Definition & Reality
in the
General Theory of Political Economy

Thomas Colignatus

Dutch University Press

Samuel van Houten Genootschap

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

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

Colignatus is the preferred name of Thomas Cool in science.

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CIP-GEGEVENS KONINKLIJKE BIBLIOTHEEK ’S-GRAVENHAGE

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 20^th century [18]

6. An Economic Supreme Court [24]

7. Position of the Court in economic theory [26]

8. The record of economics itself [26]

9. Economics ‘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]

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 20^th century, it appears that strong constitutional safeguards are required to provide for this public function. Hence an Economic Supreme Court.

Keynes (1936) already formulated a ‘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.

Definition & Realityin theGeneral Theory of Political Economy