for money and likewise only leads to higher prices. Phillips Curve is vertical in the that the money supply can easily be In the long run the Phillips Curve short run as well—governments controlled by the authorities. In the is a straight vertical line at the don’t ever have the power to 1990s countries moved away from natural rate of unemployment. reduce unemployment. monetary targeting. Many began to use the exchange rate to control The time lag between monetary Monetarism in practice inflation or to tie interest rate policy changes and output changes is It did not take long for Friedman’s directly to inflation trends. ■ often only a few quarters. Price warnings to be proven correct. In movements can take between the 1970s the supposed Phillips US president Ronald Reagan and one to two years or more to Curve trade-off fell apart when both UK prime minister Margaret Thatcher come through. These lags are inflation and unemployment were close conservative allies. Both considerably variable. For this increased together—a phenomenon pursued strict monetarist policies in reason Friedman advised known as stagflation. Governments their early years in office. governments against trying to started to introduce targets for use monetary policy to actively growth in the money supply into manipulate markets because it is their planning. Germany, Japan, the US, the UK, and Switzerland adopted monetary targeting in the 1970s. However, it proved hard to control monetary growth. One problem was which form of money to target. Most central banks targeted a broad version of money, which included bank time deposits (deposits that cannot be withdrawn for a fixed period of time). However, this proved hard to control.

202 THE MORE PEOPLE AT WORK, THE HIGHER THEIR BILLS INFLATION AND UNEMPLOYMENT IN CONTEXT F or 30 years after World War II Unemployment and the Rate of the world’s more developed Change of Money Wages, showing FOCUS economies enjoyed their a link between wage inflation and Economic policy longest ever period of growth. unemployment in the UK from Unemployment was low, incomes 1861–1957. Years of high inflation KEY THINKER rose, and economists thought they were years of low unemployment, Bill Phillips (1914–75) had overcome the crises of the 1930s. and vice versa. BEFORE This confidence stemmed from Inflation or employment? 1936 John Maynard Keynes a belief in the power of government Later work showed similar, stable attempts to explain intervention to manage the economy, relationships for other developed unemployment and recessions. which was powerfully summarized countries. Governments realized in the Phillips Curve. In 1958, New that there was a trade-off between 1937 British economist John Zealander Bill Phillips published inflation and unemployment. They Hicks turns Keynes’s insights The Relationship Between into a mathematical model. If unemployment is high, the AFTER government can boost demand by 1968 Milton Friedman argues that the Phillips Curve should increasing its spending. account for people’s expectations of inflation, and This causes prices to rise (inflation) that there is a “natural” rate of and unemployment to fall. unemployment. But as more people are The more people 1978 Economists Robert Lucas needed for employment, wages at work, the higher and Thomas Sargent attack rise, pushing up other prices. the Phillips Curve. their bills. From 1980s New Keynesian macroeconomics rehabilitates the possibility of stabilizing the macroeconomy (the whole economy).

POST-WAR ECONOMICS 203 See also: Depressions and unemployment 154–61 ■ The Keynesian multiplier 164–65 ■ Monetarist policy 196–201 ■ Rational expectations 244–47 ■ Sticky wages 303 The Phillips Curve showsINFLATION (%)but pulled prices and wages Government attempts to stabilize the correlation between upward. Inflation would rise. the economy had merely pushed up unemployment and the rate However, by the 1970s this stable expectations of future inflation, and of inflation. As unemployment relationship appeared to have actual inflation had risen as a result. goes down, inflation goes up, collapsed. Unemployment and and vice versa. inflation rose together in a condition Friedman’s challenge cleared known as “stagflation.” US economist the way for an assault on Keynesian Phillips Curve Milton Friedman (p.199) explained macroeconomics, and governments it in a way that came to dominate turned to ways of improving the At zero inflation macroeconomic theory. He said supply of capital and labor, rather unemployment that as well as showing a than focusing their efforts on is high relationship between actual prices regulating demand. ■ and unemployment, the Phillips 0 UNEMPLOYMENT Curve needed to take account of By 1931, unemployment in the US expectations of inflation. People had reached nearly 23 percent, with could pick their preferred point realized that when the government a corresponding fall in prices. The along the Phillips Curve, choosing increased spending to boost the government launched a program of either low unemployment and high economy (and raise employment), public works to create jobs. inflation, or low inflation and high inflation would surely follow. unemployment, and adjust their Consequently, any increase in at the London School of policies to suit. By increasing or government spending during Economics, but switched to reducing their spending, and periods of high unemployment economics at the post-graduate tightening or slackening monetary was taken as a sign of impending level. He became a professor policy (the money supply and inflation, and workers asked for there in 1958. In 1967, he moved interest rates), they could regulate wage increases before prices to Australia to teach but had a aggregate demand (total spending) actually rose. In the long run, said stroke two years later and to fix the economy on the curve. Friedman, there is no trade-off retired to New Zealand. The economy was treated like a between unemployment and giant machine. All major questions inflation. The economy is fixed at Key works about the macroeconomy—the a “natural rate” of unemployment. country’s whole economic 1958 The Relationship Between system—could seemingly be Bill Phillips Unemployment and the Rate of reduced to technical fixes rather Change of Money Wages than battles over ideology. Born in New Zealand in 1914, 1962 Employment, Inflation, and Alban William Phillips moved to Growth: An Inaugural Lecture The curve fit well with the Australia in his early twenties, Keynesian macroeconomics working for a time as a crocodile (pp.154–61) that was prevalent at hunter. He traveled to China in the time. When unemployment was 1937, fled when the Japanese high, it was assumed that the dip invaded, and arrived in the UK in labor and product markets would in 1938 to study engineering. drag wages and prices downward. At the outbreak of World War II Inflation would be low. When Phillips joined the RAF. employment was high, additional Captured by the Japanese in demand in the economy—perhaps 1942, he spent the rest of the from government spending—did not war in a prison camp. In 1947, he increase output and employment, took up sociology and enrolled

204 PEOPLE SMOOTH CONSUMPTION OVER THEIR LIFE SPANS SAVING TO SPEND IN CONTEXT Households devote I n 1936, John Maynard a varying proportion Keynes’s The General Theory FOCUS of their current income of Employment, Interest, and Decision making Money put the issue of consumption to consumption. center stage: if total demand in the KEY THINKER economy is critical to making it run Franco Modigliani This is because smoothly, the groups who make up (1918–2003) individuals are rational, that demand matter a great deal. look to the future, and Public spending came under BEFORE government control. Investment 1936 John Maynard Keynes dislike shocks. by firms was related to the interest publishes The General Theory rate. But consumption by households of Employment, Interest and They consume based on presented more of a challenge. Money, proposing a simple their expectations of mathematical function to lifetime income, not Keynes (p.161) claimed that describe consumption. households consume a fraction on current income. of their income and save the rest, 1938 Keynesian economist with richer households saving Alvin Hansen predicts They save when more. The proportion all households long-term stagnation in young, and use up their spend determines the size of the US economy. the “multiplier” (pp.164–65)— savings when old. the amount that government AFTER spending increases when put 1978 US economist Robert People smooth into practice. It creates jobs and Hall estimates a function to consumption over income, which is multiplied by the describe US consumption, spending of those who received potentially confirming a their life spans. the extra jobs and income—and version of Friedman’s theory. in this way they impact on the general economy. For Keynesian 1982 US economists Robert economists this multiplier effect Hall and Frederick Mishkin lies behind the way the economy propose that households moves between boom and follow a “rule of thumb” when recession over time. For this reason planning their consumption. getting an accurate picture of consumption is critical.

POST-WAR ECONOMICS 205 See also: Economic man 52–53 ■ Borrowing and debt 76–77 ■ The Keynesian multiplier 164–65 ■ Rational expectations 244–47 Keynes’s theory makes three Successive generations Franco Modigliani empirical predictions. First, richer seem to be less and households will save more than less thrifty. Franco Modigliani was born poorer ones. Second, over time, in Rome, Italy, in 1918. He as the economy grows, the amount Franco Modigliani initially studied law at the people spend will rise less quickly University of Rome, but than income, since households will Two solutions to the mystery gained switched to economics. In be growing richer and so spending acceptance. Both proposed that 1938, Mussolini passed a proportionately less of their income. rational individuals do not consume series of anti-Semitic laws, Third, following on from this, richer blindly out of their current income, and Modigliani—a fervent economies will become increasingly but look to the future and develop antifascist—left for Paris and “lethargic:” when consumption falls expectations about how much then New York with his wife, in ratio to income, it reduces the they need to save. In 1954, Italian the antifascist activist Serena multiplier and the economy begins economist Franco Modigliani Calabi. He supported his to stagnate. suggested this relates to stages in growing family by bookselling life. When people are economically while studying. He took a Lifetime savings active, they save toward old age. series of teaching posts However, the theory’s predictions When they are older, they use up before becoming a professor did not match well with reality. their savings. They try to keep of economics at the The ratio between household consumption constant, smoothing Massachusetts Institute of consumption and income over the its path over time. This is known Technology (MIT). In 1985, long run turned out to be stable as the life-cycle hypothesis. he won the Nobel Prize for across a wide range of countries, his pioneering analyses of rather than decreasing with Three years later US economist savings and financial markets. growth. It fluctuated over short Milton Friedman (p.199) proposed After his death in 2003, the periods of time but did not move the related theory that people economist Paul Samuelson said consistently in any particular smooth their consumption over time that he had been the “greatest direction. After World War II around their “permanent income”— living macroeconomist.” economists predicted stagnation, an expectation of future earnings, but economies everywhere boomed. based mostly on current wealth. Key works Any extra income is “transitory” Retirement is only enjoyable when and will be saved. This is known as 1954 Utility Analysis and the we have funds to replace our income. the permanent income hypothesis. Consumption Function (with Franco Modigliani said that our Richard Brumberg) awareness of this makes us save over More recent developments 1958 The Cost of Capital, time to allow for constant consumption. in consumption theories have Corporation Finance and the suggested that in fact consumers Theory of Investment (with tend to use “rules of thumb” Merton Miller) and other forms of “non-rational” 1966 The Life Cycle behavior when making decisions Hypothesis of Saving about how much to spend or save. ■

206 INSTITUTIONS MATTER INSTITUTIONS IN ECONOMICS IN CONTEXT S tandard economics assumes with the state, and the political the existence of markets. and social conditions that help FOCUS It also assumes that economic activity. Society and the economy governments have the policy levers necessary to encourage US economist Douglass North KEY THINKER markets towards beneficial kinds of defined institutions as the Douglass North (1920– ) trade, investment, and innovation. “humanly devised constraints However, institutional economists that shape human interaction.” BEFORE go deeper—they search for the These constraints are the “rules 1904 US economist Thorstein origin of markets, their involvement of the game,” and appear in both Veblen argues for the primacy formal and informal guises. of institutions in explanations of economic performance. Institutions are the laws, customs, and traditions of a society. 1934 US economist John Commons states that Individuals and firms work within economies are complex the bounds of these institutions webs of institutions and divergent interests. when they work, buy, and sell. AFTER “Good” institutions “Bad” institutions 1993 US economist Avner promote economic hamper economic Greif uses game theory and social progress. and social progress. to analyze the historical development of institutions Good institutions that allowed trade to develop. matter. 2001 Turkish-US economist Daron Acemog˘ lu explains institutional differences between countries in terms of their colonial origins.

POST-WAR ECONOMICS 207 See also: Property rights 20–21 ■ Public companies 38 ■ Economics and tradition 166–67 ■ Social capital 280 ■ Resisting economic change 328–29 Formal constraints are the rules that are rooted in the law and politics of each country, while informal constraints are a society’s social codes, customs, and traditions. Combined, these make up North’s institutions, and they set the broad rules of the game within which humans interact as workers, consumers, and investors. Markets and property The German Bundestag (parliament) Douglass North Property rights—of physical and was a new institution set up after 1945. intellectual property—are an Its role was important in shaping Douglass North was born in institution essential for economic post-war Germany’s law and economy. Cambridge, Massachusetts. growth. North investigated the As a student at the University emergence of property rights in power to activate property rights, of California in Berkeley, he England, claiming that they began because they cannot survive under refused to serve in World War in 1688, the year in which the anarchy. However, it is this very II, and after graduating joined Crown was made subservient to power that also allows the state to the US merchant marines to Parliament. Before then, the monarch use resources for its own benefit. avoid fighting. During his would commonly expropriate three-year service he read resources, riding roughshod over The Turkish-American many economics books, and private property rights. North found economist Daron Acemog˘ lu (1967– ) found it hard to choose that after the power of the Crown showed that this tension is rooted between studying was restricted, exchange became in societies’ colonial origins. In photography (a lifelong hobby) less costly and incentives improved. regions such as Africa where and economics on his return His view has been challenged, but infectious diseases threatened, to the US. Economics won out, the approach remains influential. colonists did not stay long. and he received a PhD from Institutions were set up with Berkeley in 1952. He began North’s example reveals a the purpose of extracting natural teaching at the University of tension that lies at the heart of resources quickly for a state’s self- Washington, where he helped institutional economics. The state enrichment, not to foster economic to found the new field of guarantees order, which gives it the growth. In the more congenial cliometrics (the economic and North American colonies, however, statistical analysis of history). Institutions provide the settlers established institutions incentive structure of that promoted long-term growth. North taught at the University of Washington until an economy. Institutions determine the 1983, but in 1996 he spent Douglass North success or failure of economies— a year in Geneva studying they create the essential structure. European economic history, Economists have yet to identify awakening his interest in the clearly the institutional mutation role of institutions. He was that triggers economic progress. awarded the Nobel Prize for Reform to institutions is difficult, economics in 1993. with the past always leaving traces in the present. ■ Key works 1981 Structure and Change in Economic History 1990 Institutions

208 PEOPLE WILL AVOID WORK IF THEY CAN MARKET INFORMATION AND INCENTIVES IN CONTEXT Some contracts require This requires work to be performed. time and effort. FOCUS Decision making … there is an incentive to If no one is watching… put in less effort than has KEY THINKER Kenneth Arrow (1921– ) been agreed. BEFORE People will avoid work if they can. From 1600 “Moral hazard” is used to describe situations T he standard model of out that, while two sides can agree where individuals may not economic behavior, first set to write a contract, there is no be honest. out by Adam Smith (p.61) in guarantee that either will fulfill it. the 18th century, assumes that all Where one party cannot observe 1920s–30s US economist the participants in markets are the behavior of the other, there Frank Knight and British rational and well-informed. However, may be an incentive for the economist John Maynard this is not always the case. less-observed party not to deliver Keynes grapple with the on all clauses of the contract, problem of uncertainty US economist Kenneth Arrow unknown to the other. There is in economics. was among the first to analyze an imbalance of information the problem of less-than-complete because actions are hidden. AFTER information in markets. He pointed 1970 US economist George Akerlof publishes The Market for Lemons, looking at the problem of limited information about a good’s quality. 2009 Mervyn King, governor of the Bank of England, describes government bailouts of the banking system as “the biggest moral hazard in history.”

POST-WAR ECONOMICS 209 See also: Provision of public goods and services 46–47 ■ Economic man 52–53 ■ Markets and social outcomes 210–13 ■ Game theory 234–41 ■ Market uncertainty 274–75 ■ Incentives and wages 302 Travel insurance may encourage encouraging excessive risk-taking requirement cannot be stipulated vacationers to try out more hazardous and ultimately bearing excessive in advance, and moral hazard activities. As a result insurance firms costs. This means there will be a can emerge in unforeseen ways. raise the price of coverage. market failure: those obtaining Principal–agent problems have insurance will pay too much, and led to the development of a large Moral hazard many people could find themselves literature on the management of This situation is known as “moral excluded from the insurance market complex tasks, dealing with the hazard.” In the insurance market, altogether. Arrow suggested that, best way to word the contracts. for instance, an insurance policy in these circumstances, there is a may act as an incentive for the case for government intervention to Too big to fail? person insured to take more risks correct the market failure. Moral hazard has more recently because he or she knows that the become a critical issue in political insurer will cover the cost of any Moral hazard can emerge in arguments following the 2008 damages. The result is that any situation where one person (the financial crisis. When banks are insurers offer less insurance “principal”) is trying to get another described as “too big to fail,” a coverage, since they are fearful of (the “agent”) to behave in a certain version of moral hazard may be way. If the behavior desired by the at work. Major banks know their principal takes effort by the agent, failure could cause a recession, and if the principal cannot observe so they may believe that they will the agent’s actions, the agent has be supported by governments no motive and opportunity to avoid matter what. Economists have work. Insurance contracts are suggested that this leads banks between firms and their customers, to take on excessively risky but the problem can emerge even investments. The euro crisis of within one firm: employees may 2012 is also thought to be an shirk their duties when an example of moral hazard at play: employer isn’t watching over them. countries such as Greece were These principal–agent problems suspected of having run economies often come about with long-term on the grounds that the country contracts for complex tasks. was “too big to fail.” ■ In such circumstances every Kenneth Arrow A native New Yorker, American Stanford and Harvard. In 1979 Kenneth Arrow was born in 1921. he returned to Stanford, until He was educated entirely in New his retirement in 1991. He is York, graduating in social science best known for his work on from City College before going on general equilibrium and social to receive an MA in mathematics choice, and won the Nobel Prize from Columbia University. He in 1972 for his pioneering switched to economics, but after contributions to economics. the outbreak of World War II he was sent to join the US Army Key works Air Corps as a weather officer, researching the use of wind. 1951 Social Choice and Individual Values After the war Arrow married 1971 Essays in the Theory Selma Schweitzer, with whom he of Risk-bearing had two sons. He began lecturing 1971 General Competitive at Columbia in 1948, then had Analysis (with Frank Hahn) professorships in economics at

210 IN CONTEXT THEORIES FOCUS ABOUT MARKET Welfare economics EFFICIENCY REQUIRE MANY KEY THINKER ASSUMPTIONS Gérard Debreu (1921–2004) MARKETS AND SOCIAL OUTCOMES BEFORE 1874 French economist Léon Walras shows that a competitive, decentralized economy can achieve a stable equilibrium. 1942 Polish economist Oscar Lange provides an early proof of the efficiency of markets. AFTER 1967 US economist Herbert Scarf demonstrates a method for applying real-world economic data to general equilibrium models. 1990s New models of the macroeconomy integrate general equilibrium analysis with real-world economic data over time. B y the 1860s and 70s mainstream economics had developed a distinctive set of claims about the world, offering mathematical models that allowed economists to assess individual behavior in certain market conditions. These models were taken from the rapidly developing mathematics that described the natural world. This development, sometimes called a “marginalist revolution,” involved a claim that value is determined by people’s preferences and resources rather than by a more objective or absolute standard, and it allowed pressing theoretical questions to be posed in new ways. Did Adam

POST-WAR ECONOMICS 211 See also: Free market economics 54–61 ■ Economic equilibrium 118–23 ■ Efficiency and fairness 130–31 ■ The theory of the second best 220–21 Market prices reflect So in theory prices demands for and supplies completely reflect both consumers’ preferences of each commodity. and the limits to an economy’s resources. But this only happens if you This implies that markets Gérard Debreu make assumptions that lead to an “efficient” rarely occur in the real world. economic outcome. Born in Calais, France, in 1921, Gérard Debreu was educated Theories about at the École Normale market efficiency Supérieure in Paris during the German occupation. After a require many period of service in the French assumptions army, Debreu returned to his studies of mathematics and Smith’s “invisible hand” of the Governments redistribute wealth developed an interest in market really guide self-interested by taxing goods such as gasoline. Under economic problems. In 1949, a individuals to the best available certain assumptions, it can be shown fellowship allowed him to visit outcomes? Were markets more, that the free market adjusts to achieve some of the top universities or less, efficient than other ways of efficient use of goods despite taxes. in the US, Sweden, and guiding society? Could completely Norway, bringing him up free markets even exist? to date with economic developments that were then Stable markets unknown in France. In the French economist Léon Walras US he became part of the (p.120) was one of the pioneers highly influential Cowles of this revolution in theory. He Commission, which had been attempted to show that markets, convened in the 1930s to left to their own devices, can pursue the mathematical achieve a stable outcome for treatment of economic issues. the whole of society, perfectly He worked at the US balancing the demands of universities of Stanford and consumers and firms with the Berkeley, teaching economics supply of goods and services. ❯❯ and mathematics. In 1983, he was awarded the Nobel Prize. He died in 2004. Key works 1954 Existence of an equilibrium for a competitive economy (with K. Arrow) 1959 Theory of Value: An Axiomatic Analysis of Economic Equilibrium

212 MARKETS AND SOCIAL OUTCOMES 20 SARAH’S APPLES 5 0 did this by proving two theorems, 10 15 10 0 known as the “fundamental 2 theorems of welfare economics.” 8 Ben (15 apples, 9 pears) 4 Sarah (5 apples, 1 pear) The first welfare theorem holds 6 that any pure free market economy Contract in equilibrium is necessarily curve “Pareto efficient”—that it leads to a BEN’S PEARS distribution of resources in which SARAH’S PEARS it is impossible to make someone 4 Ben (10 apples, 5 pears) 6 better off without making someone Sarah (10 apples, 5 pears) else worse off. Individuals begin with an “endowment” of goods. 28 They trade with each other and reach an equilibrium, which the Ben (6 apples, 2 pears) theorem holds will be efficient. Sarah (14 apples, 8 pears) 0 10 Pareto efficiency is a weak 0 5 10 15 20 ethical criterion. A situation in BEN’S APPLES which one rich person has all of a desired good and eveyone else has An Edgeworth box is a way of showing the distribution of goods in an none of it would be Pareto efficient economy. In this example the economy contains two people—Ben and Sarah because it would be impossible to —and two goods—20 apples and 10 pears. Each point in the box represents a remove some of the good from the possible distribution of apples and pears between Ben and Sarah. The yellow rich person without making him line is the contract curve, which represents the possible allocation of goods worse off. So this first welfare that could be reached by Ben and Sarah after trading with each other. theorem says that markets are Trading to points on this curve leads to Pareto efficiency. efficient but says nothing about the critical issue of distribution. It was known that a single market stability. He also said that this could achieve this balance, or equilibrium was desirable The second welfare theorem equilibrium, but it was not clear because it entailed a free society. deals with this problem. In an that a whole set of markets could economy there are typically many do the same thing. Pareto-efficient outcomes Pareto-efficient allocations of Modern economists measure resources. Some will be fairly equal The problem of “general desirability using a concept known distributions, some highly unequal. equilibrium” was rigorously solved as “Pareto efficiency” (pp.130–31). in 1954 by French mathematician In a Pareto-efficient situation it How this coordination Gérard Debreu and US economist is impossible to make one person [of supply and demand] Kenneth Arrow (p.209). Applying better off without making another takes place has been a advanced mathematics, they person worse off. An improvement central preoccupation showed that under certain takes place in an economy if goods of economic theory since circumstances a set of markets change hands in such a way that at could achieve an overall least one person’s welfare increases Adam Smith. equilibrium. In a sense Arrow and no one else’s falls. Arrow and Kenneth Arrow and Debreu had reworked Adam Debreu connected market Smith’s argument that free equilibrium with Pareto efficiency. markets would lead to social order. In doing so they rigorously probed But Smith made a stronger claim Smith’s ultimate contention that than the purely factual one that market outcomes are good. They markets tend toward a point of

POST-WAR ECONOMICS 213 An allocation of resources behavior of firms has to be reality as to be inapplicable to could be efficient in a Pareto competitive, while in practice the any situation, but theoretical sense and yet yield enormous world is full of monopolies. models aren’t intended to be faithful descriptions of reality: if riches to some and dire In addition, welfare theorems they were, Arrow and Debreu’s poverty to others. don’t hold when there are model would be useless. Instead, Kenneth Arrow economies of scale, such as in their theorems answer a central situations in which there are large question: under what conditions The theorem says that any of firms with high set-up costs—for do markets bring efficiency? The these Pareto-efficient distributions example, in the case of many public stringency of these conditions, can be achieved using free utilities companies. A further then, tells us by how much and markets—a concept represented important condition for the in what ways real economies stray by economists as a “contract efficiency of equilibrium is that from the benchmark of full curve.” However, to achieve a there should be no “externalities.” efficiency. Arrow and Debreu’s particular one of these allocations, These are costs and benefits that conditions point to what we an initial redistribution of individual do not register in market prices. might do to move closer to endowments needs to be made. For example the noise from a efficiency. For instance, we might Then trading can begin, and the motorcycle workshop might hurt try to price pollution to deal with particular Pareto-efficient the productivity of a firm of externalities, to break up allocation of resources occurs. accountants next door, but the monopolies to make markets workshop owners do not take this more competitive, or to create The practical implication broader cost into account because institutions to help inform here is that a government can it doesn’t affect their private costs. consumers about the goods redistribute resources—through Externalities hamper efficiency. that they buy. the levying of taxes—and can then Also, if individuals don’t have full depend upon the free market information about prices and about The work of Arrow and to ensure the eventual allocation the characteristics of the goods Debreu formed the foundation is efficient. Equity (fairness) and they are buying, then markets are of much of our post-war economics. efficiency go hand in hand. likely to fail. Attempts were made to refine their findings and to investigate Real-world limits What the theorems tell us the efficiency of economies under Arrow and Debreu’s results It is tempting to ask what is different assumptions. Large depend on stringent assumptions: the point of this model if its macroeconomic models, both when these don’t hold, efficiency assumptions are so removed from theoretical and empirical, were may be compromised, a situation built using Arrow and Debreu’s that economists call “market general equilibrium approach. failure.” For the theorems to hold, Some have criticized the individuals have to behave equilibrium approach for failing according to economic rationality. to take into account the chaotic, They need to respond perfectly to truly unpredictable nature of real- market signals, something that is world economies. These clearly not the case in reality. The voices have become louder recently with the failure of these kinds of models to predict the 2008 financial crash. ■ Equilibrium models failed to predict the crisis of 2008, which began when Lehman Brothers Bank collapsed and fired all its staff. This led to criticisms of the models’ basic assumptions.

214 THERE IS NO PERFECT VOTING SYSTEM SOCIAL CHOICE THEORY IN CONTEXT A t a first glance, the evaluate the economic well-being mathematics of voting of a society, the values of its FOCUS may seem to have little to individual members have to be Welfare economics do with economics. However, in the taken into account. In the interests area of welfare economics, and in of making collective decisions that KEY THINKER social choice theory in particular, determine the welfare and social Kenneth Arrow (1921– ) it plays a crucial role. Social choice state of a society, there must be a theory was developed by US system for individuals to express BEFORE economist Kenneth Arrow in the their preferences, and for these to 1770 French mathematician 1950s. He saw that in order to be combined. The collective Jean-Charles de Borda devises a preferential voting system. Voters are to choose between candidates 1780s English philosopher and social reformer Jeremy A, B, and C. Bentham proposes a system of utilitarianism—aiming for A majority of people the greatest happiness of the might prefer… greatest number. … A to B… … and B to C… … but also C to A. 1785 Nicolas de Condorcet publishes Essay on the It is impossible to Application of Analysis to devise a voting system the Probability of Majority that truly reflects the Decisions, in which he sets out preferences of an electorate. the original voting paradox. AFTER 1998 Indian economist Amartya Sen is awarded the Nobel Prize for his work on welfare economics and social choice theory.

POST-WAR ECONOMICS 215 See also: Efficiency and fairness 130–31 ■ Markets and social outcomes 210–13 ■ The social market economy 222–23 In a capitalist democracy de Condorcet (1743–94). He found The right to vote at the ballot box, there are essentially two that it is possible for a majority of shown here in 19th-century France, is methods by which social voters to prefer A over B, and B over entrenched in Western civilization and choices can be made: voting… C, and yet at the same time express almost universal, but the truly perfect and the market mechanism. a preference for C over A. For voting system is elusive. example, if one-third of voters rank Kenneth Arrow the choices A-B-C, another third no individual who determines B-C-A, and the remaining third the collective decision. Yet decision-making process is C-A-B, then a majority clearly favor paradoxically, when all the other dependent on a fair and efficient A over B, and B over C. Intuitively, conditions are adhered to, just system of voting. However, in we would expect that C is at the such a dictator emerges. Social Choice and Individual Values bottom of the list of options. But a (1951), Arrow demonstrated that majority also prefer C over A. The well-being of many there is a paradox at work. Making a fair collective decision in Arrow’s paradox (also known as such cases is clearly problematic. the general possibility theorem) is Voting paradox a cornerstone of modern social The so-called voting paradox was Arrow showed that a voting choice theory, and Arrow’s fairness first described almost 200 years system that truly reflects the criteria have formed the basis for earlier by the French political preferences of the electorate is not devising fair methods of voting thinker and mathematician Nicolas just problematic, but impossible. that take into account the He proposed a set of fairness preferences of individuals. criteria that need to be satisfied by an ideal voting system. He Social choice theory has now then demonstrated that it was not become a major field of study possible for any one system to in welfare economics, evaluating satisfy all these conditions. In fact, the effects of economic policies. when a majority of reasonable This field, which began as the assumptions are met, there is a development of abstract theorems, counterintuitive outcome. One of has been applied to concrete the criteria for fairness was that economic situations in which there should be no “dictator”— governments and planners have to continuously weigh the well- What are social welfare functions? being of many. Much of this has profound implications for the There are various methods of these functions as a means of fundamental economic problems assessing the well-being of a turning individual preferences of the allocation of resources and society. The 19th-century into rankings of possible social the distribution of wealth. ■ utilitarians thought that states (their economic position peoples’ individual levels of in society). There is an ethical utility, or happiness, could be dimension to social welfare added up, rather like incomes, to thinking. A simple form of measure overall welfare. Later utilitarianism emphasizes the economists developed “social maximization of total happiness welfare functions” in an attempt less its distribution. Another, to do the same, but these didn’t proposed by US philosopher necessarily involve the John Rawls (1921–2002), measurement of utility. Kenneth maximizes the well-being of the Arrow and others formulated least well-off person in society.

216 IN CONTEXT THE AIM IS FOCUS TO MAXIMIZE Society and the economy HAPPINESS, NOT INCOME KEY THINKER Richard Easterlin (1926– ) THE ECONOMICS OF HAPPINESS BEFORE 1861 John Stuart Mill argues that a moral act is one that maximizes overall happiness. 1932 Simon Kuznets publishes the first national income accounts for the US based purely on conventional economic variables. AFTER 1997 British economist Andrew Oswald argues that joblessness is the main reason for unhappiness. 2005 British economist Richard Layard publishes Happiness: Lessons from a New Science, revisiting the debate about the link between happiness and income. T he first modern national accounts for a country were created for the US in the 1930s by Russian-American economist Simon Kuznets. His pioneering work later led to the creation of national accounts in the UK, Germany, and other developed countries. These accounts involved summing up all the transactions made in an economy over a year to arrive at a figure for its national income, which became known as a country’s gross domestic product (GDP). Early economists, such as the Frenchman François Quesnay, had attempted to derive similar measures, but their efforts had foundered due to the apparent

POST-WAR ECONOMICS 217 See also: Measuring wealth 36–37 ■ Efficiency and fairness 130–31 ■ Conspicuous consumption 136 ■ Markets and social outcomes 210–13 ■ Behavioral economics 266–69 ■ Gender and economics 310–11 GDP was developed But national income to measure the income is not the same as national welfare. of an entire national economy. Other economic Happiness and well-being and social variables may not increase with rising income. may matter more. The aim is to Envy is one cause of unhappiness. maximize happiness, Whether or not your neighbors have more than you can be a more not income. important factor to your well-being than how much you have yourself. size of the task. It became possible a series of arguments over how best only through developments in to increase GDP. Different policies Nonetheless, GDP became the statistics, survey techniques, were pursued, but they all had paramount statistic in economics and studies of the whole economy. the same aim. and was taken to show that a country was doing well. It was Crunch number However, this overlooked some widely believed, if never quite From their first appearance, important questions. GDP is only demonstrated, that even where GDP figures presented an almost a number, and perhaps not the GDP did not perfectly match irresistible lure for politicians, most important one. There is no welfare, both welfare and GDP journalists, and economists. In a necessary connection between would move in the same direction. simple form they appear to present GDP and real social welfare, as a figure that sums up all the most Kuznets himself once pointed out A direct challenge to the important facts about an economy. in a US Congressional hearing. concept of GDP and national Rising GDP means more jobs and Rising GDP can be distributed very income was provided in 1974 by higher wages, while falling GDP unevenly, so a few people have a US economist Richard Easterlin. means unemployment and great deal of money while many He looked at surveys of people’s uncertainty. After World War II others have very little. Other factors reported happiness in 19 countries debates over economic policy very that make people happy, such as for the previous three decades and rapidly turned into little more than familial or friendly relationships, suggested that the link between simply do not register on its scale. GDP and welfare was not as robust as people thought. Easterlin found that reported happiness increased with income, much as expected. But for those earning above subsistence levels, the variation in reported happiness across ❯❯

218 THE ECONOMICS OF HAPPINESS Central America, Mexico, and CaribbeanSUB-REGION The Happy Planet ways in which decisions by South America Index (HPI) was individuals, firms, and government South East Asia introduced by the New can impact how people feel about North Africa Economics Foundation themselves and society. China in 2006. It combines South Asia three measures to One explanation was offered Western Europe produce an overall by the concept of the “hedonic Central Asia and Caucasus score: life expectancy, treadmill,” first proposed in 1971 by Middle East and South West Asia individual well-being, US psychologists Phillip Brickman Wealthy East Asia and the environmental and Donald Campbell. They Nordic Europe impact of people’s suggested that people adapt very Central and Eastern Europe consumption. rapidly to their current levels of Southern Europe well-being, maintaining this level Australia and New Zealand 40 50 60 regardless of events, good or bad. Russia, Ukraine, and Belarus When income rises, they rapidly North America fresh research into the relationship adapt to the new level of material West Africa between economics and well-being security, treating it as normal and Southern and Central Africa that had otherwise been dormant so being no happier than they were East Africa since the late 19th century. previously. An extreme version Researchers tried to assess the of this theory would imply that, 0 10 20 30 beyond subsistence incomes, nearly all economic development HPI is irrelevant for welfare, because people’s happiness is determined different countries did not vary by something altogether different, greatly, despite large differences such as character or friendships. in national income. People in rich Alternatively, researchers have put countries were not necessarily forward the importance of status the happiest. and comparisons with others. For example, if no one in a society has Over time, the picture seemed a car, not having a car makes little even more peculiar. In the US difference. But as soon as some there were continual, comparatively people obtain cars, others without rapid increases in GDP over the period since 1946, but the levels of happiness reported in surveys did not appear to follow suit—in fact, it declined over the 1960s. Money, it seemed, really did not buy you happiness. The results of Easterlin’s surveys became known as the Easterlin paradox. They sparked A spring festival in Bhutan is celebrated with dancing. In 1972, the king decreed that his government would pursue policies that maximized “Gross National Happiness.”

POST-WAR ECONOMICS 219 Economic things economists Betsey Stevenson and The people of the Bahamas score matter only in so Justin Wolfers suggested in 2008 very highly in the Satisfaction with Life far as they make that happiness does increase with Index, which was devised by British people happier. income across different countries, psychologist Adrian White to measure Andrew Oswald and that rising income also leads feelings of well-being. to greater well-being. British economist (1953– ) rather than GDP alone, new In general, researchers have priorities would emerge. These a car might experience this as a discovered that while higher might include measures to loss of status. “Keeping up with incomes do not translate easily encourage a better work–life the Joneses” means that as into increased levels of happiness, balance. Unemployment might be economies grow, the new wealth losing incomes has a seriously considered more costly, and greater has limited positive impact on detrimental effect on well-being. measures taken to alleviate it. reported happiness. Everyone ends Redundancy and unemployment hit Broader measures of well-being up in a rat race, frantically trying well-being particularly hard, as do are already in use, particularly to out-consume everyone else. serious illness and new disabilities. in discussions about developing The more unequal the society, countries: for instance, the human the worse this becomes. In other words there is some development index combines relationship between GDP and income with life expectancy and Challenging the paradox national income, but it is not a education. It has been argued that As interest in the Easterlin paradox simple one. As better data has a narrow focus on GDP growth grew during the 2000s, the paradox become available, the notion of helped to obscure the problems began to be challenged. Using data happiness and well-being as a created by the buildup of debt prior from a broader set of countries, US possible target for government to the financial crash of 2008. Had policy has gained ground. In broader indicators been available, Measuring happiness turn, this has led to the slow more attuned to perceptions of displacement of GDP as the critical well-being and closer to people’s In 2007, French President economic variable of interest. real interests, the single indicator Nicolas Sarkozy asked The argument is simple: if widely- of rising GDP alone would not have economists Joseph Stiglitz, reported economic variables do been cause for celebration. ■ Amartya Sen, and Jean-Paul not capture important aspects of Fitoussi to investigate the economic and social life, focusing measurement of social and on those variables could lead to economic progress, and to look bad policymaking. If policies were at how broader measures of based on “happiness indicators” welfare might be introduced. Their report, published in 2009, being and sustainability. argued that it is necessary to In particular, their report shift the focus of economic highlighted the fact that the policymaking from measures gap between common economic of economic production (such indicators and reported well- as GDP), to measures of well- being appears to be widening. An alternative system of measurement would, of necessity, use a range of different indicators such as health and the environmental impact of lifestyles, rather than attempt to summarize everything through just a single number.

220 POLICIES TO CORRECT MARKETS CAN MAKE THINGS WORSE THE THEORY OF THE SECOND BEST IN CONTEXT In theory, a free market S tandard economic theory is the most efficient holds that where markets FOCUS are available for all goods Economic policy economy possible. and services, and everybody using those markets is well-informed, the KEY THINKERS But real economies economy will be efficient. It is not Kelvin Lancaster (1924–99) contain many distortions possible to change the distribution Richard Lipsey (1928– ) that are inefficient and may of resources to make one person better off without making another BEFORE cause harm. person worse off, so society’s 1776 Adam Smith claims the welfare is as good as it can be in “invisible hand” of the self- Distortions may be a free market. The best available regulating market is superior linked, and it may not policy, according to the free- to government intervention. be possible for a government marketeers, is for government to to remove some of them. remove imperfections in markets, 1932 British economist Arthur bringing them as close as possible Pigou advocates the use of Attempts at removal to the ideal. taxes to correct market failures. may worsen the effects Working with imperfection 1954 In Existence of an of other distortions, so There are, however, strict Equilibrium for a Competitive governments should act conditions before efficient policies Economy, Gérard Debreu and can be achieved. In 1956, Kenneth Arrow demonstrate with caution. Australian economist Kelvin that an entirely free market Lancaster and his Canadian economy can maximize the Policies to correct colleague Richard Lipsey welfare of its participants. markets can make demonstrated that in some circumstances, policies aimed at AFTER things worse. improving market efficiency may From 1970s Welfare make it worse overall. In a paper economics is developed entitled The General Theory of through the work of Second Best, they looked at cases economists Joseph Stiglitz, where a market imperfection was Amartya Sen, and others. permanent—and where there was no way for a government to correct

POST-WAR ECONOMICS 221 See also: Free market economics 54–61 ■ Economic equilibrium 118–23 ■ Richard Lipsey External costs 137 or remove it. There was no “first One classic example is that of a A Canadian economist born in best” solution. In such cases monopolist who pollutes a river 1928, Richard Lipsey is best government intervention elsewhere during production. The pollution known for the theory of the in the economy might worsen the is both costly for society and an second best, formulated with effects of existing imperfections, inevitable result of production. Kelvin Lancaster. He is pulling the market still further It cannot be removed from the emeritus professor at Simon away from the ideal. Lancaster’s process and is a permanent market Fraser University, Canada, and Lipsey’s insight was that imperfection. But the monopoly having taught in the US and where an imperfection in one can be removed. the UK. In 1968, his defense of market cannot be removed, all the the Phillips Curve (p.203) other markets will work around it. Standard economic theory against the criticism of Milton They will achieve a relatively would tell the government to break Friedman (p.199) formed one efficient distribution of resources, up the monopoly and introduce of the great debates in given the existing imperfection. more competition to the markets. economics. Lipsey is the This would drag the economy author of a standard textbook The least bad closer to the efficient ideal. in economic theory, Positive Lancaster and Lipsey then went But competing producers would Economics, and recently has further: the best available policy produce more than a single helped develop evolutionary option, when one distortion can be producer, and also worsen the economics, co-authoring an corrected but others cannot, may pollution. The result for society’s influential book on the turn out to be the opposite of that welfare as a whole is uncertain. processes of historical change. demanded by theory. For instance, People might gain from increased it might be better for government to output and lower costs, but they Key works distort a market further, if it wants would lose out from more pollution. to improve welfare overall. Ideal The “second best” solution might 1956 The General Theory of policies, then, cannot be guided be to leave the monopoly in place. the Second Best (with Kelvin by abstract principles alone. They Lancaster) have to be based on a thorough The theory of the second best 2006 Economic understanding of how markets remains critical to economic policy, Transformations: General- operate together. recommending that governments Purpose Technologies and act with caution rather than Long-Term Economic Growth attempting to achieve an ideal. ■ (with K. Carlaw, C. Bekar) Choosing the least bad solution (2) A government could remove the monopoly (1) A monopolist is causing pollution. Both the and replace it with competing firms. However, monopoly and the pollution are imperfections as a result of more firms competing, the pollution in the market. could get much worse. 12

222 MAKE MARKETS FAIR THE SOCIAL MARKET ECONOMY IN CONTEXT I n the aftermath of World The model he chose had its roots in War II West Germany had the ideas of Franz Böhm and Walter FOCUS to rebuild its economy and Eucken of the Freiburg school of Society and the economy political system from scratch. the 1930s, which resurfaced in the Chancellor Konrad Adenauer 1940s as “ordoliberalism.” Its chief KEY THINKERS carried out this task in 1949, advocates were Wilhelm Röpke Walter Eucken (1891–1950) following the Allied occupation. and Alfred Müller-Armack. Wilhelm Röpke (1899–1966) Alfred Müller-Armack A free market economy… A socialist economy… (1901–78) … encourages economic … ensures more equal BEFORE growth and development. distribution of wealth. 1848 Karl Marx and Friedrich Engels publish It can also be volatile, suffer It lessens the effects of the Communist Manifesto. from market failures, and monopolies and market failure produce monopolies. and stabilizes the economy. 1948 German economists Walter Eucken and Franz This can lead to inequality. But it can hamper economic Böhm establish the journal growth and development. ORDO, which gives its name to ordoliberalism, a movement A social market economy aims to make that advocates the social markets fair by creating a middle way. market economic model. AFTER 1978 Chinese Premier Deng Xiaoping introduces capitalist elements into the Chinese economy. 1980s Milton Friedman’s monetarist arguments against government intervention are adopted by the US and UK.

POST-WAR ECONOMICS 223 See also: Markets and morality 22–23 ■ Free market economics 54–61 ■ Marxist economics 100–05 ■ Collective bargaining 134–35 ■ The Keynesian multiplier 164–65 East and West Germany reunified in 1990, a year after the fall of the Berlin Wall (right). East Germany abandoned its centrally planned economy to merge with West Germany’s social market. These economists aimed to Economic miracle thrived under some form achieve what Müller-Armack The mixture of free markets with of social market economy, but by called a social market economy: elements of socialism worked the 1980s some—most notably not just a “mixed economy,” with dramatically well. Germany Britain—were attracted by the government providing a bare experienced a Wirtschaftswunder ideas of Milton Friedman (p.199), minimum of necessary public (“economic miracle”) in the 1950s who advocated “smaller” goods, but a middle way between that transformed it from post-war government. British prime free market capitalism and devastation into a major developed minister Margaret Thatcher socialism that aimed for the best nation. Similar social market criticized the European model for of both worlds. Industry remained economies developed elsewhere, its state intervention and high in private ownership and was free notably in Scandinavia and taxes, which she believed to compete, but government Austria. As Europe made moves hampered competition. provided a range of public goods toward economic union, the social and services, including a social market economy was extolled as With the collapse of security system with universal the model for the European communism in the Eastern Bloc health care, pensions, Economic Community in the the planned economies of Eastern unemployment benefits, and 1950s. Many countries in Europe Europe were replaced by various measures to outlaw monopolies versions of the mixed economy. and cartels (agreements between At the same time some of the firms). The theory was that this remaining communist countries would allow the economic growth made moves to introduce reform. of free markets but at the same In China, for example, Premier time produce low inflation, low Deng Xiaoping adopted elements unemployment, and a more of free market economics to operate equitable distribution of wealth. within the centralized economy, in what he described as a “socialist The Nordic model market economy with Chinese characteristics.” His aim was While the German social market high living standards and strong to promote economic growth and is associated with right of center economic growth, helped by become competitive on the world politics, the economies of having small populations with stage. Today, China’s economy is Scandinavia developed along strong manufacturing industries still a long way from the European similar lines but were politically and, in the case of Norway, oil. social market model, but it has left of center, with more focus on made significant moves toward making the markets fair. Today, there is pressure to becoming a mixed economy. ■ The so-called Nordic model reduce the role of the state in is characterized by generous order to remain internationally welfare systems and a competitive. However, change commitment to fair distribution is gradual: governments are of wealth, achieved through mindful that deregulation in high taxes and public spending. Iceland in the 1990s led to These countries have enjoyed economic growth followed by a financial crisis.

224 OVER TIME, ALL COUNTRIES WILL BE RICH ECONOMIC GROWTH THEORIES IN CONTEXT I n the 1950s US economist have little capital, extra capital Robert Solow devised a model would add a lot to output, and FOCUS of economic growth that these returns pull in investment. Growth and development predicted an equalization of living Countries are assumed to have standards across the globe. His access to the same technology; KEY THINKER assumption was that capital by using it, poor countries use Robert Solow (1924– ) has diminishing returns: extra the additional capital to increase investments add less and less to output. The effect is larger than BEFORE output. Because poor countries would be the case in a richer 1776 Adam Smith poses the question of what makes Capital in developed But poor countries have economies prosper in The countries is subject to had so little capital invested Wealth of Nations. diminishing returns— extra investment results that investors can still 1930s and 1940s Economists in less and less output. make high returns on Roy Harrod of the UK and Russian-American Evsey their investments. Domar devise a growth model containing Keynesian Poor countries grow faster Poor countries can use (government interventionist) than rich ones, and their this new capital with new assumptions. living standards catch up. technologies to provide AFTER very rapid growth. 1980s US economists Paul Romer and Robert Lucas Over time, all countries introduce Endogenous Growth will be rich. Theory, suggesting that growth is primarily the result of internal factors. 1988 US economist Brad DeLong finds little evidence for the basic convergence prediction of the Solow model.

POST-WAR ECONOMICS 225 See also: Diminishing returns 62 ■ Demographics and economics 68–69 ■ The emergence of modern economies 178–79 ■ Development economics 188-93 ■ Technological leaps 313 ■ Inequality and growth 326–27 Cyclists in Beijing, China, eye a Ferrari parked in the cycling lane. China and India have joined the club of converging (“catch-up”) countries. country. The upshot is that growth investment. So, rather than medical interventions such as is higher in poor countries, and convergence, the result may be immunization. So, in non-income their living standards catch up divergence between countries. aspects of living standards, poor with those of rich countries in an countries have had more success effect economists call convergence. Living standards in catching up. Convergence can be measured Since the 1950s a few Asian using factors other than income. Despite this, many economists countries have caught up with the Health and literacy are related to remain focused on explaining West, but many African countries income but imperfectly so: some income differences. Attention has have fallen farther behind. Solow’s poor countries have relatively shifted away from a concern with assumptions aren’t always healthy and educated populations. capital and technology toward satisfied. Technology is not Life expectancies can increase the institutional prerequisites universal: even when knowledge is dramatically through simple needed for developing countries accessible there may be barriers to to converge with richer ones. ■ using it. Capital doesn’t always flow to poor countries; for example, weak property rights and political instability can put investors off. Finally, the endogenous growth theory, developed in the mid-1980s, goes beyond Solow’s model by more realistically analyzing the effects of technological change. In this theory new techniques developed by one firm can benefit other firms. This can lead to increasing returns on Robert Solow Robert Solow was born in New position at the Massachusetts York in 1928. His experience of the Institute of Technology (MIT), Great Depression made him want where he published his ideas to understand how economies outlining a new model of grow and how living standards economic growth. This research can be improved. He entered inspired new fields in the study Harvard University in 1940 but of economic growth and earned left to join the US Army in 1942, him the 1987 Nobel Prize. serving in World War II. After returning, he was mentored by Key works the economist Wassily Leontief, and his PhD thesis won Harvard’s 1956 A Contribution to the Wells Prize—$500 and a book Theory of Economic Growth publication. Solow thought he 1957 Technical Change and the could do better than his thesis, Aggregate Production Function so he never published it or cashed 1960 Investment and Technical his check. In the 1950s he took a Progress

GLOBALIZATION IS NOT INEVITABLE MARKET INTEGRATION



228 GLOBALIZATION G lobalization is a term that choices. Sometimes these means different things choices have added to the effect IN CONTEXT to politicians, business of technological progress on the people, and social scientists. To an integration of markets; sometimes, FOCUS economist it means the integration they have hindered it. Global economy of markets. Economists have long thought this a good thing. Market integration is the fusing KEY THINKER of many markets into one. In one Dani Rodrik (1957– ) In the 18th century Adam Smith market a commodity has a single (p.61) attacked the old mercantilist price: the price of carrots would BEFORE ideas of protectionism, which be the same in east Paris and west 1664 English economist aimed to restrict the inflow of Paris if these areas were part of the Thomas Mun says that growth foreign goods. He argued that same market. If the price of carrots requires reductions in imports. international trade would expand the size of markets and allow Christopher Columbus stumbled 1817 British economist David countries to become more efficient across the Americas on an expedition Ricardo says that international by specializing in certain products. intended to find a new trade route to trade makes countries richer. Often, market integration is seen as China. Such efforts to globalize trade inevitable because it rides on the have taken place for centuries. 1950 Raúl Prebisch and Hans back of a wave of new technology— Singer argue that developing such as smarter phones, faster countries lose out from planes, and an expanding internet. globalization because of But globalization is also affected unequal terms of trade. by choices made by nations— sometimes conscious, sometimes AFTER accidental. Although technological 2002 Joseph Stiglitz criticizes change tends to bring nations globalization as promoted by together, policy choices can push the World Bank and the IMF. them apart. 2005 World Bank economist Modern globalization is not David Dollar argues that unprecedented. Globalization has globalization has reduced waxed and waned over time as poverty in poor countries. nations have made different policy Full globalization Such harmonization Neither of these is requires the harmonization would require either feasible, and they are not of trade regulations and a global government or desired by electorates. the erosion of countries’ laws across countries. democracies. Globalization spreads In the past Globalization is with technology but is governments have made not inevitable. also impeded by barriers different choices about such as trade tariffs. the level of barriers and therefore about the path of globalization.

POST-WAR ECONOMICS 229 See also: Protectionism and trade 34–35 ■ Comparative advantage 80–85 ■ International trade and Bretton Woods 186–87 ■ Dependency theory 242–43 ■ Asian Tiger economies 282–87 ■ Global savings imbalances 322–25 in west Paris was higher, sellers of and incomes, which created a … ‘deep’ economic carrots would move from the east to demand for new products. But the integration is unattainable the west and prices would equalize. underlying barriers to trade that The price of carrots in Paris and in divided up markets, such as in a context where Lisbon might be different, though, transport costs, did not change nation states and and high transport costs and other that much. Globalization only really democratic politics still kinds of expenses might mean took off in the 1820s, when price exert considerable force. that it would be uneconomical for differences started to close up. Portuguese sellers to move their This was caused by a transport Dani Rodrik stocks to France if prices were revolution—the advent of higher there. In distinct markets steamships and railroads, the can put up tariffs and other types the price of the same good can be invention of refrigeration, and the of barriers to trade that choke off different for long periods of time. opening of the Suez Canal, which imports and stymie trade. slashed the journey time between Global market integration Europe and Asia. By the eve of The most dramatic policy- means that price differences World War I the global economy related reversal of globalization in between countries are eliminated was highly integrated, even by modern times occured during the as all markets become one. One late 20th-century standards, with Great Depression of the 1930s. As way to track the progress of unprecedented flows of capital, countries headed into recession, globalization is to look at trends goods, and labor across borders. governments imposed tariffs. in how prices converge (become These were intended to switch the similar) across countries. When the From the 19th century onward, demand of their consumers toward costs of trading across borders fall, technological change helped to domestically produced goods. In there is more potential for firms to integrate markets. It is this that 1930, the US enacted the ❯❯ take advantage of price differences, makes globalization seem for Portuguese carrot sellers to irreversible—once technology such enter the French market, for as steam-powered transport is example. Trading costs fall invented, it is not then uninvented when new forms of transport are but tends to become economically invented, or when existing ones viable in more countries. Much of become faster and cheaper. Also, this development is outside the some costs are man-made: states direct control of governments. erect barriers to trade, such as However, at a stroke, governments tariffs and quotas on imports. When these are reduced, the cost of international trading falls. The rise of global trade Long-distance trade has existed for centuries, at least since the trade missions of the Phoenicians in the first millennium BCE. Such trade was driven by growing populations By the mid-19th century Britain had new technology such as these mechanized looms in cotton mills, which allowed it to export and compete in multiple markets around the world.

230 GLOBALIZATION Improvements in transport have before World War I. Today, markets Some economists argue that this been a major driver in globalization. In are more integrated than ever as process is underway and inevitable, Shanghai, China, the US has invested transportation costs have and that global markets drive the in a gigantic “mega-port” that will continued to fall and most tariffs harmonization of institutions across make shipping safer. have been scrapped altogether. countries. Consider a multinational firm choosing a country in which to Smoot–Hawley tariff, which One vision of the future locate its factory. In order to attract raised tariffs on imported goods to of globalization involves the the firm’s investment, a government record levels. These tariffs reduced elimination of other kinds of might cut business tax rates and demand for foreign goods. Foreign barriers to trade caused by loosen regulatory requirements. countries retaliated by imposing institutional differences between Other competing countries follow their own tariffs. The result was a countries. Markets are embedded suit. The resulting lower tax collapse in world trade that in institutions—in property rights, revenues make countries less worsened the effects of the legal systems, and regulatory able to finance welfare states and Depression. It took decades to regimes. Differences in institutions educational programs. All policy rebuild the world economy. between countries create trading decisions become oriented toward costs in the same way that tariffs maximizing integration with Integration or distance do. For example, there global markets. No goods or By the end of the 20th century may be different laws in Kenya and services would be provided globalization across most markets China about what happens when a that are incompatible with this. had returned to the levels seen just buyer fails to pay. This might make it hard for a Chinese exporter to Globalization v. democracy recover what it is owed in the event The Turkish economist Dani Rodrik of a dispute, which could make the (1957– ) has criticized this vision of firm reluctant to enter the Kenyan “deep integration,” arguing that it market. Despite the removal of is undesirable and far from tariffs the world is far from being inevitable, and that in reality a single market. Borders still considerable institutional diversity matter because of these kinds persists between countries. of institutional incompatibilities. Rodrik’s starting point is that Complete integration requires the choices about the direction of ironing out of legal and regulatory globalization are subject to a differences to create a single political “trilemma.” People want institutional space. Liberalizing the money markets The liberalization of capital also allows investors greater The East Asian crisis began when (money) markets, where funds scope to manage and spread the Thai government attempted to for investment can be borrowed, their risks. float the bhat on the international has been an important contributor markets, ending its link to the dollar. to the pace of globalization. Since However, some say that a the 1970s there has been a trend freer flow of capital has raised towards a freer flow of capital the risk of financial instability. across borders. Current economic The East Asian crisis of the theory suggests that this should late 1990s came in the wake aid development. Developing of this kind of liberalization. countries have limited domestic Without a strong financial savings with which to invest in system and a robust regulatory growth, and liberalization allows environment capital market them to tap into a global pool of globalization can sow the funds. A global capital market seeds of instability in economies rather than growth.

Nations may want democracy, POST-WAR ECONOMICS 231 independence, and deep global economic integration. Yet at Democracy any one time, only two out of The 19th century three may be compatible with contained a very big each other. In the diagram each globalization bang. side of the triangle represents Jeffrey G. Williamson a possible combination. K. H. O’Rourke market integration because of the Deep economic integration Independent nation-state prosperity that it can bring. People want democracy, and they want Today, we are far from either the The liberalization era since the independent, sovereign nation- golden straitjacket or global 1980s saw an undermining of states. Rodrik argues that the three federalism. Nation-states are strong, the Bretton Woods compromise, of these are incompatible. Only two and persistent institutional diversity with the policy agenda being are possible at any one time. How across countries suggests that the increasingly driven by the aim of the trilemma is resolved implies varied preferences of different deep integration. Rodrik argues that different forms of globalization. populations are still important. institutional diversity should be Since World War II Rodrik’s preserved over deep integration. The trilemma comes from trilemma has been resolved European electorates’ desire for the fact that the deep, or more by sacrificing deep integration. welfare states and public health complete, integration of markets Markets have been brought together systems is not just about economics, requires the removal of institutional as much as possible given nations’ but also their view of justice. variations between countries. But varied institutions. Rodrik calls this Institutional diversity reflects these electorates in different countries the “Bretton Woods compromise,” different values. More practically, want different types of institutions. referring to the global institutions there is more than one institutional Compared to US voters, those in that were established after the route to a healthy economy. The European countries tend to favor war (pp.186–87)—the General requirements for growth in today’s large welfare states. So a single Agreement on Tariffs and Trade developing countries may be global institutional framework in (GATT), the World Bank, and the different from those for developed which nation-states still existed International Monetary Fund (IMF). nations. Imposing a global would mean ignoring the These organizations aimed at institutional blueprint runs the preferences of electorates in some preventing a repeat of the risk of placing countries in a countries. This would conflict with catastrophic backlash seen in the straitjacket that suffocates their democracy, and governments 1930s through a form of managed own economic development. would be placed in what US integration, in which nation-states Globalization may have limits, and journalist Thomas Friedman were free to pursue their own it may be that the complete fusion (1953– ) has called a “golden domestic policies and develop along of economies is neither feasible straitjacket.” On the other hand a varied institutional paths. nor—ultimately—desirable. ■ global institutional framework in which democracy reigned would require “global federalism”—a single worldwide electorate and the dissolution of nation-states.

232 SOCIALISM LEADS TO EMPTY SHOPS SHORTAGES IN PLANNED ECONOMIES IN CONTEXT In competitive markets A fter an initial dramatic firms’ revenues must be rush of growth after World FOCUS higher than their costs, or War II the centrally Economic systems planned economies of Eastern they will go bankrupt. Europe faced increasingly obvious KEY THINKER problems. They could mobilize János Kornai (1928– ) In planned economies, if resources on a large scale for well- firms do not cover their costs, defined tasks, such as producing BEFORE the state steps in to protect military armaments, but seemed 1870 Economists William to have difficulty meeting more Jevons, Alfred Marshall, them from bankruptcy. complex demands. Shortages and Léon Walras focus on abounded, as—despite planning— optimizing efficiency within This means that costs goods and services were not budget constraints. (materials and labor) do not delivered on time, in the required have to be closely matched to quantity, or at an appropriate AFTER quality. The gap between the East 1954 Gérard Debreu and output or demand. and the West yawned wider. Kenneth Arrow identify the conditions under which Socialism Soft budget constraints demand equals supply in leads to In response, a number of regimes all the markets of a empty shops. attempted to introduce reforms to competitive economy. the planning system. Hungary went further than most, introducing 1991 The Soviet Union elements of market competition collapses and central from the 1960s onward. In theory, planning ends. this was supposed to introduce the benefits of the market, provoking 1999 Economists Philippe innovation and expanding choice, Aghion, Patrick Bolton, and while retaining the ability of the Steven Fries publish The plan to deliver broad social goods Optimal Design of Bank- like full employment. In practice, Bailouts, arguing that banks after some initial successes the face a soft budget constraint. system continued to produce shortages and inefficiency.

POST-WAR ECONOMICS 233 See also: Free market economics 54–61 ■ Marxist economics 100–05 ■ The competitive market 126–29 ■ Central planning 142–47 ■ Economic liberalism 172–77 Attempting to understand the demand excessive amounts of Shortages were a feature of life in problem, Hungarian economist inputs relative to production levels. centrally planned economies. If a line János Kornai hit on the concept This leads to excess demands began forming, shoppers would often of the “soft budget constraint.” for particular inputs, and then join it, because it meant that some In competitive markets, firms’ shortages arising from inefficiency. essential good was briefly available. decisions are normally subject to Shortages eventually trickle down “hard” budget constraints: their to consumers, who find shop in the West face soft budget revenues must at least cover their shelves bare. Kornai argued that constraints, since they expect to be costs, or they will face financial shortages would mean that bailed out by their governments, losses. This disciplines firms to consumers would be subject to leading to inefficiently high levels of economize on inputs and sell “forced substitution,” the necessity risk-taking in the banking system. output in a way that maximizes of having to purchase the next best On the other hand introducing hard profits. Kornai noticed that in available good, given a shortage. budget constraints into every state planned economies such as or local-authority decision—such as Hungary’s, firms were not subject Bailouts sending an insolvent family to to this discipline: they faced soft, Inefficiencies such as these added jail—might be seen as unjust. In not hard, budget constraints. The up to serious weaknesses in practice, even the most free market state cushioned firms from the planned economies. Guaranteed economies contain a mix of hard threat of bankruptcy—firms that bailouts and a lack of budgetary and soft budget constraints. ■ produced essential goods would discipline meant firms had little never be forced to close. Even incentive to supply goods and after some market reforms were services efficiently. implemented, the state continued to bail out failing firms. In addition, Kornai describes soft budget firms could use political bargaining constraints as a “syndrome” of to get away with underpaying for central planning that cannot be supplies, or avoiding taxation. cured, because only a complete systemic change would bring Soft budget constraints mean a solution. The problem is not that firms do not have to cover confined to socialist countries— costs with revenues. They tend to Kornai has argued that major banks János Kornai János Kornai is a Hungarian 1955. Refused permission to economist best known for his leave Hungary, he worked at the work on the planned economy. He Hungarian Academy of Sciences experienced the horrors of fascism until 1985, when he took up a firsthand—his father died in post at Harvard. Kornai returned Auschwitz—and this drove him to Hungary in 2001. He has to communism. He studied criticized neoclassical economics philosophy in Budapest, but for preferring abstract theorizing changed to economics after to addressing and answering reading Marx’s Capital. In 1947, the “big questions.” Kornai began working on the Communist Party newspaper, Key works but he broke with the Party in the early 1950s, shaken by the 1959 Overcentralization in regime’s torture of an innocent Economic Administration friend. His critical articles resulted 1971 Anti-equilibrium in his dismissal from the paper in 1992 The Socialist System

WHAT DOES THE OTHER MAN THINK I AM GOING TO DO? GAME THEORY



236 GAME THEORY IN CONTEXT C onsidering how another Our everyday interactions involve person might react when strategic decisions that are similar to FOCUS you do something involves a game of chess, where players choose Decision making making strategic calculations. their moves on the basis of how they Successfully negotiating your think their opponent will respond. KEY THINKER way through social and economic John Nash (1928– ) interactions is a bit like a game of any choice about the price they chess, where players must choose paid for a good or the wage they BEFORE a move on the basis of what the sold their labor for. Individual 1928 US mathematician John other player’s countermove might choices had no effects on others, von Neumann formulates the be. Up to the 1940s economics it was reasoned, so they could “minimax rule” that says the had largely avoided this issue. safely be ignored. But as early best strategy is to minimize Economists assumed that every as 1838, French economist the maximum loss on any turn. buyer and seller in the market was Antoine Augustin Cournot (p.91) very small compared to the total had looked at how much two firms AFTER size of the market so nobody had would produce on the basis of 1960 US economist Thomas Schelling publishes The Strategy of Conflict, which develops strategies in the context of the Cold War. 1965 German economist Reinhard Selten analyzes games with many rounds. 1967 US economist John Harsanyi shows how games can be analyzed even if there is uncertainty about what sort of opponent you are playing against. Cooperate with him If he thinks I will cooperate, because we can agree on an I can safely cooperate. option that benefits us both. What does the other man think I am going to do? Compete with him If he thinks I will compete, because we make our I had better compete. decisions independently.

POST-WAR ECONOMICS 237 See also: Economic man 52–53 ■ Cartels and collusion 70–73 ■ Effects of limited competition 90–91 ■ Economic equilibrium 118–23 ■ Behavioral economics 266–69 ■ The winner’s curse 294–95 what they thought the other firm equally. However, his children were cooperation as maximizing was going to do, but this was an unable to find a solution and their own individual chances isolated case of analyzing eventually one of them bid 90 cents of success. Nash identified the strategic interactions. to do the work. state of equilibrium in such games where neither player In 1944, US mathematicians Nash equilibrium wants to change their behavior. John von Neumann and Oskar In the early 1950s a brilliant Players are choosing their best Morgenstern published the young US mathematician named strategy on the basis that their groundbreaking work, Theory of John Nash extended this work to opponents are also selecting their Games and Economic Behavior. look at what happens when players best strategies. Nash identified They suggested that many parts make independent decisions the state in such games where of the economic system were in non-cooperative situations— neither player wants to change dominated by a small number of where there is no opportunity for their behavior as “each player’s participants, such as large firms, communication or collaboration. strategy is optimal against trade unions, or the government. Cooperation is a possible outcome those of the others.” This is now In such a situation economic but only if each player sees known as the Nash equilibrium. ❯❯ behavior needed to be explained with reference to strategic Scissors interactions. By analyzing simple two-person games that are “zero- BeatsBeats sum” (one person wins and the Rock Paper other loses), they hoped to create Beats general rules about strategic behavior between people in every Rock-paper-scissors is an example of a simple zero-sum game in situation. This became known as which if one player wins, then the other loses. The game is played by two game theory. players. Each player must make one of three shapes with their hand at the same time. The shape one player makes will either match, beat, or lose Von Neumann and to their opponent’s shape: rock beats scissors, scissors beats paper, and Morgenstern looked at cooperative paper beats rock. Game theorists analyze games such as this to discover games in which players were general rules of human behavior. given a number of possible actions, each with its own particular result, or payoff. The players were given the opportunity to discuss the situation and come to an agreed plan of action. A real example of such a game was provided by US mathematician Merrill Flood, who allowed his three teenagers to bid for the right for one of them to work as a babysitter for a maximum payment of $4. They were allowed to discuss the problem and form a coalition, but if they were unable to agree between themselves then the lowest bidder would win. To Flood, there were easy solutions to the problem, such as settling by lot or splitting the proceeds

238 GAME THEORY The prisoner’s dilemma is an example of a non-cooperative game in which neither party can communicate with the other. The “Nash equilibrium” of the game is for both players to betray. Stays silent Betrays Stays silent 6 months 10 years Free Betrays Free 10 years 3 years There was an incredible blooming to research areas such as game captured criminals who are kept of game theory after World War II, theory, which was seen to be separate during interrogation much of it at the think tank RAND particularly relevant to the politics and offered the following choices: (the name comes from Research of the Cold War. They are told that if they both ANd Development). Set up by the testify against each other, they US government in 1946, RAND was In 1950, the game theorists at will each get a medium jail charged with putting science at the RAND devised two examples of sentence that will be painful but service of national security. They non-cooperative games. The first bearable. If neither will testify employed mathematicians, was published under the name against the other, then they will economists, and other scientists “So Long Sucker.” This game was both receive a short sentence that specifically designed to be as they will cope with easily. However, Game theory is psychologically cruel as possible. if one agrees to testify and the rational behavior in It forced players into coalitions, other does not, then the man who but ultimately to win you had to testifies will go free, and the man social situations. double-cross your partner. It is who stayed silent will receive a John Harsanyi said that after trials of the game, long sentence that will ruin his life. husbands and wives often went US economist (1920–2000) home in separate taxis. The dilemma for each prisoner is this: to betray or not to betray. The prisoner’s dilemma If he betrays his partner, he will Perhaps the most famous example go free or end up with a medium of a non-cooperative game is the sentence. If he trusts his partner prisoner’s dilemma. It was created not to betray him, he could end in 1950 by Melvin Dresher and up with a short sentence or a Merrill Flood and builds on Nash’s very long time in prison. To avoid work. The dilemma involves two the possibility of the “sucker’s

POST-WAR ECONOMICS 239 payoff”—ending up with a long Each player’s strategy sentence—the Nash equilibrium is optimal against is always to betray. What is those of the others. interesting is that the “dominant” John Nash (best) strategy of mutual betrayal does not maximize welfare for the betrayal was only chosen 14 times John Nash group. If they had both refused to against 68 times for the cooperative betray, their total jail time would solution. Dresher and Flood Born in 1928 into a middle- have been minimized. concluded that real people learn class American family, quickly to choose a strategy that John Nash was labeled as Dresher and Flood tested the maximizes their benefit. Nash backward at school due to his prisoner’s dilemma on two of their argued that the experiment was poor social skills. However, colleagues to see whether Nash’s flawed because it allowed for too his parents recognized his prediction would be true. They much interaction, and that the outstanding academic ability. made a game where each player only true equilibrium point In 1948, he won a scholarship could choose to trust or betray the was betrayal. to Princeton University. His other player. The payoffs were former tutor wrote a one-line designed so that there was a Peace–war game letter of recommendation: sucker’s payoff, but also an option The iterative version of the “This man is a genius.” for a cooperative trade that would prisoner’s dilemma came to be At Princeton Nash avoided benefit both players, a solution known as the peace–war game. lectures, preferring to develop that reflected von Neumann and It was used to explain the best ideas from scratch. It was Morgenstern’s earlier work strategy in the Cold War with the there that he developed the involving cooperative games. Soviet Union. As new technologies ideas on game theory that The experiment was run over such as intercontinental ballistic were to earn him his Nobel 100 rounds. This iterative version weapons were developed, each Prize. In the 1950s he worked of the game gave players the side had to decide whether to at the RAND Corporation and chance to punish or reward the invest enormous sums of money MIT (Massachusetts Institute previous behavior of their to acquire these weapons. The of Technology), but by now his partner. The results showed new technology might lead to mental state was worsening. that the Nash equilibrium of the ability to win a war relatively In 1961, his wife committed painlessly if the other side didn’t him for treatment for his develop the new weapon. The schizophrenia. Nash battled consequence of not developing ❯❯ with the condition for the next 25 years but never stopped Expensive technology, such as the hoping that he would be able Stealth Bomber, was developed during to add something else of value the Cold War. To avoid the “sucker’s to the study of mathematics. payoff,” game theory suggested that both sides should spend this money. Key works 1950 Equilibrium Points in N-person Games 1950 The Bargaining Problem 1952 Real Algebraic Manifolds

240 GAME THEORY it was either a huge savings of the central bank’s attitude toward You know what you are money if the other side didn’t inflation and unemployment, and thinking, but you do develop it either, or the sucker’s therefore cannot know whether it not know why you are payoff of a total defeat if they did. will increase interest rates to thinking it. reduce inflation or reduce rates to Reinhard Selten The importance of Nash’s work increase employment. Since the in a wider context was to show profits of firms in the financial money between them, and each that there could be an equilibrium markets are determined by the time they do so the pile of money is between independent self- rate of interest that the central increased by 20 percent. There are interested individuals that would bank will set in the future, firms two ways for the game to end: the create stability and order. In fact need to be able to assess the risk money is passed between them it was argued that the equilibrium of lending more or less money. for 100 rounds (hence the name achieved by individuals trying to Harsanyi showed that even if the centipede), and then the total pot maximize their own payoffs markets cannot tell which target of money is shared, or at some produced safer and more stable the central bank is more concerned stage one player decides to keep outcomes in non-cooperative with, game theory can identify the the pile of money that he or she has situations than when the players Nash equilibrium, which is the been given. Each player’s choice is tried to accommodate each other. solution to the problem. to cooperate by passing the money on or defect and keep the money. In Nash shared the 1994 Nobel The centipede game the last round the player does best Prize for economics with two other Another economist responsible by defecting and taking it all. economists who helped to develop for advancing game theory was game theory. Hungarian-born the German Reinhard Selten, who economist John Harsanyi showed introduced the concept of sub- that games in which the players game perfection in games that are did not have complete information multi-staged. The idea is that there about the motives or payoffs of should be an equilibrium at each the other players could still be stage or “sub-game” of the overall analyzed. Since most real life game. This can have major strategic decisions are made in implications. An example of such a the fog of uncertainty, this was game is the centipede game, where an important breakthrough. A a number of players pass a sum of real life example might be when financial markets cannot be sure of Getting to the truth When haggling with a buyer, a In 1960, Russian-born economist the difference in the price, it is seller may start with a price many Leonid Hurwicz began to study unlikely that this mechanism times what he is happy to accept, the mechanisms by which would create an optimal but in doing so risks losing the sale. markets work. In classical theory outcome. Sellers will naturally it is assumed that goods will be claim to want a much higher traded efficiently: at a fair price price than they actually require, and to the people who want them while buyers will offer much less most. In the real world markets do than they are willing to pay. In not work like this. For instance such circumstances they will Hurwicz recognized that both the fail to come to an agreement buyer and seller of a secondhand even though they both want to car have an incentive to lie about make a deal. Hurwicz concluded how much each values it. that if the participants could be persuaded to reveal the truth, Even if both parties revealed then the benefits to both parties how much they were willing to would be maximized. buy or sell for and agreed to split

POST-WAR ECONOMICS 241 In cooperative games players have the chance to form alliances. In many of these games, such as a tug of war, the only chance an individual has of winning is to cooperate with others. This implies that in the second-to- The optimal strategy in terms of choose the more intuitively last round defection is also a Nash equilibrium appears to be appealing solutions to games that better choice—anticipating the for the chain store to fight a price may not be sub-game perfect. future defection of your rival. By war, and for the new firm not to continuing this logic backward, try to enter the market. However, Game theory is not without its it seems that defection dominates according to Selten, if the existing critics, who say that it tells great in every round so that the sub- firm were forced to cut prices every stories but fails the main test of game perfect choice is to defect time a new firm tried to enter one of any scientific theory: it can make on the first round. This result its markets, the cumulative losses no useful predictions about what appears paradoxical, however, would be too great. Thus, by will happen. A game might have given that the sum of money in looking forward and reasoning many equilibriums. An industry the first round is very small and backward, the threat of a price war resulting in a cartel might be as hardly worth defecting over. is irrational. Selten concludes that rational a result as one that the new firm’s entry without a price descends into a price war. Further, This idea has been applied war is sub-game perfect. people don’t make decisions based to the situation where there is a on “If I do this and they do this large chain store with outlets all Bounded rationality and I do that and they do that” over the country, and a rival is These paradoxes come from the ad infinitum. preparing to enter the market in assumption that individuals playing one or more locations. The chain games are fully rational. Selten The US economist Thomas store could threaten to cut prices proposed a more realistic theory of Schelling has addressed this in the location that the new firm decision making. Although people issue by studying the idea that is thinking of entering. This threat do sometimes make decisions the triggers for behavior are not would appear to be both credible through rational calculation, often simply based on mathematical and worthwhile since it would not they do so on the basis of past probabilities. In the “coordination cost the chain store too much experience and rules of thumb. game,” where both players are profit and would deter the firm People may not always use rational rewarded if they think of the from trying to enter in that area. calculation. Instead, they may same playing card, what card in be what game theorists call the pack would you select if you When I used to theorize “boundedly rational:” able to wanted to try to match with about a nuclear standoff, someone else? Would you pick the ace of spades? ■ I didn’t really have to understand what was happening inside the Soviet Union. Thomas Schelling

242 RICH COUNTRIES IMPOVERISH THE POOR DEPENDENCY THEORY IN CONTEXT Poor countries are told that R ich countries claim that their economies will grow they do not set out to keep FOCUS if they open their borders poor countries poor—rather Growth and development that relationships between them to international trade. should help both parties. However, KEY THINKER in the 1960s German economist Andre Gunder Frank Rich countries are in a Andre Gunder Frank claimed that (1929–2005) dominant position, so they the development policies of the exploit the poor countries Western world, along with free BEFORE through unequal trading terms. trade and investment, perpetuate 1841 German economist the global divide. They preserve the Friedrich List argues against This exploitation causes the dominance of the rich world and free trade and for protectionism economies of poor countries keep poor countries poor. Frank in domestic markets. called this “dependency theory.” to stagnate or shrink… 1949–50 Hans Singer and Unbalanced trading Raúl Prebisch claim that the … while rich countries Rich Western countries were never terms of trade between poor become richer. junior trading partners to a bloc and rich countries deteriorate of powerful and economically over time. Rich countries advanced countries, as poor impoverish the poor. countries are today. For this reason AFTER some economists have pointed out 1974–2011 US sociologist that policies that helped the Immanuel Wallerstein develops advanced countries develop may Frank’s development theories not benefit today’s poor countries. to devise world-systems theory. This uses a historical The liberalization of international framework to explain the trade is often extolled by economists changes that were involved in as a guaranteed way of helping the rise of the Western world. underdeveloped economies. However, Frank’s dependency theory claims that such policies often lead to situations where rich countries take advantage of poorer ones. Underdeveloped countries

POST-WAR ECONOMICS 243 See also: Protectionism and trade 34–35 ■ Comparative advantage 80–85 ■ Development economics 188–93 ■ Economic growth theories 224–25 ■ Market integration 226–31 ■ Asian Tiger economies 282–87 ■ International debt relief 314–15 Many Nigerian oil workers work for foreign firms. These firms have poured investment into Nigeria but may benefit disproportionately from low local wages and valuable raw materials. When richer countries bring Underdevelopment is not industry and investment to poorer due to the survival of archaic countries, they claim that they will help grow the poor countries’ institutions and… capital economies. The dependency shortage… it is generated theorists claim that in reality local resources are often exploited, by… the development workers are poorly paid, and the of capitalism itself. profits are distributed to foreign shareholders rather than being Andre Gunder Frank reinvested into the local economy. produce raw materials, which are An alternative route Korea—and the extraordinary bought by richer countries, who To avoid the kinds of dangers economic growth of China expose then produce manufactured goods outlined by the dependency flaws in the dependency view. that are sold internally or between theorists, some poor countries have Here were a group of developing developed countries. This leads to taken a different route. Far from economies for whom international an unbalanced trading system opening themselves up to world trade was an engine of rapid growth where the majority of the poor trade, globalization, and foreign and industrialization. Most recently, countries’ trade is with richer, investment, they have decided dependency theory has found developed countries, while the to do the opposite and insulate echoes in the anti-globalization richer countries’ trade is mainly themselves. Some argue that the movements, which continue to internal or with other developed rise of the Asian Tigers—Hong question the classical approach. ■ nations. Only a small proportion is Kong, Singapore, Taiwan, and South with the developing countries. As a result poorer countries find Unequal export: raw and manufactured goods themselves in a weak bargaining position—they are trading with In 1949 and 1950, economists countries whose main export is larger, richer powers—and they are Hans Singer of Germany and manufactured goods. This can denied the favorable trading terms Raúl Prebisch of Argentina be explained by the fact that, they need to progress. independently published as incomes rise, demand for papers illustrating the food and commodities tend It is argued that these forces disadvantage faced by to remain steady. lead to a separation of the global developing countries when economy into a “core” of rich trading with the developed On the other hand higher countries to which wealth flows world. They observed that the incomes provoke stronger from a “periphery” of marginalized terms of trade (the amount of demand for manufactured and poor countries. The economies imports a nation can buy with luxury goods. This leads to price of poor countries also tend to be a given amount of exports) is rises and results in the poorer organized in such a way that they worse for countries whose country being able to afford discourage investment, which is primary export is a raw fewer imported manufactured a key driver of growth in the material or commodity than for goods in return for the money economy of any country. it receives from exports.

244 IN CONTEXT YOU CAN’T FOCUS FOOL THE The macroeconomy PEOPLE KEY THINKERS RATIONAL EXPECTATIONS John Muth (1930–2005) Robert Lucas (1937– ) BEFORE 1939 British economist John Hicks analyzes the way that expectations of the future change. 1956 US economist Philip Cagan uses “adaptive expectations” to explain forecasts based on the past. AFTER 1985 US economist Gregory Mankiw contributes to the emergence of the “New Keynesian” economics, which uses new models that incorporate people’s rational expectations of the future into their calculations. T he rise of government intervention and spending after World War II provided an important new way for economists to think about the whole economy. In particular they believed that the government could boost the economy by using monetary and fiscal (tax and spend) policies to achieve permanently higher output and lower unemployment. Early criticisms of these Keynesian models involved a closer examination of the idea of “expectations.” Expectations matter because what people think will happen in the future affects their behavior in the present.

POST-WAR ECONOMICS 245 See also: Economic man 52–53 ■ Borrowing and debt 76–77 ■ The Keynesian multiplier 164–65 ■ Monetarist policy 196–201 ■ Behavioral economics 266–69 ■ Efficient markets 272 ■ Independent central banks 276–77 People are rational They form and make predictions using rational expectations all the information available about the future. to them. … and adjust their They will A father passes on his knowledge behavior, rendering anticipate the effects of car maintenance to his son. The son the government policy of government attempts will make future economic decisions, to boost the economy… such as which car to buy, based partly ineffective. on this knowledge. You can’t fool However, this only works in the people. the short term: once people’s expectations catch up, they realize Initially, expectations were taken government boost to the economy, that their real wages have not risen, to be “adaptive.” This assumes an increase in their real economic and the economy reverts to its that people form expectations of activity will occur—they will original lower level of employment. the future based solely on what supply more work. In reality happened before—if Event A led the increased demand also leads Rational expectations to Event B, it will do so again. In prices to rise, so in real terms, This way of modeling each case individuals adjust for their wages have not. People are expectations was simple but the gap between what they temporarily fooled into thinking flawed. If people only looked at the expected to happen and the that their increased money wages past when making their forecasts actual outcome. reflect a raise in real wages about the future, they would be because they take a while to likely to get their forecasts The need to allow for realize that prices have also persistently wrong. Unexpected expectations within economic risen—their expectations about shocks to the economy, pushing theory was acknowledged to future price increases adjust it away (even temporarily) from weaken the outcome of Keynesian slowly. In this way it is possible its previous path would be policies (pp.154–61), where for a government to increase turned into permanent errors in governments increase spending economic output through forecasting. But if people made to raise demand. These policies monetary or fiscal policy by persistent forecasting errors, assume that if people’s wages are (in effect) fooling people. they would persistently lose out increased as a result of a against the market—and this did not seem to be a realistic picture of people’s behavior. It was dissatisfaction with the theory of adaptive expectations that helped lead US economist John Muth toward a theory of “rational expectations” in 1961. At the heart of his theory is a very simple idea. If buyers in a ❯❯

246 RATIONAL EXPECTATIONS A farmer in Australia inspects his simple but has startling would adjust their expectations crop. Farmers do not decide what to consequences. Under adaptive accordingly. For example, plant based solely on the past. They expectations government individuals would understand that also weigh factors such as the intervention might work when a government attempts to weather and levels of demand. temporarily because it could take use monetary policy (such as people by surprise. They would cutting interest rates) to maintain market are rational, they do not not anticipate future government employment, it leads to higher simply guess at future prices by policies and so an unexpected inflation. People therefore alter looking at previous ones. Instead, expansion of spending would their expectations of wage and they will attempt to forecast act like a positive “shock” in price increases accordingly. future prices based on the the economy, with short-term Instead of feeling wealthier, their information available and— real effects. Even these temporary expectation of inflation cancels out critically—using a correct model effects are impossible under the the effects of lower rates of interest of the economy. They will make theory of rational expectations looked for by the government. In educated predictions rather than since people’s forecasts for price this way monetary policy becomes blindly following past behavior. increases adjust immediately. completely ineffective because They will do this because if they it will always be accounted for, do not form their expectations Anticipating events and people’s changed behavior rationally, they will be punished In 1975, two US economists, will undo it. by the market and lose money. Thomas Sargent and Neil Wallace, claimed that if expectations are Policy makers had previously We use rational expectations rational, not only would individuals believed that there was a trade- all the time. Farmers, for instance, begin to expect government off between unemployment and make decisions about what to intervention, but they would inflation—that governments plant based on past prices, current adjust their behavior in such could boost the economy and conditions, and future probabilities. a way that policy would be achieve higher employment in They do not assume that if they rendered ineffective. Assuming the long run with higher inflation grow the same amount of the same rational expectations, people (pp.202–03). Under rational commodity they did five years would know that the government expectations, this trade-off earlier, it will achieve the same had an incentive to generate dissolves. Unemployment is market price now—and neither do shocks, such as trying to keep determined by the productive the commodity dealers trading in down unemployment. They capacities of the economy: the agricultural goods. Punishment productivity and technological from the market forces people to It is rather surprising that capacities of its firms and behave rationally and, over time, expectations have not the efficiency of its markets. their expectations can be assumed Policy makers cannot boost to be as good as the best available previously been regarded the economy beyond this level economic model. The theory of as rational dynamic models, of employment. rational expectations is deceptively since rationality is assumed The Lucas critique in all other aspects of US economist Robert Lucas entrepreneurial behavior. pointed out that if individuals’ expectations do adjust with John Muth policy, this means that the whole structure of the economy— the sets of relationships between different households, firms, and the government— alters with changes in policy. As a result the effects of policy are not always those that are intended.

POST-WAR ECONOMICS 247 This became known as the “Lucas The benefits of inflation John Muth critique,” and it was powerful derive from the use of enough to convince most expansionary policy to US economist John Muth was economists that attempts to model trick economic agents born in 1930. He studied the whole economy through its into behaving in socially industrial engineering at structural relationships, as preferable ways even Washington University in St. Keynesian models do, are flawed. though their behavior Louis, then mathematical Modeling should instead focus is not in their own interest. economics at Carnegie Mellon on people’s deeper underlying (then called Carnegie Tech) in preferences, and the resources Robert Hall Pittsburgh. Carnegie had an and technologies that direct extraordinary faculty in the individual behavior. Lucas US economist (1943– ) 1950s, when Muth studied for suggested a “new classical” his PhD there—it included approach to macroeconomics, functioning of the economy. future Nobel laureates Franco offering a partial return to the Rational expectations have come Modigliani, John Nash, Herb pre-Keynesian world. Later “real under criticism by behavioral Simon, and later Robert Lucas. business cycle” models claimed economists who work on more that changes in employment are psychologically realistic models. ■ Muth’s first paper on driven by changes in “real” labor rational expectations was factors, such as productivity Traders in financial markets form published in 1961 and was increases or changes in people’s rational expectations based partly little noticed at the time. A preferences for leisure over work. on the actions of their colleagues at shy, modest man, Muth was The critical feature of both real work. Failure to read the signs will unable to find a publisher for a business cycles and new classical lead to punishment by the market. later article on the subject and models is that they model the so moved on to work in other macroeconomy on the result of fields, producing seminal work individuals’ rational behavior. in the field of operations management and artificial Although people do not have intelligence. Other economics entirely rational expectations in researchers such as Lucas and reality, the assumption that they do Simon furthered Muth’s work helps economists to build workable on rational expectations and models that are useful guides to the won major awards for their contributions, but Muth remained unacknowledged by the wider world. He went on to teach at Michigan State and Indiana, both universities that lacked status but allowed him to satisfy his broad intellectual curiosity. He is considered to be the father of the “rational expectations revolution.” Muth died in 2005. Key works 1960 Optimal Properties of Exponentially Weighted Forecasts 1961 Rational Expectations and the Theory of Price Movements 1966 Forecasting Models

248 PEOPLE DON’T CARE ABOUT PROBABILITY WHEN THEY CHOOSE PARADOXES IN DECISION MAKING IN CONTEXT B y the 1960s mainstream expect) based on their beliefs about economics had settled on the probability of different future FOCUS a set of principles for outcomes, opting for the choice Decision making understanding people’s decision with the highest expected utility. making. Human beings are rational, KEY THINKER calculating individuals. When But this set of ideas was Daniel Ellsberg (1931–) confronted with different options challenged by results suggesting and an uncertain future, they that, even under experimental BEFORE assign a probability to each conditions, humans do not behave 1921 US economist possible future outcome and make according to the theory. One of the Frank Knight explains that their choice accordingly. They seek most important of these challenges “risk” can be quantified and to boost their “expected utility” was posed in the Ellsberg paradox, “uncertainty” cannot. (the amount of satisfaction they popularized by US economist Daniel Ellsberg in 1961, but 1954 In The Foundations of Statistics, US mathematician Economists People People shy L. J. Savage tries to show how often assume don’t care away from these probabilities can be assigned that people are ambiguities and to unknown future events. rational decision about probability make decisions AFTER makers… when they by different From 1970s Behavioral rules. economics uses experiments … and that choose. to study behavior under when they face But some conditions of uncertainty. uncertainty, people possible futures will decide on have a completely 1989 Michael Smithson the probabilities proposes a “taxonomy” of risk. unknown of each likely probability. 2007 Nassim Nicholas outcome. Taleb’s The Black Swan discusses the problem of rare, unforeseen events.