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Title: Definition & Reality in the General Theory of Political Economy
Author: Thomas Colignatus
Dutch University Press & Samuel van Houten Genootschap

Prologue

The basic idea of this book is that Keynes’s General Theory is generalised even further by including endogenous government in the model, so that we arrive at a truly general Political Economy. The world had the Great Depression 1930-1940 and has the Great Stagflation 1970-today and by including ‘stagnation in economic policy making’ in our analysis we find a better explanation. The general theory also advises a democracy to create an Economic Supreme Court as a separate constitutional power, next to the Legislative, Executive and Judicial branches.
This book is primarily directed at my fellow economists and it primarily gives theory and stylized facts. The colleagues will specifically have to understand the ‘Definition & Reality methodology’ before they will appreciate that my analysis is scientifically warranted. Much work remains to be done in practical research. And much work remains to be done by the other professions.
Since the current imbalance of powers has many victims, it may be hoped, none the less, that the parliaments of our democratic nations investigate the issue too, so that there is more hope for improvement in their living conditions. Parliaments should do as Alfred Marshall (1890, 1947:3) wrote:
“Now at least we are setting ourselves seriously to inquire whether it is necessary that there should be any so-called ‘lower-classes’ at all: that is, whether there need be large numbers of people doomed from their birth to hard work in order to provide for others the requisites of a refined and cultured life; while they themselves are prevented by their poverty and toil from having any share or part in that life.”

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

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

Contents in Brief

Book I Introduction 11
Book II Trias Politica and Economic Supreme Court 16
Book III Economics ‘as usual’ 36
Book IV Presentations for the general public 60
Book V Methodology: Definition & Reality 69
Book VI Structural models 87
Book VII Social Choice 158
Book VIII Supportive notions 186
Book IX Reduced form 198
Book X Conclusions 216
Appendices 266

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

Contents

Book I Introduction 11
1. Order of presentation 11
2. The general theory 11
3. Methodology 14
Book II Trias Politica and Economic Supreme Court 16
4. The Trias Politica 16
5. The economic record of the 20th century 18
6. An Economic Supreme Court 24
7. Position of the Court in economic theory 26
8. The record of economics itself 26
9. Economics ‘as usual’ and its inadequacy 30
10. Four empirical cases 32
11. The moral imperative 33
Book III Economics ‘as usual’ 36
12. Introduction 36
Stylized history 38
Structure of the argument 41
The difference that it means 42
13. Unemployment via taxes and minimum wage 43
The earnings distribution 44
Analysing the minimum wage 44
The Tax Void 47
Cause of the Tax Void 48
Development of the Tax Void 51
Marginal tax rate & VAT 53
Marginal tax rate & dynamics 54
Spillover and domino effects 56
Diagnosis and Therapy 56
Stagflation resolved 57
14. The 1974 Duisenberg disaster 59
Book IV Presentations for the general public 60
15. Unemployment solved ! 60
16. Enable Russia to help itself 64
Parallel 64
Risk not chance 65
Internal not external 65
Conclusion 66
17. Will the West repeat Versailles ? 66
Book V Methodology: Definition & Reality 69
18. How to check ? 69
19. Dealing economically with concepts 70
Maximising information power 70
Pythagoras and the circle 73
Falsification 76
Determinism and free will 78
From stylized fact to definition 82
Relating to Hicks 1983 83
20. Structural and reduced form 84
21. Direct application to the Economic Supreme Court 85
22. Methodological summary 85
Book VI Structural models 87
23. A textbook macro-economic model 87
The IS-LM model 87
The production function 89
Dynamics versus statics 90
Phillipscurve 90
Macro-economic interactions 91
24. Heterogeneity and nonlinear taxation 92
Heterogeneity versus homogeneity 92
Nonlinear versus proportional taxation 93
Some literature 93
25. Summary of current views 94
A simple view 94
A complex view 96
Efficiency wages intermezzo 96
A more sophisticated view 97
Confusions 98
26. Heterogeneous labour 99
Dromedary supply 99
Dutch income distribution data 100
Definitions and formulas 102
Amendment to the textbook model on the Phillipscurve 106
27. Subsistence 106
Definitions 107
Economic literature 109
Types of indexation 109
Formal development 110
28. Phillipscurve 115
Concepts 115
A homogeneous Phillipscurve 118
On expectations 121
Heterogeneous Phillipscurves 122
More factors that cause a shift 122
Crowding out 123
Poverty 124
The submarket Phillipscurves 125
Shifting back 125
29. Tax basics 126
Taxes and premiums 126
Common structure 127
Nonlinear tax function 128
Exemption 129
The marginal rate 140
Balanced growth 143
Off balanced growth 144
30. Dynamic curvature of the tax wedge 145
Introduction 145
Formulas 145
Graphs 147
31. Differential impact of the minimum wage on exposed and sheltered sectors 149
Introduction 149
Model 151
Graphs 152
Tables 154
Conclusion 155
32. Dynamic optimality 155
The Phillipscurve revisited 155
Investment, growth and productivity 156
Book VII Social Choice 158
33. Introduction 158
34. The solution to Arrow’s difficulty in social choice 159
Introduction 159
Basic concepts 162
Restatement of Arrow’s Theorem 165
A note on the name of APDM 167
A lemma 167
Rejection of the Arrow Moral Claim (AMC) 168
Rejection of the Arrow Reasonableness Claim (ARC) 168
Selection of the culprit axiom. 169
Examples of consistent constitutions 170
A reappraisal of the literature 170
Conclusion 172
Addendum: Sen’s restatement in “Development as freedom” 172
Addendum: Mas-colell, Whinston and Green, “Microeconomic Theory” 175
35. Without time, no morality 175
Introduction 175
Control of natural forces in the social process 176
Three traditional methods 177
Borda Fixed point 178
Relation to Saari’s work 179
Pareto 182
A note on cheating 182
Conclusion 183
36. Some notes on ethics 183
Book VIII Supportive notions 186
37. On the nature and significance of a free lunch 186
Some quotes 186
Consumers surplus 187
Economic growth 188
Conclusion 192
38. Proper definitions for uncertainty and risk 192
Uncertainty 192
Risk 193
Example 195
Wrong use in economics 1921-2005 196
Book IX Reduced form 198
39. The possibility of full employment in the welfare state 198
Introduction 198
Stylized facts 198
Concepts 199
The theorem 201
Graphical presentation 205
40. The possibility of co-ordination 206
Stylized facts 206
Concepts 207
The special theorem 211
The general theorem 213
On the interaction of the reduced form theorems 214
More on chance 215
Book X Conclusions 216
41. Relating to Mankiw’s “Principles” 216
42. Relating to Krugman, Phelps, Ormerod and Heilbroner & Milberg 219
Introduction 220
Review of positions and qualities 220
Krugman: “We don’t know” 222
Phelps: “Structural slumps” 224
Ormerod: “Death of economics” 228
H&M: “Crisis of vision” 230
All authors 232
43. Relating to Sen, Galbraith and Cox & Alm 232
Sen: “Development as freedom” 232
Galbraith: “Created Unequal” 235
Cox & Alm: “Myths of rich and poor” 242
44. Relating to the OECD and some of its authors 246
The OECD in general 246
The EITC, direct payroll tax reduction and wage cost subsidies 247
45. After 35 years of mass unemployment: An advice to boycott Holland 250
Summary 250
Introduction 251
First considerations 251
The realism of my advice 254
George W. Bush and Iraq and the American economy 254
More on Paul Krugman 256
The Dutch tragedy of the murder of Pim Fortuyn in 2002 256
On the European Enlargement 259
Advice to vote NO on the current proposals for a European Constitution 260
A note on my own position 261
Appendix: After 20 years of mass unemployment: Why we might wish for a parliamentary inquiry 262
46. Final conclusion 263
Epilogue 264
Appendices 266
On the definition of economics 266
Biographical note on Montesquieu 270
Price inflation and wage growth in Holland 1950-2002 272
Income distribution in Holland 1950 and 1988 273
Program used in the analysis on exposed and sheltered sectors 275
A note on Hayek 276
A note on Barrow’s “Impossibility” 278
A constitutional amendment for an Economic Supreme Court 279
A parallel argument on the Central Bank 281
About the US Council of Economic Advisers 282
From the “Employment Act of 1946” 282
Martin Feldstein on the US Council of Economic Advisers 283
Commenting on this 288
Presentation for the National Press in Washington 1993 289
Clinton administration EITC plans for 2000 293
Summaries of additional papers 298
A note on the New Economy (2000) 299
On the 2005 edition of this book 300
Autobiographical note 303
What is new in this analysis ? 305
Abstract 306
Literature 311
Index 323

Book I
Introduction

1. Order of presentation

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

2. The general theory

Political Economy is the science of the management of the state. More in general, ‘economics’ is Greekish for ‘management theory’. [1] Marshall already explained that ‘economics’ is wider than ‘political economy’, see his “Principles of economics” (1947:43). The proper definitions are:
· Economics ‘in a narrow sense’ puts the approach, methods and tools, of the discipline central, and looks at a variety of subjects.
· Political Economy puts the subject, the management of the state, central.
· Economics ‘in a broad sense’ joins the ‘narrow sense’ and Political Economy.
One way to view these distinctions is to visualize a matrix with the sciences in the rows and the subjects in the columns. The common economist may to some extent neglect the inputs of the other disciplines, but the political economist must draw on the resources of philosophy, history, law, sociology, politicology, social psychology, biology, physics and so on. [2] Political Economy is, just by definition, the study that tries to integrate all human knowledge about the management of the state. Political Economy is, in that respect, the proper continuation of ancient philosophy on that subject matter.
Confusions easily arise when these definitions are not understood. [3]
The reasons to adopt these definitions are rather mundane. The King - and the ruling elite - can derive their wealth (a) from exploitation or (b) from general productivity growth. The latter is more advantageous in the longer run. [4] Productivity can be increased in basically two ways: by technology or by management. For example, computers can add to our wealth, and we must have technology to be able to have computers. But a room full of computers does not present much value if we don’t manage their use. So technology and management are the two sides of the coin of human wealth. Though no study should neglect either side, there of course is advantage in some specialisation of those studies. The engineers take one side, the economists the other.
Psychologists and artists might object to that view, and argue that proper training in enjoyment and in particular the arts could teach people to enjoy life so much more, requiring neither additional engineering nor economics. In a sense, this viewpoint would seem to be correct. In another sense, it apparently isn’t sufficient. Human beings get used to levels of wealth, and require more wealth. It would be economics again to study why people are not happy eating bananas and watching sunsets. And dealing with issues like this, is management again.
Also, when writing this in 2000, and again 2004, there are some rumours about the ‘end of the state’ and the ‘loss of power of existing nation-states’. This clarifies that the definition of ‘Political Economy’ subsequently requires a definition of the ‘state’. I will not try to give that here. [5] For the purposes of this book it suffices to take the existing nation-states, and international governmental bodies, and we can reconsider that assumption when they all drop their constitutions.

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

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

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

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

Keynes (1936) already formulated a ‘general theory’ for political economy. Keynes subsumed the ‘classical’ approach as a special case. [7]
Keynes’s theory is rich in many respects and poor in other. On the poor side: Keynes’s book is not exact on many issues, and proper models like the IS-LM model were only developed by Hicks, Meade and others. Samuelson (1947) presented the first integration of both the competitive model and the utility maximising calculus, only then giving body to the notion of ‘classical’. [8] However, on the rich side: Keynes’s book was and still is a source of inspiration for new research angles. Note that Samuelson coined the phrase ‘neoclassical synthesis’ for ‘his’ conceptual integration of classical processes at the micro level and Keynesian processes at the macro level. This synthesis endures till today, as e.g. Colignatus (1990a), Blanchard (1999) and Krugman (1999) acknowledge. It is important to note, though, that Samuelson’s phrase is a bit awkward, since Keynes himself already proposed such synthesis - he namely did not abandon micro-economics. It would be wrong to associate Keynes only with the macro-economic leg of the synthesis. Thus the neoclassical synthesis is actually the Keynesian synthesis itself. But we may as well use the phrase ‘neoclassical synthesis’, if only to acknowledge the role of others. [9]

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

There are also good reasons to remain modest about the novelty of the ‘new synthesis’ proposed in these pages. Keynes had an open eye to the policy making process and social philosophy. Similarly, Public Choice theorists like Buchanan and Tullock have not suggested that other factors like the macro-economy itself were not important - they only emphasised the importance of Public Choice. In that sense the presently proposed extension with institutional economics, information and Public Choice is no real extension.
In addition, the three pillars of the Trias Politica are not fully independent already. There are rather numerous dependencies instead. A modern nation has decentralised much power, and created hundreds of ‘independent organisations’ - so that some speak about ‘myrias politica’ instead of ‘trias politica’.
However, from the very definition of ‘political economy’ it follows that the function of analysing, theorising and forecasting the management of the state is a part of management itself, and this function indeed can be in danger of the other three branches.
A nation that will adapt its constitution to create an Economic Supreme Court will still feel that it takes a historical step. Similarly, economists would feel the change of perspective. It would be a different world, for example, if the US Council of Economic Advisers to the President would honestly state that they ‘would rather veto the Budget’ if they really would think so; and if they would become subject to criticism from the profession if they wouldn’t start behaving like this. So, speaking about a new synthesis is of major significance. And it can be shown to be crucial.
3. Methodology
Methodology appears to be important in this book. Sometimes, paradigm shifts are as much a matter of methodology as a matter of content.
One example is Keynes. As an economist, Keynes emphasised the economic content of his analysis: notably his findings on the peculiar role of money in the economy. His observation is firstly that money is both a medium of exchange and a store of value, and secondly that storage value depends upon expected value: and then his analysis on expectations takes off. In retrospect the force of Keynes’s analysis is a bit less ‘economics’ than he thought, and has more to do with the handling of time than with money per se. Samuelson (1947, 1983:117) and Grandmont (1983) showed that the analysis can be reproduced if money is entered in the utility functions. What remains is the issue of time. From a methodological point of view, Keynes’s theory is general in that it extends economic equilibrium with the notion that market non-clearing disequilibrium such as unemployment could be a state of expectational equilibrium too (a different concept of equilibrium). And money need not be the only cause, witness for example the difficulty of forecasting sales in order to set production. [10] [11] [12]
Another example of the relevance of methodology appears to be Samuelson (1947). Samuelson emphasises his interest in a general theory (that word again) of economic theories, and clarifies that such a theory (i) should apply to various circumstances and (ii) be meaningful (as opposed to being a tautology). Samuelson clearly presents his argument as a methodological one. [13]
Originally, the draft of this book started out with methodology, but this discussion now has been moved downwards, to a place where one will better appreciate its argument and the need for it.

Book II
Trias Politica and Economic Supreme Court

4. The Trias Politica

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

“One nation there is also in the world that has for the direct end of its constitution political liberty. We shall presently examine the principles on which this liberty is founded; if they are sound, liberty will appear in its highest perfection.
To discover political liberty in a constitution, no great labour is requisite. If we are capable of seeing it where it exists, it is soon found, and we need not go far in search of it.
6. Of the Constitution of England. In every government there are three sorts of power: the legislative; the executive in respect to things dependent on the law of nations; and the executive in regard to matters that depend on the civil law.
By virtue of the first, the prince or magistrate enacts temporary or perpetual laws, and amends or abrogates those that have been already enacted. By the second, he makes peace or war, sends or receives embassies, establishes the public security, and provides against invasions. By the third, he punishes criminals, or determines the disputes that arise between individuals. The latter we shall call the judiciary power, and the other simply the executive power of the state.
The political liberty of the subject is a tranquillity of mind arising from the opinion each person has of his safety. In order to have this liberty, it is requisite the government be so constituted as one man need not be afraid of another.
When the legislative and executive powers are united in the same person, or in the same body of magistrates, there can be no liberty; because apprehensions may arise, lest the same monarch or senate should enact tyrannical laws, to execute them in a tyrannical manner.
Again, there is no liberty, if the judiciary power be not separated from the legislative and executive. Were it joined with the legislative, the life and liberty of the subject would be exposed to arbitrary control; for the judge would be then the legislator.
Were it joined to the executive power, the judge might behave with violence and oppression.
There would be an end of everything, were the same man or the same body, whether of the nobles or of the people, to exercise those three powers, that of enacting laws, that of executing the public resolutions, and of trying the causes of individuals.”
It is useful to recall Montesquieu’s definition of political liberty:
“We must have continually present to our minds the difference between independence and liberty. Liberty is a right of doing whatever the laws permit, and if a citizen could do what they forbid he would be no longer possessed of liberty, because all his fellow-citizens would have the same power.”
Thus, of key importance: A person with few means can take less advantage of his liberties than a person with more means. A person with insufficient means might be regarded as not free at all. This brings us to the economic amendment to Montesquieu’s heritage.

There appears to be a clear link between Montesquieu and Adam Smith. In his preface to his edition of Smith (1776; 1974), Skinner explains that Smith used the historic method to provide him with empirical input (rather than econometrics). Quite fittingly, Skinner writes:
“(…) it was Montesquieu rather than Voltaire who provided the most important impetus to their studies. Montesquieu was widely regarded as the ‘greatest genius of the present age’ and his Esprit des Lois came to be enjoy a considerable vogue in the circle of Smith’s friends. But while Montesquieu’s work provided an important stimulus, the Historians in general, and Smith in particular, went well beyond the teaching of the master. In the words of one of their number: ‘The great Montesquieu pointed out the road. He was the Lord Bacon of this brand of philosophy. Dr Smith is the Newton.’” (p30)

The limitations of the Trias Politica with regards to economics are a well-known theme. Marshall’s “Principles of economics” opens with the painful story of poverty - as Mankiw unfortunately waits till p421.
David M. Kennedy (1999:245), “Freedom from Fear; The American people in Depression and War”, quotes Roosevelt in a special message to the US Congress on June 8 1934:
“(…) ‘the interdependence of members of families upon each other and of the families within a small community upon each other’ provided fullfillment and security. But those simple frontier conditions now had disappeared. ‘The complexities of great communities and of organized industry makes less real these simple means of security. Therefor, we are compelled to employ the active interest of the Nation as a whole through government in order to encourage a greater security for each individual who composes it.’ The federal government was established under the Constitution, he recollected, ‘to promote the general welfare,’ and it was now government’s ‘plain duty to provide for that security upon which welfare depends’. (…)”

5. The economic record of the 20th century

Unemployment and poverty can be seen as indicators for the quality of the management of the state. They are social phenomena, and thus depend upon the rules that society defines. When they exist, then apparently something is wrong with the management.
The economic record of this century may be judged with mixed feelings. Much has been achieved, but much has gone wrong too:
1. Two World Wars.
2. The Great Depression 1930 - 1940.
3. The Great Stagflation 1970 - the present (2005). [14]
4. Disputable ways for decolonisation and development co-operation.
5. The economic disaster in Russia and Eastern Europe after the Fall of the Berlin Wall.
6. The environment.
Of this record, the wars are the focal points of attention.

Wars are disasters for the common citizen. Perhaps wars need to be fought for political reasons, but, an economist can express some doubt. In fact, Keynes wrote his General Theory with an eye to the threat of war:
“War has several causes. Dictators and others such, to whom war offers, in expectation at least, a pleasurable excitement, find it easy to work on the natural bellicosity of their peoples. But, over and above this, facilitating their task of fanning the popular flame, are the economic causes of war, namely the pressure of population and the competitive struggle for markets. It is the second factor, which probably played a predominant part in the nineteenth century, and might again, that is germane to this discussion.”
John Maynard Keynes, “The General Theory of Employment, Interest and Money”, 1936:381-382

Skidelsky even makes a strong case that it took the War for people to start listening to Keynes:
“In his biography of Keynes, Sir Roy Harrod reports a widely acclaimed speech delivered by his subject to the House of Lords in 1946, the year of his death. ‘But Keynes had been talking in this style ... for some twenty-seven years. Why had his words not been listened to .... ?’ (...) Unemployment as a problem in economic theory may have been sufficient to produce a revolution in the discipline; unemployment was not a sufficient problem to society to produce a revolution in political ideas. If it was not the prolonged experience of mass unemployment that finally broke the hold of nineteenth-century ideas, what was it ? A strong case can be made out for war. ‘Normal’ life could coexist with unemployment; it could not with modern war.”
Robert Skidelsky, “The reception of the Keynesian revolution”, in Milo Keynes, “Essays on John Maynard Keynes”, CUP 1975:89 & 102-103

Kennedy (1999) makes clear that ‘Keynesian’ elements like maintaining aggregate demand were prominent elements in even Herbert Hoover’s policies. Similarly, deliberate inflation was considered by Roosevelt e.g. to help farmers reduce their debt burden. Nevertheless, Kennedy has to write: “In the ninth year of the Great Depression and the sixth year of Roosevelt’s New Deal [i.e. 1938 /TC], with more than ten million workers still unemployed, America had still not found a formula for economic recovery.” (p362) There was contact between Roosevelt and Keynes, but with little effect - Roosevelt apparently regarded Keynes pejoratively as an academic theorist. Then:
“Deprived of adequate public or private means of revival, the economy sputtered on, not reaching the output levels of 1937 until the fateful year of 1941, when the threat of war, not enlightened New Deal policies, compelled government expenditures at levels previously unimaginable.” (p360)
The policy stagnation around 1938 is the more surprising, since Kennedy reports Roosevelt saying on a Fireside Chat at that time (April 14 1938): “History proves that dictatorships do not grow out of strong and successful governments, but out of weak and helpless ones.” (p362)

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

The Trias Politica setting is usefully limited to the nation-state. However, if we were to limit our attention to the nation-state, could we really neglect the external conditions ? One would think not. A crucial chapter in the theory of the nation-state concerns the external relations: trade and war by tradition, and then, in our age: the risks of world population growth and of environmental disaster, i.e. risks that may spill over across the border. Wise managers would not close their eyes to external risks. Hence, though this book concentrates on the situation in the Western democracies, we also regard the non-democracies in the developing world.
Projections for the future indicate such external risks:
“The Global Crisis scenario (...) explores the risks and dangers of a neglect of, and late response to regional and global challenges (...) the world may end up in the throes of widespread distress, an eco-crisis, which can only be corrected at high cost. The policy message conveyed by this scenario is abundantly clear. Dismissing this scenario as unduly gloomy and pessimistic is in our view, absurd; such a statement would be tantamount to a complete denial of large segments of twentieth-century history.”
Centraal Planbureau, “Scanning the future”, SDU 1992:211

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

UNDP administrator Speth correctly states:
“Fifty years after the adoption of the Universal Declaration of Human Rights, one third of the world’s people are enslaved by a poverty so complete that it denies them fundamental rights.” (UNDP 1999 internet site)
This quote usefully recalls to memory that Montesquieu’s liberty has been extended in this century with more rights, so that there is an even stronger intellectual case to test whether the system of Trias Politica serves the demands made on it.
Amartya Sen’s “Development as freedom” (1999) is along this line of reasoning.

The hypothesis of self-interest clarifies that Western nations are less interested in the development issue. Surely, if the Democratic State knew that economic policies were feasible that would make external development Pareto improving rather than wasteful, then it would deem it wise to pursue such a course. And part of the argument in this book is that such knowledge does not get the attention that it deserves. On the other hand, we should presume the lack of that attention, and the lack of sufficient knowledge. But we can still argue that the current world development situation should provide the West with some worry anyhow.
For Western democracies, current situations in the developing world might be regarded as replays of their own past, and as forecasts for their own future - if times of distress were to return again. A 1996 UN-WIDER statement was:
“Thus, man-made crises have become a serious, perhaps the most serious, threat to human security in the present world.” [16]
“Over the last ten years, the number of humanitarian crises has escalated from an average of 20-25 a year to about 65-70, while the number of people affected has risen more than proportionately. The International Red Cross estimates that the number of persons involved is increasing by about ten million a year. As a result, scores of people have been left dead, maimed, starving, displaced, homeless and hopeless. Afghanistan, Bosnia-Herzegovina, Burundi, Cambodia, Central America, Haiti, Liberia, Sierra Leone, Rwanda and Transcaucasia are the countries or regions where the most acute crises have occurred during the last two decades. In turn, Guyana, Kenya, Surinam and Zaire are nations where negative trends in the factors under analysis make many fear that social explosions may take place in the not too distant future, unless corrective measures are introduced urgently.” (idem)
E. Wayne Nafziger (1998), of UN-WIDER, reports in the Financial Times:
“Many people believe that humanitarian disasters are ethnically determined, arising from differences of language, race, tribe or national origin between disputants. These differences, it is thought, are so deeply rooted that they are not amenable to economic and political reform: violence cannot be avoided. That is too pessimistic a conclusion. Our research focuses on the contribution to humanitarian crises of two factors: national income and the role of the government. Both provide some reasons for modest optimism, or at least subjects for action. (…) An analysis of the root causes of humanitarian crises indicates that the mechanism for preventing them are primarily macro-economic.”

Then, there are Russia and Eastern Europe after the Fall of the Berlin Wall in 1989. The risks of turmoil in Russia, while nuclear weapons are abundantly about, were already evident in 1989, and indeed we have seen an attempted coup against Gorbachev and later the bombing of the Duma parliament building. Eastern Europe had the criminal actions of Milosevic. The risks with respect to Russia still exist. Both in 1989 and today in 2004 a reasonable expectation was and is that Eastern developments would and will be positive. But the crucial issue does not concern the average, but the risk. Who understands the economics of unemployment will see that Western economic policy is deficient on this point - a topic that we shall return to.
In the middle of 1999 the UNDP also published a report on Eastern Europe. The conclusion is that there is much more misery than commonly recognised, and that most misery is needless and also a result of wrong decisions by Western governments. In an interview with director Kruiderink, a key question and answer is:
Q: “According to some experts it went wrong precisely since the economic reforms did not go far enough.” A: “Nonsense. The ruin would only have been greater. No, precisely the reform of the state should have been the main target. Some people actually said that ten years ago, but they were not listened to. They were considered to be softies, since they wanted to maintain parts of the communist system. You currently see economists of the Worldbank and IMF slowly change their minds too.” [17]
What is crucial is that the methods, by which such dissenting ‘softies’ were silenced, were unscientific. Crucial policy preparations were left to the fric and fray of politics and bureaucrats, unworthy of a decent democracy.

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

Above uses plain human survival to judge on the economic record, it focusses on war, humantarian disasters, overpopulation, diseases, environmental deterioration. It is sobering to regard the more standard economic outcome. Table 1 reviews the unemployment in the European Union for 2003, reassembling the data after the enlargement of May 1 2004.
Table 1. Unemployment in the European Union in 2003
Eurostat [19]
EU (after enlargment)
EU 15
Total population
451 million
378 million
Unemployed
19.0 million
14.2 million
Idem, % labour force (age 15+)
9.1 %
8.1 %
Participation [20]
72.0 %
72.4 %

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

We can conclude this chapter as follows. The economic record of the last century is mixed, and human suffering was large. For the future: there still are serious risks. Bad economic conditions don’t necessarily result into wars. During the Great Depression the US remained a democracy and didn’t resort to fascism. Though it came close ! [21] Nevertheless, there can be situations in which certain politicians can rise to power by exploiting social, religious and racial sentiments - which sentiments actually draw on economic distress and uncertainty. Such is actually the rule, and stable democracy is rather the exception. Though the probability of such developments might be limited, in the currently affluent West, their costs would be great, and hence the risk may be sufficiently large to try to do something about it. If the system already fails now, what may happen if circumstances would turn out to be far less favourable ?
Since Western societies since the Second World War already have much experience with standard approaches to enhance economic security, and are apparently failing to a large degree, it becomes time to look for a more fundamental approach. We may look into the very process of economic policy making itself.

6. An Economic Supreme Court

Since the problem is found to be equal across nations and across time, we may look for common factors. The basic factor that we can identify is the Trias Politica structure of Western democracies. The present checks and balances are imperfect. This structure appears to allow too much leeway for forces that are detrimental to the economic well-being of the population at large, their economic security and their possibilities for the pursuit of happiness. The structure of economic policy making allows politicians, bureaucrats and special interest groups too much room to distort the contribution of economic scientists.
The conceptual scheme of the Trias Politica was a useful ladder to climb out of the situation of feodality and absolute kings. But a ladder is not a goal in itself. Democracy is a living concept and can develop further. If we find that the Trias Politica fail with regards to our needs, then we should adapt it.
In the past there have been two steps towards more independence and more checks and balances in the management of the economy. First there was the independent Central Bank, and then the separate Council of Economic Advisers to the government (or other planning body). Indeed, the situation after the Second World War has been much improved: instead of a Great Depression we only got a Great Stagflation.
Okun (1983), “The economist and Presidential leadership”, provides an recommendable account of current practice. Two quotes are particularly relevant, one that observes current partiality and one that advises impartiality:
“Given these constraints, members of the Council of Economic Advisers are clearly recognized as the President’s men. If they speak publicly, they will be identified as spokesmen for administrative positions.”
“One wishes for a more effective way of influencing public and congressional opinion in the areas of professional consensus. There is a role to be played by a Supreme Court in the profession, although a less important one than that actually fulfilled by the Council and the Bureau of the Budget in recent years.” (p580)
We are advised to go one step further than the current situation, and create a scientific Economic Supreme Court safeguarded within the Constitution as an equal partner next to the three of the Trias Politica. Its role will be limited, but crucial.
The argument is not that politicians could not be qualified in economics. The argument is the balance of power. Having an Economic Supreme Court increases democracy, since it improves the quality of the checks and balances. It caters to the civic right of good government and to the right to know.
The crucial considerations are:
· The first point is theory dependence. The State will decide on its policy while using an economic model. Hence policy is directly dependent upon the state of economic theory. Who is going to decide what the current state of theory is ?
· The second point concerns self-reference (reflexiveness). The model contains a submodel of State instruments. Clarity requires that policy itself is clearly formulated and put into the model too (with error terms to allow for possible discretion).
· The third point is conflictive self-reference. One can conceive the situation that the government announces a policy while the true scientific forecast shows that the policy is untenable and will be repealed later. Hence there is an internal source of conflict - the worst kind, not a dysfunctional person, but a logical knot.
· Finally, there is a ‘general conflict of interests’. Governments have more objectives, and any power group might want to exert its influence anyway.
It follows from this that the Constitution should warrant for the Economic Supreme Court:
· It would be possible for the Court to use a model with an endogenous government. The Court would scientifically forecast government actions, instead of conditionally. The conditional forecast assumption that government promises will be kept and government assumptions realised, will be dropped.
· As the Court will have a scientific base, there can be publications and discussions with different analyses, and these would not by themselves mean a breach of confidentiality.
· The Court cannot exist without some power.
It would suffice for the Court to have the power to veto the national budget if the information that the Executive presents or uses for the budget is scientifically incorrect (in the judgement of the Court). The information and statistics only. The Court will focus on the statement on the deficit and the national debt, since all errors accumulate in those figures - though it can call any number or piece of economic information into question. Parliament of course keeps the power to decide on the budget and on policy. President and Parliament would lose the power to make misleading statements as judged by the Court.
An appendix contains a draft constitutional amendment as an example, to start thinking about it. The appendices also contain a description of the current US Council of Economic Advisers, and the difference should be clear - e.g. where the CEA appears to have no scientific status.
With an Economic Supreme Court in place, a downside is that a nation could get stuck in a specific economic theory. A Court could believe in Monetarism while reality would require something differently. Indeed, Keynes himself addressed his General Theory to his fellow economists, who were as conservative as politicians in rejecting his proposals about fighting the Great Depression. To answer this: Such stagnation in policy making can happen nowadays too, but the situation with a Court is much more transparant. Also, the very job of the Court requires it to pay attention to the data, and this tends to make for eclectic views.
 
7. Position of the Court in economic theory

It is useful to indicate in more abstract terms what this book does. Unemployment is not taken as a natural disaster like an earthquake, but regarded as the result of policy. The central questions in the political economy of employment are: can one solve unemployment and poverty, does one know how, and does one want to ?
Next to the budget set and preferences, it appears useful to distinguish information. Government policy making is not guided by prices as markets are. Perceptions play an special role. For example, when policy makers associate tax policy with income distribution policy, and in that manner overlook inefficiencies such as the tax void, then policies are blocked that would otherwise benefit everyone.
Colignatus (1990a) forecasted a revival of institutional economics. We see this happening in the literature indeed. This current book belongs to that development. An Economic Surpreme Court, or the lack of it, is a topic in institutional economics, and thus has a natural position in the proposed new synthesis. [22]
There have been precursors to this approach indeed. Galbraith (1998:199) correctly quotes Michael Kalecki (“Political aspects of full employment”):
“The assumption that a Government will maintain full employment if only it knows how to do it is fallacious.”

8. The record of economics itself

Economics is not a finished science. Hicks (1983) even rejects the notion of ‘science’ itself, and writes a chapter with the title ‘A discipline not a science’. (See also below.) He quotes Keynes:
“The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, a technique of thinking, which helps its possessor to draw correct conclusions.”

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

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

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

If we regard the role of economic theory itself, then we cannot overlook the error that economists made with respect to Arrow’s Theorem in the theory of Social Choice.
First of all, there has been a stagnation in theory development:
“Tullock sees public choice as a subject in which there was a burst of interest from the 1950s to the 1970s, but which has now ‘died out’ (p39). The cause of death was the set of unremittingly negative conclusions that issued from the analysis of the Condorcet and Arrow paradoxes.” Sugden (1999).
Secondly, it turns out that economists and Arrow himself gave a wrong interpretation to the mathematics. Below we will present a novel analysis with respect to the Arrow problem, and show that economists have run astray indeed. This gives another reason to be humble.
But, our discussion also provides clarity that social choice can be based on reasonable and morally attractive axioms. And thus there is a logical basis for a Court too.

Evaluating in general:
· Looking at this circus, it would be wrong to be only entertained. The proper point to see - the real upshot of Krugman’s books - is that the current government structure has little protection against this circus, the fads and fashions, the David Stockmans: and that this protection would be larger with a well selected Court. Note that the word ‘court’ has been chosen judicially: the job of this body is to make a judicious choice, a wise selection of all competing theories and approaches.
· It is useful to realise that the academia basically write for the journals, i.e. each other, and do not necessarily have the focus of analysing or predicting the national economy. Van Bergeijk c.s. (1997) point to these different focusses and the ‘dangers’ thereof. [25] The academic job also is to generate and test new ideas, not only the implementation of accepted theory.
· Another aspect of the distinction between the academia and practical policy advice is that only the first have the luxury of saying that they ‘don’t know it’. In policy advice this luxury basically lacks, and a decision has to be supported with the best information available. Much academic criticism on economic policy advice is overdone, since it does not take this condition into account.
· Also, economics has come far, and many economic models show similarities. So there is a body of ‘existing economics’ or ‘accepted theory’ and a rather firm scientific base. Let me indicate as such: the textbooks of Dornbusch & Fischer (1994), Mankiw (1992), Blanchard & Fischer (1989), Mueller (1989), research like Bruno & Sachs (1985), Layard, Nickell & Jackman (1991), Phelps (1994), and the practical work such as of the Dutch Central Planning Bureau (1990) (in which I participated) and Gelauff (1992). [26] [27] As Montesquieu for his Trias Politica referred to the existing example of England, we can point to Holland, where the Dutch Central Planning Bureau has earned itself a strong position, even to the extent that political parties have their programmes evaluated before elections. One can be severely critical of that CPB, precisely since it is no real Economic Supreme Court, but the current achievement is there, and is an argument for ‘promotion’.

If we regard the arguments for a court again, in the light of this evaluation of the record of economics itself, then:
· The issue is not quite the difference between unfinished science and finished science. Even if economics were to be like engineering with some finished science - like Keynes’s famous dentistry, where it would be easy to switch from one economist to another - then still there are always decisions to be made. How to interprete the data ? Is factor X now crucial or not ? Even if a science is finished, then its application to reality still is an art, and there are differences in the artists. One should realise that choices are made nowadays too, albeit hidden and not in the open, and with less scientific scrutiny as is advisable. Currently we have the President and Parliament deciding what will be the ‘information’ on which policy is based: and only too often they select that kind of presentation that suit their goals rather than the truth. The only suggestion here is to make procedures such that the result better serves democracy.
· It is important to see that we are dealing with a natural monopoly here. When the government has to establish its budget and thereby wants to rely on science, then there has to be an instance at which it is decided what the current state of science is. Even if one would ‘privatise’ forecasting, and have universities compete in bids for the contract, then there still is the decision which university to take for this year. By definition there is a monopolistic situation for that decision maker at that moment.You cannot compete that away. My analysis and advice is to embed that authority in the Constitution, and provide warrants that the critical decisions are taken in scientific manner.
· Thus crucially: If the government on the one hand would desire to use the results of scientific advice for its budget process, and on the other hand would not opt for an Economic Supreme Court, then its definitions would be logically inconsistent, and it would thereby tend to create a cause for dishonesty and improper manoeuvreing and thereby corrupt its processes. [28]
· We should realise that also law is no ‘finished business’. Our ancestors have opted for an independent judiciary, even though there is no unanimity about formulations and interpretations. But precisely since there is no unanimity, we need an institute to make a decision - a court.
· It will also be useful here to recall one of the key aspects of being a scientist: namely the responsibility to make up one’s own mind. The scientist is in this respect as a judge. He or she has to balance all pro’s and contra’s, to review theories and facts, to replay all opinions of the colleagues, and then make a decision as to what he or she believes is the right thing to think. For example, to let one’s opinion to be swayed by the opinions of others is unscientific. Now, in the light of the enormous complexity of an economy, and the additional complexity of human made theories about the economy, many academics have the liberty to choose not to ‘believe’ anything - except the logical consistency of the paper that they read or write. But in policy advice, this luxury, as said, is lacking, and much more scrutiny of what one really believes, in terms of probable effects and such, is required.
9. Economics ‘as usual’ and its inadequacy

Economists can be aware of the problems posed here; but then they tend to look for solutions within the given framework of the Trias Politica:
“There may be a communication problem. Using the words of Cairncross, again: ‘Policymakers as a rule are slightly deaf: there is too much noise’. In other words, there is a need to raise the ‘signal-to-noise’ ratio. One cannot overemphasize the importance of the packaging — the simplicity and saleability of ideas and the need to pursue these in clear and non-technical language using simple diagrams, etc. Moreover, often the more important contributions of economic advisers are in the clarification of the most basic and simple (simple only for us, professionals) concepts (...)” Bruno (1990:276)
The suggestion to my fellow economists is contrary: Thinking within the framework of the Trias Politica rather is a waste of time. It is like working from within astrology to arrive at astronomy.

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

Figure 1: Isoquants of national income

Figure 1 shows how national income is produced. Capital and labour combine in a production function and give national income. Capital is aggregated in dollars, labour in personyears. [29]
Let labour supply be LS and the unemployment rate be u. In the unemployment regime 0 only LS (1 - u) work, producing a national income of Y0 in wages and profits. The slope of the tangent gives the price ratio of wages and rents. In regime 1 LS work, producing Y1. The rise of national income from regime 0 to 1 is the increase in efficiency from going from the lower to the higher isoquant. The graph clarifies about the improvement in efficiency that: (a) more people work, (b) total income is higher, (c) average wage costs are lower, indicating lower pressure on prices, (d) hence, when there is unemployment, then there is a possible improvement, that benefits some while it needn’t hurt others.
The story of course doesn’t stop with Figure 1, and is a bit more difficult. Some points need to be developed - just indicative, not extensive:
1. We have to show that (current) unemployment is inefficient indeed, and that it is not caused by technology or globalisation or labour market inflexibility (which would cause it to be a form of efficient unemployment).
2. Wages may fall on average, but the story for each individual is different. We have to deal with heterogeneous labour. And we have to develop the impact on inflation.
3. An econometric problem is that observations are based on observations of LS (1 - u), i.e. on the inefficient area, so that extrapolations towards the true efficiency frontier are difficult, especially when labour is heterogenous.
4. Policy makers tend to see the decision process as a clash of preferences. When a tax reduction is proposed, to tackle unemployment, then this is translated in their minds into terms of the (re-) distribution of income - and then it is quickly opposed. So we have to deal with this source of misunderstanding too.
5. Though above uses a Bergson-Samuelson social welfare function, many economists are hesitant about that approach and refer to Arrow’s theorem. This matter then needs clarification too.

Indeed, I might present much of the argument along these ‘economics as usual’ lines.
But doing that makes part of the problem go away. We no longer see the dead of the two World Wars, the hungry of the Great Depression, the ruined lives of the Great Stagflation. We no longer see the devastation in Russia and many of the Eastern European Countries in the first decade after the Fall of the Berlin Wall. Closing our eyes to these issues, would be closing our eyes to the evidence for the need for an Economic Supreme Court.
The critical observation is: If economics would not confront the serious problems of mankind, it would lose it relevance to democratic policy making, and would rather become disinformation and a veil for anti-democratic policy making. It would become an accomplice in economic policy stagnation.
10. Four empirical cases

If economics is a science, then it must regard facts as sacred.
Many economists don’t quite understand this. When they see some unpleasant facts, they run, and start studying something else. Or they live in the corridors of power, and - like politicians - massage the facts, and make those fit the mold of the times. But running from a scary fact shows only a partial understanding of their importance. The proper attitude is to stare at the facts till they don’t go away and till they aren’t scary anymore, and then adjust theory to fit them.
Sometimes it is said that ‘facts’ don’t say much, but that it is the theory that makes them tick. People have lived for ages with the ‘facts’ that the moon is 2D round and shows stages of illumination, but it took them almost as long to accept 3D roundness of heavenly bodies as a theory. Admittedly, it is hard to impossible to pinpoint a ‘fact’ without also invoking theoretical concepts. But it would be wrong to switch to the view that ‘everything is theory’. Facts do exist, they can bite, and economists can be scared by them.
It is scary to economists that economic disaster can be related to the role of economics and economists.

At a crucial moment in his life J.M. Keynes was what we nowadays would be calling a ‘whistleblower’. As a civil servant and senior Treasury representative he served at the Versailles negotiations after the First World War. At a certain moment he resigned, and wrote The Economic Consequences of the Peace (1919). Many people thought that he should have kept silent given his position as (ex-) civil servant, and perhaps this played a role in his never becoming a full professor. I don’t have the intention to resolve this issue. But a valid question is: Would it not have been better if we had had Economic Supreme Courts at that time, that because of their scientific agenda would have put Keynes’s analysis up for discussion, that would have given him more protection, and that would have forced the other branches to answer to some questions ?
Another example is Keynes’s General Theory in 1936. Note that Hicks’s simplification of IS-LM was available in 1937. Then the same questions.
The General Theory itself contains the famous lines: “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.” (p383) He continues: “(…) there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest.” Perhaps Keynes would have supported the idea of an Economic Supreme Court that keeps its knowledge up to date.
A third example is Jan Tinbergen’s 1936 model of the Netherlands (vide Barten (1988), with p48 highly amusing). The same questions.
The fourth example involves my own person at the Dutch Central Planning Bureau (CPB) around 1989-1991. This book already wins the argument without mentioning my own experience, but it would not be correct not to mention it. This book presents an analysis that has been suppressed by that bureau with abuse of power - see also my biographical appendix. Then the same questions.

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

Interestingly, Frank Sulloway’s (1996) “Born to rebel” argues, roughly put, that first-borns tend to be more conservative and that later-borns are more open to new scientific findings. Van den Berg (2004) calls this finding into question. But an Economic Supreme Court packed with conservatives could be a recipe for stagnation anyway. [30]
To be sure: my question of ‘would it not have been better if…’ is not intended to be rhetoric, and I grant that a Court at times will be slow to take up a challenge.
There however is a proper analogy: In the same way, occasionally, a fireman is caught causing fires himself. But this does not cause us to abolish the whole fire-department. As said, the appendix contains an example constitutional amendment that tries to find the middle ground, something that is workable and a huge improvement compared to the current situation.

11. The moral imperative

The modern economist entertains a sharp distinction between science and values. This indeed is a proper attitude, and also a crucial instance of the division of labour. It is up to Parliament and the President to set the course and make the value judgements - and once the ship’s course has been set, economists will build the ship, rig the sails and do whatever necessary to get there. [31]
It is interesting to observe however that economists regularly express values. It is well-known that Marshall and Tinbergen were drawn to the subject out of a desire to understand the causes of poverty and ‘do’ something about it. Less well known may be this quote of Pigou:
“I would add one word for any student beginning economic study who may be discouraged by the severity of the effort which the study, as he will find it exemplified here, seems to require of him. The complicated analyses which economists endeavour to carry through are not mere gymnastic. They are instruments for the bettering of human life. The misery and squalor that surround us, the injurious luxury of some wealthy families, the terrible uncertainty overshadowing many families of the poor---these are evils too plain to be ignored. By the knowledge that our science seeks it is possible that they may be restrained. Out of darkness light! To search for it is the task, to find it perhaps the prize, which the “dismal science of Political Economy” offers to those who face its discipline.” --- A. C. Pigou [32]
Keynes wrote the General Theory not only motivated by the beauty of economic theory itself but also against the backdrop of the Great Depression and the threat of communism and facism, and war. He even presented the GT somewhat in the fashion of ‘either you accept my theory or there will be a world revolution’:
“The authoritarian state systems of to-day seem to solve the problem of unemployment at the expense of efficiency and freedom. It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated - and, in my opinion, inevitably associated - with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom.” - GT:381
What do we make of these value judgements ? Do these economists cross the line ? Do they wander in the perk reserved for politics ?
The answer is no. They only emphasise that society may be well willing to do something decent about unemployment and poverty, if only people had the knowledge. If the knowledge is lacking, then society faces a tough choice, and people in power will tend to look after themselves first. But with the knowledge, the situation is entirely different, and even those in power will be quite ready to help create the new prosperity. By doing so, they may also become popular, and gain or retain power. Note that it is not obvious or self-evident that the powerful will allow such change, but they might be persuaded to it.
Of course, in a sense, it could be considered a political act, when one provides crucial knowledge that changes a situation. But properly seen, this is just the definition of a scientist: to provide knowledge. Scientists can be knowledge (power) brokers - see also Throgmorton (1991). If one does not like this role of scientists, then throw out Montesquieu too.
In the same manner the economist can, with his or her knowledge, elucidate the moral problems of society. People may not be aware of certain choices that they implicitly make, and they will be grateful - though not necessarily happy at the first instance when responsibility dawns on them - when these choices are pointed out. The economist then again is only helpful in clarification. Though of course it is often wise to only try to clarify matters if one can predict that this will cause a change - otherwise much discussion and sweat will have been for nothing.
But clearly, the economist has to be protected by the Constitution to be able to perform his or her task of clarification, since new or seemingly contrary ideas always run the risk of misunderstanding and disproportional reaction.

My analysis in 1990 was, vide Colignatus (1990a), and the first edition of this book in 2000 stated:
“In my analysis the moral imperative for the Western nations since the Fall of the Berlin Wall is to help the Russian and Eastern European peoples to recover from the brutal communist oppression that they have suffered. The best way to help is to allow trade. But the West is afraid for cheap products, and thus its own unemployment. And hence there are barriers to trade again. But the true cause of unemployment is not external, but internal to the West, internal in our system of economic policy making. It is the West’s own stupidity that causes hurt to others.”
The second edition of this book in 2005 witnesses the Enlargement of the European Union on May 1 2004. This is a great step in the right direction. There are still obstacles, however, if not internally to the EU then externally to the other nations.
The argument thus has not changed fundamentally.
Hence, the moral imperative for Western nations is to reconsider the Trias Politica structure of economic policy making. [33]

Book III
Economics ‘as usual’

12. Introduction

In ‘economics as usual’ we neglect the World Wars and concentrate on the current problem of stagflation. This book then also provides a novel explanation in this area - novel in the sense that it bundles the articles that have been written since 1989.
In the years after World War II, Western societies created systems of social security - the ‘Welfare State’ - and for a while it seemed as if they could do so without serious economic consequences. From a macro-economic point of view, they hoped to enjoy growth, full employment and low inflation. These indeed happened in the golden years 1950-1970. However, there arose the problem of stagflation around 1970, i.e. the combination of high unemployment, high inflation and stagnating growth. Around 1980, unemployment and inflation reached double digit values. Other economic indicators in the red were budget deficits, high interest rates, and the crowding out of private investments. Adjustment to these problems has been difficult and slow. The economic performance around 2004 is a major improvement from the worst episode, but the progress seems to be stagnating. The ongoing discussion in policy making circles during all these years is how the Welfare State arrangements are related to these economic problems, and what the proper policy reaction should be.
Welfare state economics differs from ‘traditional’ macro-economics in that there are more arrangements that protect individuals from insecurity and that entitle them to benefits. Welfare state economics however does not differ from ‘traditional’ macro-economics in the respect that the basic laws of economics cannot be changed. Generous as arrangements can be, people fundamentally still react to incentives. Welfare state arrangements tend to reduce the base of the economy of those participating in the workforce and they increase the burden on those. The welfare state also tends to generate more unemployment and inflation. While unemployment would ‘traditionally’ cause people to lose their income and thus to be more cautious with their wage demands, in the welfare state they receive an unemployment benefit and may continue tot insist on high wages. These points can readily be verified from comparing the results of the EU and US economies, where the EU is more of a welfare state and where the US has more traditional features.
Not surprisingly, there has been much debate about the sustainability of the welfare state. The US economy clearly is more dynamic and in many respects also more successful and innovative than the European economy. In this debate, a wide range of issues is discussed, from trade to investments, technology, monetary policy, migration, and so on. All these features indeed are very important for a balanced economic judgement. A common conclusion remains that employment plays a key role, as is for example witnessed by the OECD (1994) “Jobs Study”, the OECD Economic Studies 31 (2000), OECD (2003), to name a few. This conclusion actually is not so surprising, since the very definition of the welfare state suggests that it tries to protect people from the uncertainties of the job market rather than anything else.
Many people accept these days that Western economies have a problem with jobs with a low level of productivity and thus a low level of market-earned income. The United States tolerate more poverty while Europe sets its minimum wage much higher so that Europa has more unemployment. This problem with low productivity jobs finds various explanations, notably those of technology, globalisation and labour market inflexibility - or ‘welfare state sclerosis’. Policies based on these explanations have been enacted for some time now. For quite some time, in fact; while little is being achieved. It is proper that we pose the question: why is it that we don’t achieve much ? [34]
The novel analysis presented in these pages finds the problem and answer in taxes. [35] As noted, benefits have to be financed, and the tax arrangements have a key impact on incentives and costs. We will focus on the influence of taxes that runs via the labour market, both directly by ‘labour taxes’ and indirectly by ‘consumption taxes’ that also affect the cost of labour. The emphasis in our study is on dynamics where interactions have more time to take hold. The idea of this present study is that by proper management of tax dynamics, the economy could become more efficient, in both the EU and US alike, so that ultimately the drawbacks of a welfare state can find a better balance with its advantages.
Obviously, when this analysis is new, then it has not been recognised before, and then it has likely been missing in policy. And policy that was based on a wrong analysis, is likely to have been the cause of the very problem that it wanted to solve.
The emphasis on taxes does not mean that technology, international trade and labour market inflexibilities are irrelevant. It does not mean that we can throw away the current macro-economic models. On the contrary: the emphasis on taxes is only an amendment to the current models. The tax analysis would be meaningless without these current models. I myself participated in the construction of the CPB (1990) Athena model, a sectoral model of the Dutch economy with 7000 variables, and I would be the last one to suggest that only taxes matter !
Though the amendment sounds simple, there still are grounds to cover. Unemployment obviously has a much longer history than the current problem. Also, the Western track record on unemployment can only be understood when the record on inflation is taken into account too. A wrong diagnosis of the cause of unemployment would also have its effects via the anti-inflation policy of the monetary authorities.

Stylized history

Consider the empirical evidence since 1950. This track record coincides with decades:
· The 1950s had low unemployment and low inflation, and high real growth.
· The 1960s had the threat of unemployment, and governments accommodating inflation in order to actually prevent it.
· The 1970s nevertheless had mass unemployment bursting into the open, and governments accommodating high and accelerating inflation to battle it. Growth is volatile.
· The 1980s had governments come down hard on inflation, while they accept high levels of unemployment and stagnating growth as the price for stability.
· The 1990s-till-now: There are different reactions on both sides of the Atlantic. Europe appears reluctant to dress down the welfare state, accepts high minimum wages and more unemployment that is partly hidden in Welfare State programmes. The USA appears willing to accept more poverty. (This difference in regional reactions started already earlier, but is clearest in this period.)
One sees a certain “trade-off” between unemployment and inflation. Figure 2 reviews the official data for the United States and Figure 3 for the Netherlands for 1950-2001. [36] For both countries, the official values for the 1950s and 2000s are in the same lower left and favourable region, but they have been far outside of it during the years in-between. [37] Since the official statistics in the 2000s have returned to the favourable lower left region, the natural question to ask is whether stagflation has been defeated. Figure 4 reviews the situation in the Netherlands, where the official values have been extended with those on the labour force ‘not working’. [38] One can suspect that Welfare State programmes can hide unemployment.
In macro-economics, the relation between unemployment and inflation is expressed in the Phillipscurve. Next to the standard (wage-) Phillipscurve there is the (price-) Phillipscurve that gives the relationship between unemployment and (consumer) prices (and that relies upon a dependence of prices on wage-costs). A more extensive (participation-) Phillipscurve links the development of wages and prices to unemployment or ‘not-working in general’. Understanding the relationships of the curves is subtle: it is not just the inclusion of the numbers, but rather the effect on the market. Notably, when ‘disability’ means a reduction of the workforce, the remaining workers face less competition and might raise their wage demands (see Figure 4).
Figure 2. The unemployment - inflation space 1950-2001, United States

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

Figure 4. The Netherlands, ‘official unemployment’ (drawn) and ‘not working’ (dashed)

Above rough division in decades suggests, as said, some ‘trade-off’. There is a discussion among economists whether such a ‘trade-off’ really exists, and in particular for the short run, but, with this division in decades, it cannot be denied that there are some systematic choices involved. Our object of study, stagflation, can be rephrased by observing that the Phillipscurve apparently has shifted to a higher and unfavourable position.
The authors Okun (1981), Hebden (1983), Blanchard & Fischer (1989), Friedman (1991), Phelps (1994) help to put the Phillipscurve in perspective. Extensive empirical work has been done by the Central Planning Bureau (1992a&b).
Okun (1981) emphasises the stability of the US Phillipscurve over the 1954-1969 period, but accepts that wages and prices thereafter are less flexible in the short run, due to ‘implicit contracts’ and ‘invisible handshakes’. Referring to Friedman and Phelps he notes: “In the sense that all economists must recognize that adverse shift of the short-run Phillips curve, they have all become accelerationists now (to reverse Friedman’s celebrated concession to Keynes).” (p239). Rather than getting lost in finding proper functional formats, Okun concentrates on formulating various elements that are important for policy making, indicating that a whole range of instruments must be used. The minimum wage gets short mention, but is not considered in relation to the Phillipscurve.
Hebden (1983) gives a recommendable review of econometric issues and empirical work (till that time) on the Phillipscurve, including (a) the original article by Phillips, (b) papers that remain close to his format, and (c) papers that include trade union influence and price expectations. Hebden notes:
“Models that seek to explain the causes of the inflation that has been experienced in the recent past, and hold out the possibility of helping economists to predict and maybe control inflation in the future, are sought after eagerly by economists and politicians. Many models have been produced and a fair degree of unanimity has been found as to the mechanics of the relatively mild inflation experienced in Britain in the 1950s and 1960s. But when inflation accelerated, in this country as in most of the industralised world, in the mid-1970s, those models were unable to cope; and though almost a decade of ‘hyperinflation’ has passed since then, no model that adequately explains its causes has yet been found.” (p158)
Blanchard & Fischer (1989) note:
“The Keynesian framework, embodied in the “neoclassical synthesis”, which dominated the field until the mid-1970s, is in theoretical crisis, searching for microfoundations; no new theory has emerged to dominate the field, and the time is one of explorations in several directions with the unity of the field apparent mainly in the set of questions being studied.” (p27).
On the Phillipscurve they note:
“The contemporaneous correlation between innovations in wage inflation and GNP is, however, positive and significant: it is this correlation that underlies the Phillips curve, which plays a central role in theories of the business cycle that allow aggregate demand disturbances to affect output.” (p19). [39]
Their discussion is critical and enlightening, but does not involve the role of the minimum wage. On p551 they discuss the high European unemployment, but then refer to the Layard & Nickell 1986 & 1987 model, concluding, a bit non-committingly:
“The Layard-Nickell model provides an example of how to relate the theories developed in this book to the data. It suggests a complex set of causes for high unemployment in which both demand and supply factors play a role and the labor market’s own dynamics explain the persistence of high unemployment with nearly stable inflation.” (p555).
Our analysis will allow a stronger conclusion. From the 1950s till the beginning of the 1990s the common view among economists and policy makers tended to be that the unemployment in the trade-off was “general” unemployment. This is not quite true for all economists, but many made this simplifying assumption. Nowadays we tend to link unemployment to lowly productive labour. For us it may be obvious, but compared to the earlier view of many it is a change of perspective that the once-thought-to-be “general” unemployment now turns up as a rather specific type. To make this change specific: we will hold that the unemployment in the trade-off has always been related to the distribution of productivity across labour.
Structure of the argument
The crucial insight is that the people who can demand pay rises need not be the people who run the risk of unemployment thereof. High productivity workers run less risk of unemployment and can more easily demand pay rises, while low productivity workers run the larger risk of unemployment. High productivity workers are more versatile and are able to shift the risk of unemployment to the lower income groups. When jobs are scarce, the high productivity workers even crowd out others from the labour market. [40]
The policy rule on taxes is: don’t tax low productivity labour. Why ? To keep it employed so that more productive labour will meet more competition and will not demand inflationary pay rises. In Europe, taxes on low productive labour are still high, causing a high minimum wage that causes unemployment. These taxes could be abolished, and without costs, since these workers are unemployed anyway. Similarly, marginal tax rates are less a problem than often said. The proposed alternative policy provides an improvement on both unemployment and inflation, exactly the kind of policy measure required for in the current situation.
This analysis is not common knowledge. It is missing in the economic journals, it is missing for example in Borjas’s (1996) much used textbook for undergraduates. Borjas (1996:441) states: “The minimum wage, however, affects mainly less-skilled young workers, so it is difficult to attribute much of the unemployment problem to minimum wage legislation.” [41] For policy makers, the OECD (1998) reports: “The cross-country evidence suggests that the minimum wage has no significant impact on overall adult employment.” though OECD (2000) is more guarded, see chapter 44. We will show however that a minimum wage can have huge ‘multipliers’.
The difference that it means
It is useful to clarify the difference between currect macro-economic policy in Western nations and what macro-economic policy can be according to this book.
Current macro-economic policy:
· accepts unemployment as a consequence of low inflation and reduced deficits
· sees the likely cause of unemployment in technology, globalisation and labour market inflexibility
· focusses on aggregates and averages
· discusses the distribution of wages mainly in terms of income (in-) equality.
The new macro-economic policy:
· sees a way to combine low inflation and balanced budgets with full employment
· sees the cause of current unemployment in the system of taxation
· focuses on distributions
· discusses the distribution of wages in its relation to productivity and unemployment.
Table 2 tabulates the differences.

Table 2: Differences between current and possible policy
 
Current policy
Possible policy
low inflation & low deficit
accepts unemployment
full employment
cause of unemployment
technology, globalisation and labour market inflexibility
system of taxation
method
aggregates & averages
distributions
distribution of wages
income equality
productivity & unemployment

The new analysis means that we get a different perspective on the existing models.
For example, a current argument in Holland on labour market inflexibilities is that the replacement rate is too low. There would be a so-called poverty trap. People in a benefit situation would have little incentives to accept a job offer, since they would earn hardly more. This is regarded as a supply issue, and since one cannot raise wages (which would increase unemployment), the only solution seems to be the reduction of benefits. This was actually the statement of the Dutch Minister of Social Affairs at the presentation of the Dutch National Budget in September 1999. Even the small Socialist Party (SP) accepts this view, vide its January 2000 internet site. The Minister and the oppostion party however are misguided and badly advised. In the proper analysis the problem is crucially different. If there would be sufficient jobs then there already are regulations that people can be fined for not accepting a job offer. This fine creates an incentive of 30% in a warning stage and eventually 100% by full withdrawal of the benefit. So the problem is rather that there are insufficient job offers - with sounds more like a demand problem. By manipulating taxes, it is possible to reduce gross wage costs - and increase demand - while still allowing for a decent net income.
Another point of attention is the word ‘unemployment’. Holland in 1999 features an ‘official unemployment rate’ of about 3.2 %. It seems as if unemployment is no problem for Holland. As an economist I however cannot accept the sausage that the Statistical Office (in this case the Dutch CPB and CBS) here present. (1) Dutch ‘official disability’ is about 10% of the true labour force, (2) people older than 55 years are often excluded from the ‘official labour force’ too, (3) many people work part-time since they cannot find a full-time job, (4) many women will not work outdoors since childcare is too expensive because of the wrong wages, (5) etcetera. Many economists classify these issues under the denominator of ‘participation’, and then agree that Holland has a participation problem. However, in proper economic terms it is unemployment: people who would want jobs but cannot find them. I urge the statisticians to remain servient to economic science, as they claim they are, rather than servient to politics and disinformation.
13. Unemployment via taxes and minimum wage

Let us see in stylized fashion how it went wrong in 1950-2005. Our discussion uses Holland as the example to clarify the general OECD situation. The discussion will also use simplifying assumptions and few footnotes, to keep the text transparant. These defects will be remedied in the subsequent chapters.
Key aspects are:
· heterogeneous labour, and the use of an earnings distribution
· the minimum wage and unemployment
· decomposition of the minimum wage in subsistence and tax burden
· analysis of the Tax Void
· differential indexation
· dynamic marginal tax rates
· consequences for the macro model: spillover and domino effects.
Figure 5: Earnings distribution

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

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

M = minimum wage [43]
B = subsistence [44]
T = arbitrary tax function
Bentham = Bentham tax function [45]
y = an arbitrary level of income
r = marginal rate
x = exemption
(13.1a)             M = B + T[M]
 
(13.1b) Bentham[y] = r (y - x) for y > x,
= 0 for y x
 
(13.1c) Net[y] = y - T[y]
The minimum wage provides subsistence and thus consists of that net minimum and the taxes at that minimum, which is expressed by (13.1a). Since net income must be larger than B, this means for the Bentham function:
y - r (y - x)  B & equality at M M = (B - r x) / (1 - r)
Malthus has subsistence B enforced by nature. Under current rules of (European) welfare states, B can be higher, since people who cannot earn subsistence B are entitled to a benefit of that level. [46] Table 3 gives the Dutch example.
Table 3: Tax wedge at subsistence (single person)
Dutch legal minimum wage 2002 (per annum)
€
Gross minimum wage in the official statute
15,638
Net, after deduction of taxes incl. premiums for the employee (single person)
12,516
Gross minimum wage: gross + premiums for the employer
18,265
All taxes incl. premiums (though exclusive of VAT etc.)
5,749
Tax as a percentage of gross minimum wage
31.5 %
Tax as a percentage of net income
45.9 %

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

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

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

The Tax Void

Let us now combine the earnings distribution and the tax plot.
Note that the tax figures have shaded areas only above the minimum wage. The tax appears effective at and above the minimum wage, but not below it. Though taxes are defined below the minimum wage, there are no taxes collected, since people are unemployed below the minimum wage. The clear area from net minimum till the gross minimum wage M can be called the Tax Void.
The difference between net and gross is called the tax wedge, and it is generally seen as a vertical jump. There is a change of perspective now, in that we see it also as a range, particularly relevant for the minimum wage.
In the Tax Void the tax code has only a paper function (in terms of tax collection). The tax code helps to drive up the minimum wage, but it does not collect any revenue. Abolishing taxes in this area therefor does not cost anything too. Note that abolishing the tax void would mean that exemption would be chosen at subsistence.

Figure 10: Tax Void Unemployment

Part of unemployment below the minimum wage is still above subsistence. If taxes would be abolished in that section, then the affected people could still earn a living wage, and need no income support. This kind of unemployment can be called the Tax Void Unemployment. Figure 10 gives a plot of that section (shaded) for Holland.
For the record: the Dutch minimum wage only holds for fulltimers, and not for parttimers. Holland has a lot of parttime work (for that reason). We have eliminated parttimers from the present analysis.

Cause of the Tax Void

How has the tax void come about ? Since abolishing the tax void does not cost anything, and would generate a lot of employment, why don’t we abolish it ? Why do we continue the present absurd situation of mass unemployment ?
It appears that the situation has come about gradually, by a mechanism that is difficult to observe directly. It involves the co-ordination of tax policy with social policy, specifically the indexation of taxes and subsistence.
First note that OECD countries adjust their taxes for inflation, see OECD (1986). Tax exemption in 2002 will often be close to the inflation-adjusted real value of 1950. On the other hand, research in social psychology shows that subsistence tends to rise with the general level of income, the growth of which consists of inflation and real growth (or real net income). So there is “differential indexation”. In the 1950s exemption was pretty close to subsistence, so that there was no void to speak of. Since then, exemption has lagged behind the standard of living. When tax exemption lags behind net subsistence, then there is a multiplier effect on gross subsistence, with an accelerated increase of the tax void. This process also explains the ‘squeezing of income differentials’ in OECD countries.
Holland is the example again. In 1951, exemption for a single person household was € 354 and for a couple without childern € 463. At that time there was no official minimum wage, but it can be taken at that value. The price level in 2002 (1951=1) is 6.25 and the wage index 2002 is 25.59. This allows us to construct Table 4.
Table 4: Development of tax exemption in Holland
Euro’s
1951
1997
2002
Inflation index (%)
100
545
625
Wage index (%)
100
2082
2559
Exemption, single person
354
3223
8025
Idem, price adjusted
354
1930
2211
Idem, wage adjusted
354
7369
9060
Exemption, couple without children
463
6445
*13116
Idem, price adjusted
463
2524
2892
Idem, wage adjusted
463
9638
11850
* Dutch readers can find the computation in Colignatus & Hulst (2003)
Till 1997, official exemption € 3223 lagged strongly behind the wage adjusted 1951 value € 7369. In recent years the gap has been reduced, but the 2002 official exemption of € 8025 still lags more than € 1000 behind the wage adjusted 1951 value. Most important, it lags € 4500 behind the (single person) net minimum wage of € 12500.
Taxes
If we index tax parameters on inflation only, then this affects exemption x in the Bentham tax function, and thus x should be included in the function call.

P = price index
x[0] = exemption at the
base year
xi = real exemption index

(13.2a) x = x[0] xi P (and here xi = 1)
 
(13.1b’) Bentham[y, x]
 
(13.2b) Bentham[y, x[0] P] = r (y - x[0] P)

We also write the tax function as T[y, x] and net income as Net[y, x].
Subsistence
The indexation of subsistence differs from other incomes. When wages follow, on average, an index wi, the real subsistence index rsi commonly follows the net average wage, i.e. the wage after taxes.

W = the average wage (nominal)
W[0] = the average wage in
the base year
wi = wage index = W / W[0]
rwi = real wage index = wi / P
B[0] = subsistence in the base year
h = B[0] / W[0]
rsi = real subsistence index
rnai = real net average wage index
(13.3a) W = W[0] wi = W[0] rwi P

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

(13.3d)

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

 with B[0] = W[0] h:

(13.3d)

For example, if base subsistence is half the base year average wage, B[0] = ½ W[0] then h =0.5. When r = 0.5 then rsi = 0.33 + 0.67 rwi.
With h and B[0] given, the causal chain is {rwi, r} rsi B M u. [47]

When all incomes grow as fast

Before we continue it is useful, however, to first clarify a formal property for the Bentham tax function.
Property (13.3e): For the Bentham tax function: There is equal growth of gross and net income, if and only if exemption is indexed on either.
Note: The distinction between (13.3d) and (13.3e) is that the former indexes x[0] on P only, and the latter indexes x[0] and B[0] on wi = P rwi.
Corrollary: Under (13.3e): If the income distribution remains the same (all incomes grow with the same rate) then also the average income, y = W grows at the same rate, and then also the net income distribution remains the same, and then the ratio of net average to subsistence remains the same too. Note: Western nations thus could wisely index subsistence and exemption on gross average income.
Note: These relations seem obvious enough, but actually proving it turned out to be a bit tedious.
Proof: Denote y[+1] = (1+gr) y = g y for growth rate gr, and Net[y[+1]] = n Net[y] (both g and n one period indices).
Net income with the Bentham tax is Net[y[+1]] = g y - r (g y - X) with X the new exemption. This should be equal to n Net[y] = n (y - r (y - x)). Thus n is defined by:
g y - r (g y - X) = n (y - r (y - x))
() Take z = g = n. Then z y - r z y + r X = z (y - r y + r x) and this gives X = z x.
( g) Take X = g x. Then g y - r(g y - g x)) = n (y - r (y - x)), so that  n = g.
( n) Take X = n x. Then
g y - r(g y - n x)) = n (y - r (y - x))
g y - r g y + r n x = n y - n r y + n r x
g y - r g y = n y - n r y
g (1 - r) y = n (1 - r) y
g = n
Q.E.D.

Development of the Tax Void

These formulas call for a graphical illustration. We only need data on rwi, r and h for a stylized display. We will take r = h = 50%. Then we need data on rwi, and we can use our example of Holland.
Graphical presentation of the Dutch data
Appendix Table 20 gives the required data on the Dutch economy. Dutch 1951 exemption can be taken as 1951 subsistence. Before we use the data for the formula, let us first see what they mean. Figure 11 and Figure 12 on inflation P and real income growth rwi = wi / P  show that the data fit above classification of subperiods for inflation and real income growth behaviour.

Figure 11: Continued inflation, stagnating real wage
Holland, 1951 = 1

Figure 12: Inflation plotted against the real wage
Holland, 1951 = 1

Using the data for our analysis

We now use the data for our analysis. There are four combinations of gross/net and real/nominal. This results into Figure 13. ‘Subsistence’ is always measured as a net term, and ‘minimum wage’ as a gross term. For Holland, we find that real subsistence has risen about 4-fold since 1951, and the nominal minimum wage more than 30-fold. The computed nominal minimum wage relates well to the factual 2002 minimum wage. Not only inflation accounts for the rise, but also an increased tax burden (that encounters inflation again).
Figure 13: Different indices at the minimum [48]
Holland, 1951 = 1

 It was the slow rise of subsistence B and the lagging of exemption x in the 1950-1975 period that caused a multiplied rise of M, creating the Tax Void. Also, since the earnings distribution is nonlinear (lognormal), there was an even sharper nonlinear increase in unemployment.
Figure 13 shows that the real values stagnate since about 1980, and that the development since then is determined by inflation. Since inflation does not occur in the rsi index, the real situation is stable. For example, the gross-to-net ratio at the minimum since 1980 is quite constant.
Note too that this in a sense presents a difficulty. The problem with the minimum wage was caused before 1980, and policy makers wanting a solution in 2002 will rather look at the last decennium rather than to the 1950-1975 period.

Marginal tax rate & VAT

While the above considers exemption x, the analysis can be extended with an analysis on the marginal tax rate r.
Many economists hold that a high marginal tax rate is a disincentive for labour effort. They frequently propose a change from the income tax to the Value Added Tax (VAT). If we assume the same total tax revenue then the VAT might allow for a lower marginal tax rate, for the reason that the VAT has no exemption. At least, that is commonly conjectured.
Above analysis already exposes one flaw to the argument ‘in favor of the VAT’. Having no exemption means a higher minimum wage ! So, those tax theorists who propose a shift from income tax to VAT tend to neglect an important part of labour market economics. Note that a higher VAT on luxuy cars does not affect the subsistence worker who cannot afford these, and hence there is some truth in the statement that a VAT sometimes can be preferred. However, once we have solved unemployment by proper labour market policies, the discussion about income tax or VAT could be done in terms of fiscal properties only, and it might quickly appear that a low VAT of say 5% suffices. [49]
Secondly, it is said that a VAT taxes profits too and thus seems to allow a general reduction of the price of labour. But it raises costs disproportionally for the lowly productive (who generally work with less capital).
Figure 14 shows the development of the relative revenue shares of Dutch income tax and VAT for a selection of years (i.e. 1975, 1980, 1985, 1990, 1997 and 2003). The Dutch minimum wage problem has worsened also by this development.
Figure 14: Revenue shares of income tax and VAT

 
Marginal tax rate & dynamics
I agree with the basic idea about the disincentive effects of marginal tax rates. Namely, economic theory assumes maximising agents, and the condition for a maximum can normally be expressed in terms of marginals. However, the marginal must be computed correctly. Above marginal rate r is only a static rate, that applies to a specific regime, for example a specific period. However, tax rates are adjusted from year to year. A dynamic situation requires a dynamic analysis.
Let y = y - y[-1]. Then the proper (dynamic) marginal tax rate is DMR = T / y. For the Bentham function:
 
Generally the dynamic marginal is lower than the static marginal. In fact, when tax parameters are indexed in a certain way, then the tax can have the same growth rate as income, and then the dynamic marginal rate equals the average tax rate. This holds for individuals and for the macro data if all individuals are on a balanced growth path. Let the balanced growth rate be bgr:

(13.4)

The following is a small example of how a dynamic marginal rate can equal a normal average. Let exemption be $10000, and let the statutory marginal rate thereafter be 50%. Someone earning $50000 pays the tax of $20000, on average 40%. Let all incomes grow 5%, and exemption be indexed on national income. Then exemption becomes $10500, income $52500, tax $21000, again 40%. Thus on the (dynamic) “marginal dollar” this person doesn’t pay 50% but 40%.
For the Bentham tax function we can derive a simple expression for individual growth. We are most interested in expected developments. Let personal income grow by rate , so that y[+1] = (1 + ) y, and let exemption be expected to be adjusted by rate , so that x[+1] = (1 + ) x. Then we find:

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

Empirical analysis often shows marginal rates to be less relevant - and average tax rates to be more important - than ‘common theory’ claims. This analysis on the dynamic marginal provides a useful part of the explanation.
Spillover and domino effects
Above analysis concerns minimum wage unemployment. The next question is how this relates to other kinds of unemployment.
It is useful to observe that the analysis in these pages is new. Concepts like the tax void, differential indexation and dynamic marginal tax rates, and the insights on their interaction, are really new, and have been concocted by me in a search for new scientific results. That means that governments have not incorporated these concepts in their policy making (even though the occasional civil servant may have been aware of some phenomena). Policy making up to now has been based upon a different analysis, and, alas, by being different from the right analysis, the governmental analysis is a wrong one. This is not without consequence. By analogy, when a patient gets a medicine based on a wrong diagnosis then the illness may get worse rather than diminish. In the present case, the tax void unemployment has important spillover or domino effects on unemployment above the minimum wage, and the channel of transmission is the misguided policy reaction up to now.
For example, in the 1970s governments tried to stimulate the economy by incurring big deficits, but they ended up with inflation. In the 1980s and 1990s governments opt for low inflation, and they end up with high real rates of interests and mass unemployment in Europe and poverty in the United States.
For example, Dutch economic policy is based on a general restraint on wages. This policy has fueled Dutch exports and reduced Dutch imports. The general restraint in fact subsidises exports, and Holland runs an external surplus for quite some years now. The internal imbalance is reflected in an external imbalance. The proper policy reaction however would be a wage cost policy targetted at the minimum.

Diagnosis and Therapy
Please note that the present review only gives a diagnosis, and that it is a different affair to find the proper therapy. The first is necessary step before the second can be considered.
In the course of some years I have experienced that discussing therapy is useless when people do not even understand the diagnosis. Policy makers tend to be focussed on therapy - but judge this from a wrong diagnosis. For example, in The Hague in 1992 (at a social-democratic political rally when I was no longer a member of his party) mr. Wim Kok, the Dutch Prime Minister of 2000, occasional chairman of the European Union and the social-democratic ‘respected elder’ to mr.-s Clinton, Blair, Schröder and Jospin, and a person who did some basic econometrics in his younger years, laughed loudly when I suggested to raise Dutch tax exemption from the then € 3 thousand to € 10 thousand. He must have thought of staggering costs, and it didn’t help when I said that it need not cost anything.
A major remark about therapy is that to undo the damage of the last four decades, it is not necessary to take four new decades. Return to optimality can be much faster.
The alternative and new policy would be to abolish taxes in the tax void and to allow people to earn their own - decent and untaxed - living. This alternative policy reminds of an old rule. The Dutch economist Cohen Stuart proposed in 1889 (cited in Hofstra (1975)) to put tax exemption at the level of subsistence. To drive the point home he drafted the following analogy:
“A bridge must carry its own weight before it can carry a load.”
In 2005 there is the additional argument that abolishing void taxes will not cost anything, while nations will save benefit payments due to more employment.
Note that the ideas of Cohen Stuart’s ‘bridge’ and the tax void are not very complex in themselves. In 1991 I explained them to a 12 year old kid and he commented: “A child can understand that.” Still, the EU and its score of modern governments sin against these concepts.
If unemployment is inefficient, then by definition there is a Pareto optimising solution, that will not cost anything. Most economists don’t believe in cheap solutions. Much of the debate hence focusses on ‘efficient unemployment’, where the sad state is caused for example by globalisation, technology or ‘welfare state scelerosis’ (with poverty traps). But, clearly, the tax void exists, it is a cheap way out, and the other arguments will turn out to be ghosts, which they already can be shown to be.
Note though that some period of transition may be required. Policy makers will be hesitant, advisedly, about an overhaul of the tax system. Note, then, that the tax system defines our notion of a subsidy. A wrongly levied tax, in this case the tax void, can be compensated for by a wage cost subsidy. [50] Abolishing the tax void is more sensible in the long run, but since this can only be done gradually, then some general subsidy directed at lowly productive jobs would speed up short term adjustment. The rule would be that those subsidies are reduced when tax exemption rises towards subsistence.

Stagflation resolved
More employment.... Does that not fuel inflation ? The pieces of the puzzle fall into their places when the tax void is related to the unemployment & inflation problem. The steady rise of the tax void explains the track record of unemployment and inflation. The 1950s have been characterized by relatively low taxes on low income earners, and this allowed for full employment and low inflation. From the 1960s onwards the lagging tax exemption started causing problems with unemployment. The tax policy since at least 1965 enhanced the imbalance of the internal bargaining positions of labour instead of counter-balancing it. Hence inflation was persistent, and high levels of unemployment were required to achieve price stability.
As said, governments suffer from a co-ordination problem. How governments reacted in the past depended upon the view of the day. Since the proper solution was not known, the problem did not go away. The differential indexation of tax exemption and the social minimum did not draw attention to itself. Each year adds only a slight effect which is hard to see. But over the years the void has accumulated, and with huge consequences. And the problem will remain with us in the future unless policy changes.
The co-ordination problem persists, currently. Governments currently regard minimum wage unemployment as just one type of unemployment, and not even the most important type. Current policy is based upon other explanations for unemployment, notably those of technology, globalisation and flexibility. The policy reaction based on these views is to reduce taxes for higher incomes, so that they are encouraged to work, invest and spend more, and so that labour market flexibility might be increased. However, the ineffectiveness of current policy can be explained by the fact that these views are not entirely logical. The arguments of technology, globalisation and flexibility run up against contradictions:
· Technology is a source of wealth, and it boosts the productivity of the lowly productive jobs, making the problem of poverty and unemployment less serious than it would otherwise have been.
· “Globalisation” is a scare word for “trade”. Trade however is another source of wealth, and it too has been with us for ages. Rising wealth in distant countries means rising wages over there, and trade itself thus puts limits to foreign competition. Japan over the last 60 years is a prime example of this phenomenon, but every rich nation has had the same experience.
· The “flexibility” or “welfare state sclerosis” argument can only explain that the US has poverty and Europe unemployment, but it does not explain that there is a problem with low productivity jobs in the first place. The poverty trap as said does not exist.
Thus to be sure: the real policy target is low inflation, and policy makers only discuss technology, globalisation and sclerosis/flexibility in a second line of the argument. This second line is essentially a cop-out, since it does not concern the real issue - and a discussion can be very tiring if people behave like that.
At the same time, the wrong policies work counterproductively. The reduction of taxes for the higher incomes obviously is financed by a reduction of provisions for the lower incomes, aggravating the minimum wage and poverty problems.
In my analysis, the present situation bears another surprise. We diagnose current unemployment as inefficient. Be sure that you see what inefficiency means: it means that there is a solution that is beneficial to some and that does not hurt others. Having a bright idea always means a “win-win” situation or a free lunch. In the present case there is the move to full employment under price stability. The present unemployed will find jobs. The higher productivity group will have a theoretically larger risk of unemployment, but in practice this risk will be modest as in the 1950s. The real gain for the higher income earners will come from the services that will be provided by the jobs of the presently unemployed. So you do not need to reduce taxes for the higher paid, since they already will have a real gain at current income.
This was it, in a nutshell. Now I beg your understanding. My analysis is more complex than can be stated in these few lines. Both tax policy and social policy are quite complex themselves, and this certainly holds for their interaction with inflation and unemployment. For example, you may ask why I haven’t discussed income redistribution effects. Actually, this is because the alternative policy could be neutral to the income distribution. The reason for