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

Definition & Reality
in the
General Theory of Political Economy

Thomas Colignatus

Dutch University Press

Samuel van Houten Genootschap

This text is made available by the copyright owner as an etext for the Project Gutenberg (see http://www.gutenberg.org). The Project Gutenberg header specifies under what general conditions the book may be distributed while associated with the Project Gutenberg trademark. Additional conditions are: (a) No commercial use or resale of the etext is allowed, (b) Hardcopy prints are to be acquired at the publisher Dutch University Press (see http://www.rozenbergps.com and ISBN 90-3619-172-6) or their designated partners. Please note that the etext uses HTML so that the etext layout will differ significantly from the official layout.

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

Colignatus is the preferred name of Thomas Cool in science.

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Prologue

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

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

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

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

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

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

Contents in Brief

Book I Introduction 11

Book II Trias Politica and Economic Supreme Court 16

Book III Economics Â‘as usualÂ’ 36

Book IV Presentations for the general public 60

Book V Methodology: Definition & Reality 69

Book VI Structural models 87

Book VII Social Choice 158

Book VIII Supportive notions 186

Book IX Reduced form 198

Book X Conclusions 216

Appendices 266

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

Contents

Book I Introduction 11

1. Order of presentation 11

2. The general theory 11

3. Methodology 14

Book II Trias Politica and Economic Supreme Court 16

4. The Trias Politica 16

5. The economic record of the 20^th century 18

6. An Economic Supreme Court 24

7. Position of the Court in economic theory 26

8. The record of economics itself 26

9. Economics Â‘as usualÂ’ and its inadequacy 30

10. Four empirical cases 32

11. The moral imperative 33

Book III Economics Â‘as usualÂ’ 36

12. Introduction 36

Stylized history 38

Structure of the argument 41

The difference that it means 42

13. Unemployment via taxes and minimum wage 43

The earnings distribution 44

Analysing the minimum wage 44

The Tax Void 47

Cause of the Tax Void 48

Development of the Tax Void 51

Marginal tax rate & VAT 53

Marginal tax rate & dynamics 54

Spillover and domino effects 56

Diagnosis and Therapy 56

Stagflation resolved 57

14. The 1974 Duisenberg disaster 59

Book IV Presentations for the general public 60

15. Unemployment solved ! 60

16. Enable Russia to help itself 64

Parallel 64

Risk not chance 65

Internal not external 65

Conclusion 66

17. Will the West repeat Versailles ? 66

Book V Methodology: Definition & Reality 69

18. How to check ? 69

19. Dealing economically with concepts 70

Maximising information power 70

Pythagoras and the circle 73

Falsification 76

Determinism and free will 78

From stylized fact to definition 82

Relating to Hicks 1983 83

20. Structural and reduced form 84

21. Direct application to the Economic Supreme Court 85

22. Methodological summary 85

Book VI Structural models 87

23. A textbook macro-economic model 87

The IS-LM model 87

The production function 89

Dynamics versus statics 90

Phillipscurve 90

Macro-economic interactions 91

24. Heterogeneity and nonlinear taxation 92

Heterogeneity versus homogeneity 92

Nonlinear versus proportional taxation 93

Some literature 93

25. Summary of current views 94

A simple view 94

A complex view 96

Efficiency wages intermezzo 96

A more sophisticated view 97

Confusions 98

26. Heterogeneous labour 99

Dromedary supply 99

Dutch income distribution data 100

Definitions and formulas 102

Amendment to the textbook model on the Phillipscurve 106

27. Subsistence 106

Definitions 107

Economic literature 109

Types of indexation 109

Formal development 110

28. Phillipscurve 115

Concepts 115

A homogeneous Phillipscurve 118

On expectations 121

Heterogeneous Phillipscurves 122

More factors that cause a shift 122

Crowding out 123

Poverty 124

The submarket Phillipscurves 125

Shifting back 125

29. Tax basics 126

Taxes and premiums 126

Common structure 127

Nonlinear tax function 128

Exemption 129

The marginal rate 140

Balanced growth 143

Off balanced growth 144

30. Dynamic curvature of the tax wedge 145

Introduction 145

Formulas 145

Graphs 147

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

Introduction 149

Model 151

Graphs 152

Tables 154

Conclusion 155

32. Dynamic optimality 155

The Phillipscurve revisited 155

Investment, growth and productivity 156

Book VII Social Choice 158

33. Introduction 158

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

Introduction 159

Basic concepts 162

Restatement of ArrowÂ’s Theorem 165

A note on the name of APDM 167

A lemma 167

Rejection of the Arrow Moral Claim (AMC) 168

Rejection of the Arrow Reasonableness Claim (ARC) 168

Selection of the culprit axiom. 169

Examples of consistent constitutions 170

A reappraisal of the literature 170

Conclusion 172

Addendum: SenÂ’s restatement in Â“Development as freedomÂ” 172

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

35. Without time, no morality 175

Introduction 175

Control of natural forces in the social process 176

Three traditional methods 177

Borda Fixed point 178

Relation to SaariÂ’s work 179

Pareto 182

A note on cheating 182

Conclusion 183

36. Some notes on ethics 183

Book VIII Supportive notions 186

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

Some quotes 186

Consumers surplus 187

Economic growth 188

Conclusion 192

38. Proper definitions for uncertainty and risk 192

Uncertainty 192

Risk 193

Example 195

Wrong use in economics 1921-2005 196

Book IX Reduced form 198

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

Introduction 198

Stylized facts 198

Concepts 199

The theorem 201

Graphical presentation 205

40. The possibility of co-ordination 206

Stylized facts 206

Concepts 207

The special theorem 211

The general theorem 213

On the interaction of the reduced form theorems 214

Book I
Introduction

1. Order of presentation

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

2. The general theory

Political Economy is the science of the management of the state. More in general, Â‘economicsÂ’ is Greekish for Â‘management theoryÂ’. [1] Marshall already explained that Â‘economicsÂ’ is wider than Â‘political economyÂ’, see his Â“Principles of economicsÂ” (1947:43). The proper definitions are:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

3. Methodology

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

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

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

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

Book II
Trias Politica and Economic Supreme Court

4. The Trias Politica

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

5. The economic record of the 20^th century

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

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

1. Two World Wars.

2. The Great Depression 1930 - 1940.

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

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

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

6. The environment.

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

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

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

John Maynard Keynes, Â“The General Theory of Employment, Interest and MoneyÂ”, 1936:381-382

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

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

Robert Skidelsky, Â“The reception of the Keynesian revolutionÂ”, in Milo Keynes, Â“Essays on John Maynard KeynesÂ”, CUP 1975:89 & 102-103

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

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

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

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

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

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

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

Projections for the future indicate such external risks:

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

Centraal Planbureau, Â“Scanning the futureÂ”, SDU 1992:211

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

UNDP administrator Speth correctly states:

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

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

Amartya SenÂ’s Â“Development as freedomÂ” (1999) is along this line of reasoning.

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

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

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

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

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

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

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

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

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

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

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

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

Table 1. Unemployment in the European Union in 2003

Eurostat [19]	EU (after enlargment)	EU 15
Total population	451 million	378 million
Unemployed	19.0 million	14.2 million
Idem, % labour force (age 15+)	9.1 %	8.1 %
Participation [20]	72.0 %	72.4 %

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

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

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

6. An Economic Supreme Court

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

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

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

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

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

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

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

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

The crucial considerations are:

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

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

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

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

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

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

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

· The Court cannot exist without some power.

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

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

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

7. Position of the Court in economic theory

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

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

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

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

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

8. The record of economics itself

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

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

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

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

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

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

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

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

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

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

Evaluating in general:

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

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

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

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

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

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

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

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

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

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

9. Economics Â‘as usualÂ’ and its inadequacy

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

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

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

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

Figure 1: Isoquants of national income

Figure 1 shows how national income is produced. Capital and labour combine in a production function and give national income. Capital is aggregated in dollars, labour in personyears. [29]

Let labour supply be LS and the unemployment rate be u. In the unemployment regime 0 only LS (1 - u) work, producing a national income of Y₀ in wages and profits. The slope of the tangent gives the price ratio of wages and rents. In regime 1 LS work, producing Y₁. The rise of national income from regime 0 to 1 is the increase in efficiency from going from the lower to the higher isoquant. The graph clarifies about the improvement in efficiency that: (a) more people work, (b) total income is higher, (c) average wage costs are lower, indicating lower pressure on prices, (d) hence, when there is unemployment, then there is a possible improvement, that benefits some while it neednÂ’t hurt others.

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

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

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

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

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

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

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

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

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

10. Four empirical cases

If economics is a science, then it must regard facts as sacred.

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

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

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

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

Another example is KeynesÂ’s General Theory in 1936. Note that HicksÂ’s simplification of IS-LM was available in 1937. Then the same questions.

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

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

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

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

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

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

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

11. The moral imperative

The modern economist entertains a sharp distinction between science and values. This indeed is a proper attitude, and also a crucial instance of the division of labour. It is up to Parliament and the President to set the course and make the value judgements - and once the shipÂ’s course has been set, economists will build the ship, rig the sails and do whatever necessary to get there. [31]

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

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

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

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

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

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

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

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

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

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

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

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

The argument thus has not changed fundamentally.

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

Book III
Economics Â‘as usualÂ’

12. Introduction

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

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

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

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

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

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

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

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

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

Stylized history

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

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

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

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

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

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

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

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

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

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

Figure 4. The Netherlands, Â‘official unemploymentÂ’ (drawn) and Â‘not workingÂ’ (dashed)

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

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

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

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

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

Blanchard & Fischer (1989) note:

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

On the Phillipscurve they note:

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

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

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

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

Structure of the argument

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

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

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

The difference that it means

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

Current macro-economic policy:

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

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

· focusses on aggregates and averages

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

The new macro-economic policy:

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

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

· focuses on distributions

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

Table 2 tabulates the differences.

Table 2: Differences between current and possible policy

	Current policy	Possible policy
low inflation & low deficit	accepts unemployment	full employment
cause of unemployment	technology, globalisation and labour market inflexibility	system of taxation
method	aggregates & averages	distributions
distribution of wages	income equality	productivity & unemployment

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

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

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

13. Unemployment via taxes and minimum wage

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

Key aspects are:

· heterogeneous labour, and the use of an earnings distribution

· the minimum wage and unemployment

· decomposition of the minimum wage in subsistence and tax burden

· analysis of the Tax Void

· differential indexation

· dynamic marginal tax rates

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

Figure 5: Earnings distribution

The earnings distribution

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

Figure 6: Unemployment below the minimum wage

Analysing the minimum wage

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

M = minimum wage [43]

B = subsistence [44]

T = arbitrary tax function

Bentham = Bentham tax function [45]

y = an arbitrary level of income

r = marginal rate

x = exemption

(13.1a) M = B + T[M]

(13.1b) Bentham[y] = r (y - x) for y > x,

= 0 for y x

(13.1c) Net[y] = y - T[y]

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

y - r (y - x) B & equality at M M = (B - r x) / (1 - r)

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

Table 3: Tax wedge at subsistence (single person)

Dutch legal minimum wage 2002 (per annum)	Â€
Gross minimum wage in the official statute	15,638
Net, after deduction of taxes incl. premiums for the employee (single person)	12,516
Gross minimum wage: gross + premiums for the employer	18,265
All taxes incl. premiums (though exclusive of VAT etc.)	5,749
Tax as a percentage of gross minimum wage	31.5 %
Tax as a percentage of net income	45.9 %

The Dutch situation is depicted in Figure 7, the tax plot. The horizontal axis gives income y, the vertical axis the tax t. The tax line T[y] gives the Dutch tax brackets. Net income is given by the difference between the tax and the 45-degrees line (t = y). Subsistence causes the line y - B parallel to the 45-degrees line. This line cuts off a part of net income. The intersection of the subsistence and tax lines gives y - B = T[y], and this solves into the minimum wage y = M. You must earn at least M to satisfy the minimum net income requirement B.

Figure 7: Tax plot

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

Figure 8: Tax plot revisited

Figure 9 gives gives the same result but then as a net income plot. The horizontal axis gives income, the vertical axis net income. The tax is given by the difference between net income and the 45-degrees line. Subsistence now is a horizontal line at B. The intersection of the B-line and the net income line gives the minimum wage M. You must earn at least M to satisfy the minimum net income requirement B.

Figure 9: Net income plot

The Tax Void

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

Note that the tax figures have shaded areas only above the minimum wage. The tax appears effective at and above the minimum wage, but not below it. Though taxes are defined below the minimum wage, there are no taxes collected, since people are unemployed below the minimum wage. The clear area from net minimum till the gross minimum wage M can be called the Tax Void.

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

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

Figure 10: Tax Void Unemployment

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

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

Cause of the Tax Void

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

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

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

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

Table 4: Development of tax exemption in Holland

EuroÂ’s	1951	1997	2002
Inflation index (%)	100	545	625
Wage index (%)	100	2082	2559
Exemption, single person	354	3223	8025
Idem, price adjusted	354	1930	2211
Idem, wage adjusted	354	7369	9060
Exemption, couple without children	463	6445	*13116
Idem, price adjusted	463	2524	2892
Idem, wage adjusted	463	9638	11850

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

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

Taxes

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

P = price index

x[0] = exemption at the
base year

xi = real exemption index

(13.2a) x = x[0] xi P (and here xi = 1)

(13.1bÂ’) Bentham[y, x]

(13.2b) Bentham[y, x[0] P] = r (y - x[0] P)

We also write the tax function as T[y, x] and net income as Net[y, x].

Subsistence

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

W = the average wage (nominal)

W[0] = the average wage in
the base year

wi = wage index = W / W[0]

rwi = real wage index = wi / P

B[0] = subsistence in the base year

h = B[0] / W[0]

rsi = real subsistence index

rnai = real net average wage index

(13.3a) W = W[0] wi = W[0] rwi P

(13.3b) Subsistence = B = B[0] rsi P

(13.3c) rsi = rnai =
Net[W] / P / Net[W[0]]

(13.3d)

Deduction of the real net average income index

We choose the base year so that x[0] = B[0]. Let W[0] be the average wage in the base year, and let h = B[0] / W[0] be the base year ratio with subsistence. Then the index of real (net) subsistence rsi is set to the index of the real net average wage rnai, and is (proving (13.3d)):

with B[0] = W[0] h:

(13.3d)

For example, if base subsistence is half the base year average wage, B[0] = ½ W[0] then h =0.5. When r = 0.5 then rsi = 0.33 + 0.67 rwi.

With h and B[0] given, the causal chain is {rwi, r} rsi B M u. [47]

When all incomes grow as fast

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

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

Note: The distinction between (13.3d) and (13.3e) is that the former indexes x[0] on P only, and the latter indexes x[0] and B[0] on wi = P rwi.

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

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

Proof: Denote y[+1] = (1+gr) y = g y for growth rate gr, and Net[y[+1]] = n Net[y] (both g and n one period indices).

Net income with the Bentham tax is Net[y[+1]] = g y - r (g y - X) with X the new exemption. This should be equal to n Net[y] = n (y - r (y - x)). Thus n is defined by:

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

() Take z = g = n. Then z y - r z y + r X = z (y - r y + r x) and this gives X = z x.

( g) Take X = g x. Then g y - r(g y - g x)) = n (y - r (y - x)), so that n = g.

( n) Take X = n x. Then

g y - r(g y - n x)) = n (y - r (y - x))

g y - r g y + r n x = n y - n r y + n r x

g y - r g y = n y - n r y

g (1 - r) y = n (1 - r) y

g = n

Q.E.D.

Development of the Tax Void

These formulas call for a graphical illustration. We only need data on rwi, r and h for a stylized display. We will take r = h = 50%. Then we need data on rwi, and we can use our example of Holland.

Graphical presentation of the Dutch data

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

Figure 11: Continued inflation, stagnating real wage

Holland, 1951 = 1

Figure 12: Inflation plotted against the real wage

Holland, 1951 = 1

Using the data for our analysis

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

Figure 13: Different indices at the minimum [48]

Holland, 1951 = 1

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

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

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

Marginal tax rate & VAT

While the above considers exemption x, the analysis can be extended with an analysis on the marginal tax rate r.

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

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

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

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

Figure 14: Revenue shares of income tax and VAT

Marginal tax rate & dynamics

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

Let y = y - y[-1]. Then the proper (dynamic) marginal tax rate is DMR = T / y. For the Bentham function:

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

(13.4)

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

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

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

Figure 15: The dynamic marginal rate

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

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

Spillover and domino effects

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

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

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

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

Diagnosis and Therapy

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

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

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

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

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

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

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

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

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

Stagflation resolved

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

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

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

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

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

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

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

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

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

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

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

14. The 1974 Duisenberg disaster

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

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

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

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

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

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

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

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

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

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

Book IV
Presentations for the general public

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

15. Unemployment solved !

A breakthrough in economic theory

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

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

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

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

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

· The 1950s had low unemployment and low inflation.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(March 1996)

16. Enable Russia to help itself

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

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

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

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

Parallel

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

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

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

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

Risk not chance

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

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

Internal not external

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

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

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

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

Conclusion

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

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

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

(March 1996)

17. Will the West repeat Versailles ?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Book V
Methodology: Definition & Reality

18. How to check ?

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

Thus, crucially: it is up to the fellow economists to check my findings. They / you should actually do this anyhow, since a critical perspective always is best. For example: What are the data on the minimum wages in the other OECD countries ? OK, the OECD internet site shows that 1997 statutory minimum wage is 39% of median wages incl. overtime in the USA, 60% in France, 30% in Japan, etcetera, quite sizable [53] - but what about the tax void, the development, the indexation, the discouraged workers below the minimum, etcetera ? [54] What about the shifts of the Phillipscurves in this light ? What about the effects of the dynamic marginal rate ? How are these topics in all nations ? And what would happen, if all nations gain confidence about growth policies again, and they fire up each other and move all to a new higher growth path ? Clearly, the research agenda is huge.

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

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

19. Dealing economically with concepts

Maximising information power

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Pythagoras and the circle

Regard a triangle with perpendicular sides a and b and hypotenuse c. There are two points of view:

1. Pythagoras proved [57] that the square of the hypotenuse equals the sum of squares of the perpendicular sides, i.e. that a² + b² = c²

2. For the circle, it is taken as the defining quality of the circle, and thus accepted without proof, that the points are at equal distances from the origin. In other words, a circle with radius c is defined as the collection of points (a, b) at a distance of c from the center. Thus a² + b² = c² by definition.

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

Let us take the square with sides z = a + b and surface z * z = z² = (a + b)². Within this square we can see four triangles with straight sides a and b and hypotenuse c, as has been done in Figure 16 in the square on the left.

In the square, another tilted square has been drawn, with sides c and thus a surface of c². There are four surrounding triangles, each triangle has a surface of ½ a*b. The surface of the large square is equal to the surface of the tilted square and the four triangles.

Figure 16: Pythagoras and the circle

Thus:

· From the big square itself: z² = (a + b)²

· From the tilted square and the triangles: z²= c² + 4 ab/2.

Elimination of z then gives a² + b² = c².

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This quote is troubling for the following reasons:

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

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

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

4. It is possible to translate the Dutch Â‘lijnÂ’ as Â‘pointÂ’, and Â‘puntÂ’ as Â‘lineÂ’ (thus conversely) and still find a consistent model for EuclidÂ’s axioms. But this is a mathematical exercise, and it does not necessarily have to do with Â‘spaceÂ’.

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

Falsification

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

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

(ad 1) Take logic first.

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

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

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

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

The model:

Estimation:

Observation X[+1] forecasts:

Final observation:

y = X ß +

y = X b + e

y_est[+1] = X[+1] b + Exp[e[+1]]

y[+1]

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

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

Logic and stochastics cause me to take the following position.

There is a difference between all₁ (universal) and all₂ (generally, usually, normally). The statement All ravens are black can be seen as:

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

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

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

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

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

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

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

Determinism and free will

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

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

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

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

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

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

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

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

Figure 17: Janus head analogy

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

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

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

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

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

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

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

But GillÂ’s argument does not convince me. The point is: you may pose that nature would be such, but you donÂ’t know for sure. You are still using only a model. The scientific challenge remains to develop a model that increases accuracy.

Yes, there is the Heisenberg uncertainty model that if you measure position then you no longer know speed, and if you measure speed then you no longer know position: and this model nicely captures a basic notion of uncertainty. But, try for a better model then - and take some thousands years more to do so. [64] [65] [66]

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

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

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

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

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

From stylized fact to definition

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

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

So we adopt the methodology:

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

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

(d) link back to conclusions about reality.

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

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

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

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

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

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

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

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

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

Relating to Hicks 1983

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

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

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

20. Structural and reduced form

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

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

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

With y a vector of endogenous variables, x a vector of exogenous variables, and f and g functions, then a structural form is y = f(y, x) and a reduced form is y = g(x).

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

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

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

21. Direct application to the Economic Supreme Court

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

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

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

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

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

22. Methodological summary

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

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

· we use some key properties that will be documented here

· this chapter on methodology explains the validity of the method

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

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

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

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

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

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

Book VI
Structural models

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

23. A textbook macro-economic model

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

The IS-LM model

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

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

C = consumption

G = government consumption

I = investment
(incl. unintended stocks)

NX = exports minus imports

YR = real gross domestic product

YD = YR - RTAX + TRF = C + S
= disposable income

TRF = government transfer payments [69]

RTAX = real tax revenue

DEF = G + TRF - RTAX = S - I - NX
= government deficit

S = saving [70]

We take G, TRF and NX as exogenous and known. We are now only interested in expectational equilibrium. Aggregate demand is YR* = C* + G + I* + NX. With the rate of interest i and the marginal tax rate r, behavioural relations are:

C* = TRF + c (YD* - TRF) + C₀

I* = I₀ - b i*

RTAX* = r YR*

In equilibrium C = C* gives YR* = YR - since C = C* iff YD = YD* iff I* = S* = I = S. This can be represented by the IS curve:

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

i = (C₀ + G + I₀ + NX + TRF - (1 - (1 - r) c) YR ) / b (IS)

For the money and bond market:

L + DB WN / P MX / P + SB

L = demand for real balances

DB = demand for real bond holdings

SB = real value of the supply of bonds

WN = nominal financial wealth

P = price level

MX = money stock (M1, M2 or M3) [71]

Liquidity demand is:

L = k (1 + h / (i - i_min)) YR

Equilibrium on the money market L = MX / P gives the LM curve:

(LM)

Intersection of the IS and LM curves gives equilibrium for YR and i, and from these the other variables can be solved, in particular the price level P = MX / L[YR, i].

Note that we also use: [72]

Y = P YR

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

The production function

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

YR = Y₀ LE^a KE ^{1 -}^a

Y P YR = W LE + i P_K KE,

We assume that firms maximise profits - and since we assume constant returns to scale, there is no surplus. If firms accept wage W, then the marginal productivity of labour equals the real wage W / P, and then this determines LE which must be at most labour supply LS. Unemployment then follows as u = 1 - LE / LS. If companies also accept the rental price of capital, then the marginal productivity of capital must equal i P_K/ P, and this determines the employed real capital stock KE, which must be at most total stock KS.

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

LE = Y / W

KE = (1 - ) Y / (i P_K)

With YR, P and i given from above, there is one degree of freedom from either P_K or W. It is customary to close the model with a relationship that sets the average wage W. [73]

YR = real income

LE = employment

KE = employed real capital stock

KS = total real capital stock

LS = labour supply

u = rate of unemployment

W = average wage

WT = W LE = total wage sum

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

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

Dynamics versus statics

Let p be an arbitrary price.

Statics assumes a timeless dimension. With supply S[p] and demand D[p], equilibrium (in expectations) is given by S[p] = D[p] and it solves for the equilibrating price p^·.

Dynamics concerns developments in time. The price movement pÂ’ = dp/dt is related to excess demand D[p] - S[p], so that pÂ’ = dp/dt = f[D[p] - S[p]]. The solution of this differential equation gives the movement towards equilibrium. Dynamics causes different concepts of equilibrium: depending upon the specification of variables and function, the equilibrium can be market clearing (p°) or the fulfillment of expectations (p*). Economic agents generally have different speeds of reaction when expectations are not fulfilled. When there are surprises, there can be a Â‘trade-offÂ’ between prices and quantities.

Phillipscurve

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

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

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

dLog[P] = f[u]

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

dLog[P] = dLog[P]* - 0.1 Log[ u / u* ]

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

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

Macro-economic interactions

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

Figure 18: Some macro-economic interactions

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

Table 5: Positive impulses

Positive	Cause	Prime effect	Then	Then again
YR P	growth	increases demand	adds to inflation
u DEF	more unemployment	less income, less tax revenue	more expenditure on benefits	higher deficit
P i	more inflation	the Central Bank (CB) raises interest rates to fight it	possibly, though, inflation means more profits and a reduced demand on loans	and thus a lower rate of interest: but then the CB will maintain the level of interest
i DEF	higher interest rates	the government has a higher interest bill	higher deficit
DEF i	a higher deficit	more demand for loans, more supply of bonds	thus a higher rate of interest
DEF YR	a higher deficit	sustained expenditure	and thus sustained growth (at least by that channel)

Table 6: Negative impulses

Negative	Cause	Prime effect	Then
u P	more unemployment	lower wage demands	and thus less inflation
P DEF	more inflation	more tax revenue	and thus a lower deficit
i YR	a higher rate of interest	makes investments more costly	and thus lower growth
YR u	more growth	more demand for labour	lower unemployment

24. Heterogeneity and nonlinear taxation

Heterogeneity versus homogeneity

Homogeneity assumes that S[p], D[p] and p are real variables, while heterogeneity assumes vectors or densities. This book takes the density approach. In fact, employment e[w] = Min[s[w], d[w]] also provides the earnings or income distribution, i.e. the function that gives the number of people earning a level of income w, for labour supply s[w] and labour demand d[w].

Nonlinear versus proportional taxation

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

Some literature

The following references put the argument into perspective.

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

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

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

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

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

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

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

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

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

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

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

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

25. Summary of current views

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

A simple view

There exists a simple popular view that makes two errors:

· it is static and not dynamic

· it assumes homogeneity and not heterogeneity.

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

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

In this Marshallian model, the original equilibrium is attained at the intersection of the LS and LD curves, at wage W° and employment LE°. An income tax causes workers to demand a higher wage, and supply shifts up, to LS1. Premiums that raise wage costs for employers cause these employers to offer a lower direct wage, and demand shifts down, to LD1. The new equilibrium of LS1 and LD1 is LE < LE° where employers pay direct wage W1 > W° and where workers receive net W2 < W°.

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

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

There are clear objections to this model:

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

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

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

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

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

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

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

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

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

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

A complex view

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

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

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

Efficiency wages intermezzo

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

I tend to regard this approach as an example of academic excess. This may be an error on my side, but let us look at some of the arguments: 10% of the European labour force is unemployed, hence Europeans apparently shirk a lot ! And employers are so dumb that they cannot think of cheap ways to determine productivity, like setting standards and

The Project Gutenberg eBook, Definition & Reality in the General Theory of Political Economy, by Thomas Colignatus

Definition & Reality in the General Theory of Political Economy

Book I Introduction

1. Order of presentation

2. The general theory

3. Methodology

Book II Trias Politica and Economic Supreme Court

4. The Trias Politica

5. The economic record of the 20th century

6. An Economic Supreme Court

7. Position of the Court in economic theory

8. The record of economics itself

9. Economics Â‘as usualÂ’ and its inadequacy

10. Four empirical cases

11. The moral imperative

Book III Economics Â‘as usualÂ’

12. Introduction

Stylized history

Structure of the argument

The difference that it means

13. Unemployment via taxes and minimum wage

The earnings distribution

Analysing the minimum wage

The Tax Void

Cause of the Tax Void

Taxes

Subsistence

Deduction of the real net average income index

When all incomes grow as fast

Development of the Tax Void

Graphical presentation of the Dutch data

Using the data for our analysis

Marginal tax rate & VAT

Marginal tax rate & dynamics

Spillover and domino effects

Diagnosis and Therapy

Stagflation resolved

14. The 1974 Duisenberg disaster

Book IV Presentations for the general public

15. Unemployment solved !

16. Enable Russia to help itself

Parallel

Risk not chance

Internal not external

Conclusion

17. Will the West repeat Versailles ?

Book V Methodology: Definition & Reality

18. How to check ?

19. Dealing economically with concepts

Maximising information power

Pythagoras and the circle

Falsification

Determinism and free will

From stylized fact to definition

Relating to Hicks 1983

20. Structural and reduced form

21. Direct application to the Economic Supreme Court

22. Methodological summary

Book VI Structural models

23. A textbook macro-economic model

The IS-LM model

The production function

Dynamics versus statics

Phillipscurve

Macro-economic interactions

24. Heterogeneity and nonlinear taxation

Heterogeneity versus homogeneity

Nonlinear versus proportional taxation

Some literature

25. Summary of current views

A simple view

A complex view

Efficiency wages intermezzo

Definition & Reality
in the
General Theory of Political Economy

Book I
Introduction

Book II
Trias Politica and Economic Supreme Court

5. The economic record of the 20^th century

Book III
Economics Â‘as usualÂ’

Book IV
Presentations for the general public

Book V
Methodology: Definition & Reality

Book VI
Structural models