The Beginnings of Capitalism Theory

A student relying on secondary sources might surmise that the theory of capitalism's dynamism originates in the classical case for competitive markets – a case first made by Adam Smith two centuries ago. This classical thesis was that the presence of many buyers and sellers competing with one another in the marketplace caused wasteful resource allocations to be weeded out “as if by an invisible hand.” Under equilibrium conditions, efficiency in production prevailed. (One person's choice could be expanded only at the expense of another's.) This valuable feature of unimpeded markets, even if not fully realized, could not be matched by a government bureau: there were just too many goods and factors for a central planner to cope with. The point was made against communism by both “market socialism” theorists and capitalism theorists in the interwar years of the twentieth century.

Going farther, Ludwig von Mises, another of the early moderns (and also a champion of capitalism), argued in the early 1920s that market socialism, a new system then beginning to be envisioned, would also fail to match the efficiency of market economies under private ownership. If managers did not receive the profit and bear the risks of their decisions, the resource allocations of socialist competition would be highly inefficient – an argument that effectively founded property-rights theory.

Access to a career and to a livelihood in society's mainstream economy is again a topic of discussion among economists and sociologists. Great value is placed on working-age people having the opportunity to obtain rewarding work in the formal economy and to earn enough in such jobs to be self-sufficient. These are the twin conditions for what is sometimes termed social inclusion, or, more aptly, economic inclusion.

The central importance of jobs and self-support derives from several human needs. People need to engage their minds and, for most people, jobs are the main means by which they encounter new problems to solve, discover their talents and expand their capabilities. People gain satisfaction from achieving something and experience personal growth from working with others. A great many people also want involvement in their society and, for them, to work in a job in the economy's mainstream is to be a part of society's grand project. Last but not least, the pecuniary reward from working is of both material and symbolic value. People want the dignity brought by self-support and the autonomy brought by having a substantial income of their own to meet their special needs. Earning one's own way – making enough to support one's self at a decent level by society's standards and to be a part of community life – is hugely important for people's self-respect.

Abstract

This paper models two kinds of wage subsidy in a model of the natural rate having a continuum of workers ranked by their productivity – a flat wage subsidy and a graduated wage subsidy, each financed by a proportional payroll tax. In the small open economy case, with the graduation as specified, we show that both schemes expand employment throughout the distribution; for those whose productivity is sufficiently far below the mean, take-home pay is unambiguously up, though the tax financing lowers take-home pay at the mean and above. For any particular class of workers paid the same amount of the wage subsidy under the two plans, the graduated plan expands employment more. In the closed economy case, employment is increased for workers whose productivity levels are below or equal to the mean but the interest rate is pulled up, and that may cause employment to fall at productivity levels sufficiently far above the mean.

There is considerable agreement that the extraordinarily low commercial productivity of active-age persons in the lower reaches of the distribution relative to median productivity is the number one social problem of our time. In creating a huge wage gap it makes the less productive incapable of supporting a family, or in some cases themselves (in a way that meets community standards of decency at any rate), and having access to mainstream community life.

It is a special pleasure to participate in this Festschrift celebrating the contributions of Kenneth Arrow to economics. Almost uniquely in our profession, Arrow bestrides two worlds in economic theory – the Old World of neoclassical theory and the New World of modern theory, as I like to call it.

Arrow made significant contributions to the final expression of neoclassical theory with his work in the 1950s and subsequent years, some of it in collaboration with Gerard Debreu. Their work on the existence and uniqueness of general equilibrium and its extension to stochastic and intertemporal settings is well known. This is the theory of the equilibrium of a competitive economy operating under perfect information.

The “Arrow” to which I (and most in my age group and younger) have been drawn, however, is the pioneer in models exhibiting imperfect information. By that term, now widely used if inadequate, I refer to economic settings in which not every one is able or willing (because of costliness) to become perfectly informed about the state of the world and each participant's actions. Some information may be inherently private, hence concealable and unverifiable. His best remembered contribution, to my mind, is his rather informal yet trenchant analysis of market failure in the provision of insurance (Arrow (1953)). That essay, with its emphasis on asymmetric information, seems to have heralded the direction of the modern economic models emerging in subsequent years. Moral hazard and adverse selection both make their appearance in that essay.

The equilibrium volume of joblessness in the advanced economies, though it has in some countries receded a little from its high in the 1980s, far exceeds the accustomed level of the early postwar decades. In the USA and the UK, for example, the natural unemployment rate has been estimated to be around 6½ per cent in the mid 1990s. In France and Italy it stands around 8 per cent. The bulk of this equilibrium rise in aggregate unemployment is adequately explained in terms of a broadbased slowdown in the demand for labour in the face of a lesser slowdown in the general wage level required for effective worker performance as the income from private wealth and especially social entitlements barely slackened; the increased tax wedge between employers' cost of labour and employees' net wage falls into a third category, as do restrictions on hiring and firing.

As usually happens in slumps of macroeconomic origins, the relative position of disadvantaged workers – those who, for whatever reason, have poor earnings prospects over their entire lives, not just in their youth – has worsened alongside the aggregates. Joblessness is always heaviest among those workers at the lowest rungs of the labour market ladder, of course. (Although the disadvantaged, which are heavily drawn from racial minorities and recent immigrants, account for little of the unemployment in countries where they are a small proportion of the labour force, the unemployment rate among generally disadvantaged subpopulations tends to be much higher than the general unemployment rate in Europe as well as elsewhere.)

In chapter 5, Edmond Malinvaud has produced a sympathetic and thoughtful review of my (1994) book. Let me begin by restating the book's intention, since some false impressions on that score have appeared here and there. The aim is to understand the causal forces and mechanisms behind lasting shifts and long swings in national unemployment rates. The impetus for this study, of course, is the rise over the 1970s and 1980s of joblessness to new plateaux in one Western country after another.

The approach taken begins with a theoretical study of the path of the general unemployment rate; an empirical section and a policy discussion follow. The vehicles for this study are a selection of what are termed ‘modern equilibrium’ models. By that term I mean models reflecting some of the imperfect information present in real-world markets (thus modern theory, not neoclassical theory such as the real-business-cycle or RBC models use) and postulating that the belief of firms and households about wages and prices are correct (until the next unforeseeable shock) – hence equilibrium theory, unlike the monetary employment theory of Keynes and Friedman in which agents have to do a lot of guessing. Hence the theory part of the book endogenises the path of the natural unemployment rate – a path to which the equilibrium unemployment rate is always tending. Such an approach is attractive if we are willing to bet that real-life economies, after the confusion following any shock or sea-change, tend toward their new equilibrium path.

Introduction

One of the most debated problems in Europe today is the definition of the strategy for achieving monetary integration. The European Monetary System (EMS) was established as an intermediate step toward such unification. The EMS has produced increasing stability in exchange rates, but this success has been facilitated by the existence of widespread capital controls that have discouraged speculative activities. The process of financial liberalization which is now in progress, while certainly beneficial in other respects, could seriously undermine the solidity of the EMS. One of the main reasons for concern is the uneven status of the government finances of the member countries. Exchange rate systems like the EMS impose monetary discipline that may be too tight for countries that are struggling with large public deficits.

The close link between budget decisions and the exchange rate is analysed in Grilli (1988). There it is shown that the financing of government expenditures may be incompatible with a fixed exchange rate and that, historically, this incompatibility has been one of the main causes of exchange rate crises. According to this point of view, inflation is an essential element of an optimal taxation program. Therefore, waiving discretionary power over money supply decisions (as implied by a fixed exchange rate system) without, at the same time, surrendering sovereignty over fiscal policies, may not be a credible arrangement. Similar concerns have been expressed by others, e.g. Dornbusch (1987) and Giavazzi (1987).

Understanding the formation of individual expectations and the roles of information and knowledge in economic decisions has long been one of the most difficult and important problems in economics. Until the recent rational expectations movement, it was widely thought that expectations behavior contained psychological and sociological elements and hence could not be modeled with only the tools of individualistic optimization calculus and statistical decision theory.

Modern thought on expectations modeling

Knight, in his classic book, introduced the distinction between measurable uncertainty – which he called “risk” – and “true uncertainty,” which cannot “by any method be reduced to an objective, quantitatively determined probability” (Knight, 1921, p. 321). For Knight, the uncertainty of events arises from their uniqueness:

But there is some regularity in economic life. Although Knight's insistence on the unique aspects of each situation cannot be neglected, economics must also recognize the recurring elements. It must do so if it is to aspire to any explanatory power.

Keynes, too, spoke of uncertainty. Unique developments over the future – parameter shifts, in modern terms – make it impossible to assign an objective probability distribution to distant future states. In fact, Keynes noted that “[not] all probabilities are measurable” (Keynes, 1921, p. 34), because it is not generally possible to enumerate all possible states of the world (thus foreshadowing a problem for contract theory!).

In this book we are publishing the proceedings of the conference “Expectations Formation and Economic Disequilibrium,” held in New York City, December 4, 1981.

We are immensely grateful to the C. V. Starr Center for Applied Economics at New York University for inviting us to hold this conference under its auspices and for providing generous financial and organizational support. We are grateful also to New York University for providing facilities and hospitality to the participants at the conference.

We also want to express our deep appreciation to the authors and discussants whose contributions are published here for their participation in the conference and readiness to help in every way in the preparation of this book.

In addition to the authors and discussants whose work appears herein, the following persons also participated in the conference: Jess Benhabib, Franklin M. Fisher, Duncan Foley, Walter Heller, Peter Howitt, Pentti J. K. Kouri, Melvyn B. Krauss, Mark Lilla, Francisco L. Lopes, Fritz Machlup, Cathy Morrison, Robert A. Mundell, Ishaq M. Nadiri, Gerald P. O'Driscoll, Joseph Ostroy, Michael Parkin, James B. Ramsey, R. Robert Russell, Thomas J. Sargent, Mark Schankerman, Paul Wachtel, Bernard Wasow, Lawrence White, Clas Wihlborg, and Andreas Woergoetter. Their great interest in the subject and lively contributions to the discussion added much to the value of the conference.

The hypothesis of rational expectations, as ordinarily defined, makes a crucial assumption that is in some circumstances difficult or impossible to justify. The essence of rational expectations – rational in the sense of Muth – is that, according to the hypothesis, each agent uses the modeler's own model to make the forecasts of the endogenous variables, like prices and income, that (together with his exogenous parameter estimates) determine his actions. Of course, a market model makes the behavior of an endogenous variable, such as the money price level, a function of certain actions taken by the totality of individual agents, such as the aggregate output supplied to the goods market. Therefore, to forecast the endogenous variables as predicted by the model, each agent must forecast the other agents' forecasts of the endogenous variables and their forecasts of the exogenous parameters. It is at this point that a difficulty may arise: The individual agent cannot generally know what the other agents expect the weather, cultural fashions, and social policy to be; so how will he decide, or estimate, these expectations held by the others (if indeed they hold any)?

The rational expectations hypothesis meets this difficulty with the implicit assumption that, in fact, each agent supposes the other agents to have the same expectations about the various exogenous parameters that he has.