Annex 1: Economic Growth: the Objective of Economic Policy
Standard economic theory argues that competitive markets are efficient, and that Adam Smith's invisible hand will lead to a unique and optimal allocation of resources. This result, which is known as the first fundamental theorem of welfare economics, was formalised by Arrow and Debreu. As a result, it is sometimes assumed that we do not need to take a view about the level and growth rate of per capita incomes. Instead it is assumed that we can depend on people to look after their own interests, so that enabling people to transact effectively in markets is necessary and sufficient to ensure an optimal or near-optimal outcome.
However, the first fundamental theorem of welfare economics is only valid under quite stringent conditions. In particular, it assumes that a complete set of markets exist (including insurance markets against every possible risk and uncertainty), that all agents share the same set of information (e.g., about possible future states of the world, including about current and future technologies, and about the probability of different future states occurring), that there are no externalities or public goods and that there are no significant increasing returns.
Of course, nobody actually believes that these conditions actually hold. The assumption was that this model was a good approximation to what actually happened in the real world. However, work by Professor Joseph Stiglitz and others on the Economics of Information, for which Stiglitz received the Nobel Prize, show that even a small information imperfection can have a profound effect on outcomes. Information asymmetries can for example destroy markets that would exist if people share the same information set.
Accordingly, the absence of the above conditions undermines the standard argument for reliance on markets with limited government involvement. Market failures are important and pervasive.
Notwithstanding these concerns, almost all economists would accept that the primary means of organising an economy and connecting producers and consumers should be the market. An economy is a complex system, and markets appear to be very effective (though not perfect) at resolving the enormously complicated problem of coordinating actions of individuals and businesses across the economy and indeed across the world (Stiglitz 2004). And as well as recognising the failures of markets, we also need to be aware that both because of the incentives they face and because of their lack of knowledge, governments can also fail to deliver welfare improving interventions.
However, the result above means that we cannot rely on markets by themselves to reach a unique welfare maximising, or even a particularly good, outcome. This is particularly true for the market for innovation and so for economic growth.
The implication of this discussion is that there is no robust argument to argue for or against any particular objective for economic policy, especially where per capita income growth is concerned. In particular, standard economic theory, while it sensibly focuses on consumer welfare, does not allow us to translate that focus into a robust policy prescription. Despite this, many mainstream economists continue to act as if the first fundamental theorem of welfare economics more or less holds.
Nelson and Winter put it this way. They acknowledge that many would see such an attack on orthodoxy as attacking a straw man. However, they argue that a theoretical orthodoxy does exist that fundamentally undermines the ability of economics to understand economic growth and makes the assumption that markets lead to optimal outcomes invalid. They state "This is particularly so with views concerning the efficiency properties of market systems: there seems to be a remarkable tendency for discussion of this question to throw off the encumbrances of advanced learning and revert to a more primitive and vigorous form. …It is a caricature to associate orthodoxy with analysis of static equilibria, but it is no caricature to remark that continued reliance on equilibrium analysis, even it its more flexible forms, still leaves the discipline largely blind to phenomena associated with historical change. Thus although it is not literally appropriate to stigmatize orthodoxy as concerned only with hypothetical situations of perfect information and static equilibrium, the prevalence of analogous restrictions in advanced work lends a metaphorical validity to the complaint…..Last there is one key assumption in the structure of orthodox thought that [gets great weight in] advanced theory. This is the assumption that economic actors are rational in the sense that they optimize…." (Nelson and Winter 1982, pages 7-8).
The upshot of all this is that we have no value-free method of determining what economic policy should be trying to achieve. We are therefore left with the need to use judgement, informed by empirical data of various kinds, to decide what we should be trying to achieve through economic policy, and how it might best be achieved.
Many authors who write about economic development tend to the view that a key objective of economic policy should be to achieve growth in material well-being, which we proxy by growth in income per capita, and that the primary way that should be achieved is through increases in income per hour worked. Two examples are:
- Baumol suggests that "the capitalist economy can usefully be viewed as a machine whose primary product is economic growth" (Baumol 2002, page 1).
- The recent World Bank work reviewing the lessons of the 1990s, emphasises the need to have a growth strategy and not just focus on economic efficiency (World Bank 2005, page 10).
I concur. It is clear that productivity growth has been fundamental to material wellbeing. It dwarfs other reasons for gains in material wellbeing. (In contrast, static efficiency gains are generally estimated to be tiny). Economic evidence suggests that, over the longer term, productivity growth is responsible for all but a small fraction of a country's growth in income per capita. (Baumol 2002, page 3). From 1820 to 1998, income per head in the developed world grew about 19 times, after adjusting for inflation (Maddison 2001). Most, if not all, of this growth has come from improvements in productivity.
Our approach of using growth in income per hour worked as the objective of economic policy approach clearly relies on judgement in application35, since not all approaches to implementing it will be equally desirable. Often it will lead to conclusions that are consistent with traditional neo‑classical analysis. And often neoclassical analysis will be useful for isolating issues that need to be addresses, as outlined in the main body of this paper. But to act as if the first fundamental welfare theorem is more or less right will often be seriously misleading, particularly where innovation and economic growth is involved.
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