AN ECONOMIC DEFENSE OF LIBERALISM
A capstone project submitted in partial fulfillment
of graduating from the Academic Honors Program
at Ashland University
Markets are not perfect. They are vulnerable to failure, they can be inefficient and they are not inherently fair. My thesis “An Economic Defense of Liberalism” argues government can be used to fix the problems of a completely free market. Government can prevent markets from failing, it can make markets fairer and in some cases it can actually make markets more efficient. The paper justifies this using sound economic theory. Conservative microeconomic theory and more liberal macroeconomic theory are used to demonstrate both the advantageous and necessities ofgovernment involvement in the market. It argues an economy is maximized when there is a healthy mix between the free market and prudent government involvement.
In recent decades, the term liberal has lost its true meaning. It has taken on negative connotations, and in many ways it has become a pejorative term. Liberal is synonymous with a big government, tax and spend socialist. However, that is a mischaracterization of liberalism. Liberalism was not always viewed the way it is today. From post World War II up until 1980 liberalism was the dominant political theory in this country. The purpose of my thesis is to defend the true meaning of liberalism. It is to defend the core principles of liberalism. It is to demonstrate that liberalism is still very much relevant in today’s society. And it is to demonstrate liberalism leads to economic growth.
I begin by providing a true definition of liberalism, and explaining its core principles. The principles of economic fairness, equal opportunities and smart government involvement are the heart of liberal theory. I then turn to the microeconomic theory of public finance; here I strengthen the liberal argument by using liberal principles to solve the problem of market failure. I argue government can be used in areas where markets are inefficient. I then justify liberal principles with macroeconomic theory. This only further demonstrates the role government has in the economy. From here I move on to what is known as behavioral economics. This is an area of economics that argues humans are not always rational. Government has the ability to push people to become more rational. The discovery of behavioral economics adds a psychological backing as to why government involvement may be necessary. After establishing, that economically speaking, government has a role in the economy I look at countries with greater government involvement than the United States. Many of these are Northern European countries. They all have greater government involvement, and have better results in areas like health care and education. Finally, I look at two problems the country currently faces; making Social Security solvent, and reducing greenhouse gas emissions. I offer liberal solutions to both of these problems.
Liberalism’s Core Motivation
Post World War II American politics through 1980 was dominated by liberal ideals and important liberal politicians such as Franklin Delano Roosevelt and John F. Kennedy. Liberalism was the main practice of this era and its principles resulted in arguably America’s most prosperous time. What were these liberal principles and ideals that brought about such prosperity? And how did they differ from their conservative counterparts?
Liberalism is the idea that society should be fair, people should have equal opportunities, and government involvement should work to satisfy these ends. The notion of fairness being paramount to a society is important to the liberal argument. The reason: even if markets worked perfectly and even if they operate at optimal efficiency that does not mean they are fair. Conservatives claim pure capitalism and free markets always work and they may be correct, but it is not clear whether markets are always fair.
One of America’s most prominent political philosophers, John Rawls, argues fairness is creating equal opportunities for all citizens (Rawls, 1971). This may require helping the most disadvantaged citizens in order to give them an opportunity to succeed. According to Rawls, fairness is best achieved if decisions are made behind a “veil of ignorance.” Rawls argues that all rule and policy-making should be conducted behind a veil of ignorance where each is ignorant of their social, financial and political ranking within society (Rawls, 1971). This needs to be done to ensure policies and laws are in the interest for all people and not just for the existing power structure. Rawls argues when decision-making occurs behind the veil people will tend to choose the option that either results in the greatest gain or the fewest negative consequences for the most disadvantaged in society (Rawls, 1971). This creates a fairer system because individuals pursuing their self-interest will make the best society for everyone because it is possible they could be born disadvantaged. For Rawls, a society designed behind his veil of ignorance is fair.
Designing an economy behind the veil of ignorance is ideal for a liberal. The veil of ignorance provides a framework for fairness in an economy by ensuring equal opportunities. It is not clear conservatives consider the goal of equal opportunities guaranteed by government as ideal. Conservatives emphasize freedom and private property as the starting point for the good society. This is not equivalent to striving for the type of fairness achieved in an economy through the veil of ignorance.
Rawlsian ideals provide Liberalism with a solid philosophical foundation. Rawls argues a truly just society is one where fairness for all is paramount, and therefore society should strive for fairness regardless of a person’s social or financial ranking. The veil of ignorance is optimally used when those behind the veil have substantial decision-making power. Although, people cannot actually go behind the veil of ignorance, those in power, i.e. government, should use its principles. So if the government were to operate on the principles of the veil of ignorance then Government can be used to create a society where fairness is prevalent. This is what liberalism and liberal thinkers in the twentieth century promoted: Government as a positive factor in the economy. Liberalism at its core is about economic fairness. This means individuals should have equal opportunities to pursue happiness. By giving every individual a chance to be successful the result is an overall better society. This does not mean government handouts or socialism but rather an economy where all people have equal opportunities and chances to succeed. Liberalism wants to achieve this with the most efficient mix of public and private systems.
In his recent book, American Liberalism: An Interpretation for our Time John McGowan explains for society to be more successful we must look to the successes of liberalism in the past. He explains liberalism has always tried to mix realism with idealism (McGowan, 2007). This is important because he is not arguing that liberalism is simply about more government spending, more government regulation or more overall government involvement in the economy. Rather liberalism has an idealistic mindset constrained by realism. Liberals recognize that economies have flaws that need realistic solutions.
Liberalism believes men are not perfect and an ideal society cannot be achieved through atomistic individuals pursuing self-interest. The founders understood this principle and thus set up a system of checks and balances (McGowan, 2007). The founders understood the need for regulation and set up our democracy with rules that constrained the self-interests of our government’s various branches (McGowan, 2007). Liberalism believes in extending this same intellectual framework to the economy. Liberalism is not socialism or communism. It understands a completely ‘free market’ at a minimum requires some rules and regulations. Liberalism argues for a mixed economy where government works to enhance market outcomes and curb potential problems, which would result from an unregulated market. Fairness in society is best achieved by a market-based economy with smart government involvement.
Liberalism believes that government involvement in the economy is necessary in order for a market-based economy to achieve fairness. Government is the only entity large enough and powerful enough to have an impact on the economy and society as a whole. Liberalism is for achieving a fair society while still maintaining a healthy capitalistic economy.
American historian Arthur Schlesinger, in 1956, laid out the differences between conservatives and liberals. Schlesinger argued liberalism is about improving society by using our ability to reason and think through problems to solve the difficulties a society faces. Conservatives, he argues, oppose change because conservatives believe change is more likely to do harm than good (Schlesinger, 1956). He also notes conservatives are especially against any change that attempts to redistribute wealth.
Schlesinger also argues liberalism is not strictly about government involvement, it is about achieving a better society. In a Rawlsian sense, this means creating a fair society. Schlesinger believes when the economy is operating unfairly for individuals then government should use its power to correct that unfairness. This could entail changing the tax code or government funded projects. From the liberal perspective all options, legal under the Constitution, are viable if they are directed at the goals of economic fairness and equal opportunities, of course constrained by their impact on economic growth. As Schlesinger states, liberalism is about being “faithful to the goal rather than to the dogma”.
In 1960, the iconic liberal president John F. Kennedy gave a speech explaining liberalism. His basic message was the liberal party is not about platforms or talking points like conservatives, but rather our goal should be to make a society that “cares about the welfare of the people – their health, their housing, their schools, their jobs, their civil rights and their civil liberties” (Kennedy, 1960). It is not about individuals and corporations gaining more share of the wealth at the expense of everyone else. Conservatives argue individuals should be able to use their private property in order satisfy their own ends. Liberals do not disagree with this, but liberals believe when people are successful it is in part because society has made it possible. Therefore, it is not unfair to divert a portion of the incomes of successful people to help their disadvantaged fellow citizens. This view is not an attack on successful individuals, but rather an attempt to give more people more opportunities. Liberals believe this will lead to a more prosperous economy.
Similar themes arise throughout all liberal thinkers. The main themes of liberalism are not set ideals but rather it is a broader understanding of how an economy and society should operate. It realizes change is not only necessary but should be sought after in order to continue the betterment of society. Liberals are willing to sacrifice some economic growth in order to increase fairness.
Also, there is evidence that a fairer economy, one where there is not large income inequality, actually grows faster than one where wealth is concentrated in a small percentage of the population (Burman, 2012). In the United State’s, the top one percent of Americans earn around 23 percent of the income. In the 1950s, 1960s, and 1970s that number hovered around 11 percent (Appendix 2). Some have argued that this misdistribution of income is leading to slower U.S. growth because poor families invest less in their children, making them less productive workers (Burman, 2012).
Conservatives only see government programs as a zero sum game. Liberals see government programs as having the potential to achieve greater fairness, a healthier economy, and a more stable political order. Higher tax rates on high income Americans designed to help their struggling fellow citizens cannot be said to be unfair if fairness is synonymous with equal opportunity. This is especially true given the emerging evidence suggesting the prosperity of a person’s parents has profound effects on that person’s own future well-being (Krueger, 2012). The benefits of redistributive government programs do not end with increasing fairness. As suggested earlier, good arguments exist for linking fairness to more rapid economic growth. One final benefit of a fairer society, often ignored by conservatives, is the relationship between fairness, civility, and sound public policies. When humans fail they do not crawl under a rock and die. Often they react to their failure by committing more crimes and support more populist policies some of which are economically irrational (i.e. trade restrictions)
John Maynard Keynes was a prominent twentieth century economist and Keynesian economics is a wholly liberal view of the economy. It is about doing what is necessary in order to achieve a desirable society. Not only is Keynesian economics considered liberal, but also Keynes himself was a liberal. Keynes gave a speech titled “Am I liberal?” where he laid out what it means to be a liberal. Like most liberal thinkers his idea of liberalism starts with the premise that past decisions and policies are not sacrosanct (Keynes, 1925). Past events and historical traditions represent just one possible solution to today’s problems and issues. This reiterates a theme present in all liberal thought: the liberal party should not be a party of set assumptions and ideals. It should be the party that tries to correct errors from the past by looking to the future for solutions.
Further, he believed the liberal party should embrace government involvement rather than think of it as a drain to society (Keynes, 1925). Keynes felt the government should actually be involved in more sectors of an economy. Although Keynes gave this speech in 1925 it is still widely relevant in today’s politics. What divides American political parties is how much government should be involved in our lives. Issues like abortion, gay marriage, healthcare, Social Security, tax codes and many others divide the parties. Each party wants more or less government in each issue. Keynes and other liberals argue that government should use its power on issues where it can make the biggest difference and create the fairest society. Liberals want government interference in unfair markets. This is in accordance with the goal of creating equal opportunities with its attendant civil and economic benefits. Conversely, some conservatives want government interference in ‘bedroom’ issues. They want to ban gay marriage and outlaw abortion. It is interesting that the party who argues for personal freedom and accountability are in favor of restricting a person’s individual freedoms.
We currently have high unemployment, millions without healthcare and unprecedented income inequality. Liberals see this as unfair and detrimental to society. Liberals argue that these are problems markets on their own cannot cure and advance the proposition that only through smart government policies can they be mitigated.
Markets Fail: Government Can Help
In this chapter, I want to further argue for liberalism by linking liberal policies to what many consider a conservative school of economics known as Neo-Classical Economics. This might sound counter intuitive, but it is not. It turns out that some of the strongest arguments for liberal policies can be found in a branch of microeconomics called public finance. Public finance studies the economic extent of government, its financing and the logic of public choice options. In the previous chapter, I agued even if markets always worked efficiently they could still be unfair, therefore requiring government involvement. The fact is markets do not always operate efficiently. Public finance recognizes various forms of market failure. Markets fail when they do not operate efficiently. The principal measure of efficiency in public finance is Pareto efficiency (Backhaus, 2005). A Pareto inefficient market is one where it is possible to make one human better off without making another human worse off. In order to determine if a market is Pareto efficient there must be voluntary exchange, free entry and exit into the market and complete information. Markets that are Pareto inefficient are subject to fail. There are three forms of market failure, which are relevant to this discussion: public goods and the free rider problem, externalities and asymmetric information.
Public Goods and the Free Rider Problem
Public goods are typically defined as non-rivalrous and non-excludable (Grosen, 2008). Non-rivalrous means the value of a particular good is not reduced when some other person or thing uses the good (Grosen, 2008). Non-excludable means preventing someone from using the good is either impossible to do or incredibly expensive (Grosen, 2008). In economics, a lighthouse is typically used to illustrate a public good. Lighthouses are used to warn ships of the oncoming shore and they are both non-rivalrous and non-excludable. It is non-rivalrous because when one ship uses the lighthouse the value of the lighthouse is not decreased for another ship. It is also non-excludable because preventing a ship from using the lighthouse is difficult to accomplish. It would be almost impossible to prevent one ship from using the lighthouse while allowing another ship to use it. Public goods are different from other goods in this sense because it is difficult to charge people for use of the good. This is why government provides many of the public goods we have.
An easier way to understand public goods is to ask whether or not a private company could make a profit from a public good. Since the company cannot effectively charge people it is difficult for a company to bring in enough revenue to cover its costs. With public goods there will always be free riders. Free riders are those who use a good, but do not pay for it (Grosen, 2008). Take a private lighthouse company who wants to charge the ships that use the lighthouse. Some of the ships may pay the company, but there will also be ships that choose not to pay for the lighthouse. Those ships still benefit from the lighthouse but they did not pay for it; they are free riders. Free riders cause the market for public goods to fail because not enough people will pay for the good who benefit from it. So in effect, public goods provided by private companies will always be underinvested in. Due to free riders in a market, a company will never receive enough revenue to satisfy the demand for the good. This can be seen as a failure in the market. Government can provide public goods more efficiently because government will not under invest in public goods and has the ability to overcome the free rider problem. Government has power, like the ability to levy taxes, which gives it the capabilities to capture income from a larger population in order to fund public goods and avoid the free rider problem.
The strongest argument for public goods to be provided by government is national defense. National defense is almost entirely provided by the government. The defense department is actually the largest employer in the world at 3.2 million people (The 10, 2012). Typically national defense is understood as one of the United States’ most crowning achievements. National defense, however, is a public good. Regardless of whether a person fights in the military or works in the Department of Defense he or she receives the same national security as everyone else. Liberals argue private companies could not achieve this same level of security.
Take an example of a neighborhood cul-de-sac whose inhabitants want to hire a security guard to watch their homes. Imagine if only half the neighbors pay for this new security guard while the other half does not. The non-paying neighbors are free riders because they receive the same security as the other neighbors mostly due to the security guard being a deterrent to crime. The market is Pareto inefficient. The neighbors who paid for the security service are now better off and so are the neighbors who did not pay for the security service. Now, if the security company is protecting more houses than it is being paid for, and if this happens on a larger scale then their revenue will not be able to cover their costs. So the security market fails due to the free rider problem. Government has enough resources and capabilities to overcome the free rider problem while still providing the highest level of national security as possible.
Government involvement is necessary in certain markets due to its ability to provide public goods. Government is also able to create a more efficient market for public goods like in the case of national defense. A private national defense system would not operate as efficient as a public one.
Some conservatives argue public goods could be better provided by charities. If taxes were lessened then people would be willing to spend that extra money towards private charities that would provide public goods. Conservatives like this because it gives people a choice and allows the free market to dictate what public goods a society will receive. It also removes power from the government and puts it in the hands of the private sector. This is optimal for the conservative because it sets up a marketplace for public goods. However, it is unclear whether or not charities could raise enough money to provide a public good. This is because a private system still faces the free rider problem. People would be unwilling to pump enough money through a private system of charities because too many people would realize they are able to reap the benefits of various public goods without having to donate to them. So in effect, public goods provided by the government are far more efficient than if provided by a private company. Government run public goods are closer to Pareto efficiency because government has the power of taxation. Therefore, it can better overcome the problem of the free rider. Eliminating free riders moves a market toward Pareto efficiency. So unlike private entities, government has the ability to reduce free riders and account for them in ways private companies cannot.
Another reason markets fail according to public finance theory is due to asymmetric information or incomplete information. This occurs when either buyer or seller knows more information than the other (Backhaus, 2005). The most common example of asymmetric information is the sale of the “lemon car.” A lemon is a car that is not as good as the salesman makes the buyer believe. In this situation, the seller knows more than the buyer. The sale of a lemon car represents a market that does not have full information, which means the market is not Pareto efficient.
To understand why it is not Pareto efficient the concept of Pareto improvements must be understood. Before transactions take place markets are Pareto inefficient. So when I have $2 and I want to buy bread, and a store has bread and it wants $2 the market is Pareto inefficient because if I give the money to the store and the store gives me bread then we are both better off. So before the transaction the market is Pareto inefficient because it is possible to make both parties better off. However, after the transaction there is a Pareto improvement because now the neither the store nor I can be made better off without making the other worse off. So transactions between parties should create Pareto improvements and push markets toward Pareto efficiency.
In the example of the lemon cars, transactions are not Pareto improvements. Lemon cars are a part of the larger market of the sale of used cars. The used car market has both lemon cars, and cars that are in good condition, sometimes referred to as cherries. The problem is that buyers do not know whether or not they are buying a lemon or a cherry. Say buyers are willing to spend $1000 on a lemon and $2000 dollars on cherry. So on average used cars will be sold at $1500. However, if buyers are only willing to spend $1500, because they do not know what kind of car they will get, then owners of cherries will not put their cars in the market. So we have a situation where bad cars are driving out good cars in the market. The market for used cars now consists mostly of lemons. This means when a person buys a lemon for $1500 the buyer is made worse off while the seller is made better off. This transaction is no longer a Pareto improvement. So the market for used cars fails due to lemons cars and the existence of asymmetric information.
George Akerlof outlines this problem in his famous paper The Market for Lemons: Quality Uncertainty and the Market Mechanism. A few years after the paper was published Congress passed the Magnuson-Moss Warranty Act. The act protects consumers from things like lemon cars. The act upholds warranties on cars even after re-sale (Donovan, 2008). So the burden of payment is taken off the buyer and pushed onto the car manufacturer. Here we see government involvement as a means to control the problem of asymmetric information.
Under the umbrella of asymmetric information is what is known as adverse selection. This type of asymmetric information is relevant in insurance and healthcare. The basic problem of adverse selection in insurance is buyers of insurance are the people who need it most. Let’s take the example of health insurance. Ideally insurance companies would like to be able to charge an average premium to all people. However, if insurance companies did this then the people who would buy insurance are the people who need it most (Belli, 2012). These people tend to have healthcare costs above that average price. Meanwhile healthy people and younger people, or the people who tend to have lower healthcare costs than that average price, would opt out of buying insurance. So if insurance companies want to stay viable they can no longer charge that average price, but instead they have to charge a much higher premium. Since people who buy insurance need the most insurance, insurance companies have no other option then to charge a premium that reflects those extra healthcare costs (Belli, 2012).
This makes healthcare unaffordable to many people and it deters healthy people from buying insurance. Similar to how bad cars drove goods cars out of the market, unhealthy people drive healthy people out of the market. Why this causes problems is because people who cannot afford healthcare can still get sick and people who are healthy can still get in accidents. When this happens people without insurance now require healthcare and cannot pay for it. In 2009 uninsured people cost the insured person an average of $368 more and a family $1,017 more (Dennis, 2009).
Adverse selection is a situation where the people who need healthcare are the ones who purchase the most (Belli, 2012). This creates higher health care costs in general, which pushes low-income and healthy people out of the market. When those people without health insurance need emergency care and cannot afford it, hospitals and patients are forced to pay for those costs. This only further increases the costs of health insurance. Our current health care system suffers from this problem and it contributes to America’s high healthcare costs.
A possible solution to this problem could be a government run system. Often times referred to as universal health care or a single payer system. Government can make healthcare mandatory for everyone by instituting a tax system into which everyone pays. This eliminates the problem of adverse selection. If every person is in the health care market costs are more dispersed and average costs will be lower (Belli, 2012). If every person is in the market then those who need the most healthcare will not drive up prices like they do under the current system. With universal healthcare adverse selection is not a problem because there is no selection, everyone is automatically covered. So universal healthcare covers everyone, and does it with lower costs then the current system.
Conservatives argue with more people insured it will create inefficiencies due to the increased number of patients needing care. However, our current system takes care of uninsured people, in emergency situations, there is just no funding for it. If everyone is insured all costs are more easily covered. Further, by giving everyone access to healthcare means they have more access to preventative care. This reduces costs because more times than not stopping an illness or disease before it happens is much cheaper. A government run healthcare system can operate much more efficiently than a privately run system, it can provide coverage to more people and it eliminates the problem of adverse selection.
Part of this argument deals with economies of scale but a significant portion of the benefits of a universal health care system are the result of the elimination of adverse selection. Adverse selection drives up insurance costs, which pushes healthy and low-income people out of the healthcare market, which only drives up costs even more once those people require emergency attention. A universal healthcare system takes adverse selection out of the equation and the result is an overall more efficient system.
Externalities in public finance theory are unintended consequences of an action. They are important to economics because they can be both benefits to people that are not paid for and they can be costs to people that are not paid for (Grosen, 2008). Externalities can be both positive and negative. An example of a positive externality would be when someone gets a vaccine. That person benefits because they will be immune from the disease, but it also helps society because it reduces the chance of the disease being spread. This ultimately benefits society and is a positive externality.
Positive externalities are beneficial while negative externalities impose costs to society. Both can cause market failure though. Normally the biggest negative externalities deal with environmental issues. This is something like a factory that pollutes the water or air. The pollution is a negative externality and the company is not taking the costs of the externality into account. It is incredibly difficult to determine the cost of clean air or clean water.
One option to solve the problem of negative externalities is assign property rights (Grosen, 2008). Let us take a situation where there is a lake in which a factory dumps its pollutants, but the lake is also used for fishing. The polluting factory is harming the lake and killing the fish population, which hurts the fishing company. This negative externality faced by the fishing company is a result of no person or business owning the lake. So the factory is able to dump pollutants without any additional costs. If property rights were assigned to the lake it would reduce the negative externality. If the fishing company owned the lake then it could charge the factory for polluting the lake giving the factory incentive to reduce its pollution. Or it could simply force the factory to stop dumping any pollutants. Conversely if the factory owned the lake and allowed people to fish for a certain price the fishing company would only agree to the contract if the pollution dumped into the lake would not deplete the fish population. So regardless of who owns the lake the negative externality would be reduced so long as property rights are assigned. (Example from Grosen, 2008)
This idea of property rights works if two conditions are met. The first condition is the parties involved in the assigning of property rights must be able to negotiate at a low cost. Second and more importantly the damages or negative externalities must be able to be identified and be able to be prevented legally (Grosen, 2008). This is known as the Coase theorem and it works very well when the decision-making is between two small groups and the externality affecting the groups is isolated to those groups (Grosen, 2008). However, when those conditions are not met it becomes difficult to apply the Coase theorem and even more difficult to find a solution to the negative externality.
Air pollution is one of those problems where the Coase theorem does not apply. Air pollution affects a wide variety of people and can affect other areas of the environment in the form of pollution like acid rain. Further, it is difficult to determine how far wide spread the air pollution is producing negative externalities. Robert Mendelsohn is an economics professor from Yale who has been studying this issue. He has been trying to take into account these negative externalities and actually put a number on them (Planet Money 1, 2011). He developed what he calls GED or Gross External Damages. He says unlike the GDP, GED measures all the negative externalities (Planet Money 1, 2011). Through his research he has discovered that some industries are actually producing more costs in terms of negative externalities than they are producing in benefits (Planet Money 1, 2011). The worst of these industries is the coal industry, which produces massive amounts of air pollution (Planet Money 1, 2011).
How do we deal with negative externalities produced by coal industries when the Coase theorem is not applicable? Mendelsohn says these companies need to be charged the amount they are costing society. This would result in coal factories reducing their pollution. This would be costly and those costs would result in higher electricity bills for people. However, it must be realized that although people think their costs are increasing, on a whole they are not because no longer will the social costs like health care have to be paid for by the people (Planet Money 1, 2011). This system just makes the costs more noticeable, but it does result in less pollution and overall fewer costs to society.
In reality this theory is really pushing for a system, in a case when the Coase theorem does not apply, to charge businesses or industries for the negative externalities they produce. This can reduce costs and if done correctly can set up a market for pollution and negative externalities, which will increase efficiency. The only unbiased entity capable of enforcing and enacting these types of policies, and is able to do the necessary research is government. Therefore government can be used to reduce negative externalities.
Government can also be used to maximize positive externalities. Public education can be viewed as a positive externality. Public education is government-funded education that produces far more externalities than a private education system. The more educated a society is the more productive those people tend to be, resulting in a more prosperous economy and a higher standard of living. There are also other benefits of education like a better school system increases property values. Education creates these externalities and government can be used to maintain these externalities through adequate amounts of funding.
Conservatives want to argue a private system will be more efficient than government run education. However, a private education system will be always be under invested in compared to a public one. In a private system parents invest money towards their child’s education. Parents, unlike government, are only concerned about their child’s education. Parents will only invest the amount of money they feel needs to be invested to provide their child with a good education. They do not care about externalities. Government on other hand does care about externalities. Government will always invest enough money to not only provide every student with education, but also to produce the externalities provided by education. So if we have a completely private system there will not be as many externalities because parents, those paying for the education, do not care about externalities. Government funded education does not face this problem. Government wants to produce externalities because it benefits all of society. A public education system is more efficient and produces more externalities than a private one.
So we know government should be involved in public education because it provides more positive externalities, but also public education is fairer than private education. Public education strives toward equal schooling opportunities for all students. This same goal is not intrinsic to a private system. As previously mentioned, in a private system parents will invest what they feel is appropriate for education. Some parents may not have the same means as other parents or they may not put the same value on education as other parents. In both situations education will be under invested in. Along with under investing, it also sets up a system where those who have the means to a better education will get a better education while some students are left with an inferior one. This means students are not receiving equal schooling opportunities.
Government can solve this problem because government takes parents’ willingness to invest and means to invest out of the equation. Government sets up an education system independent of those issues. Government wants to provide equal schooling to everyone. Therefore, the result is a fairer system where all students receive the same access to quality education, and this arguably leads to more positive externalities. If all students receive a good education then those students will be more productive in the future. The benefits a good school system brings to a community can be maximized if all schools are providing quality education. These externalities created by education stem from education that is adequately funded through government. Only government has the means, the ability, and the willingness to produce all the possible positive externalities that are created by education.
Using government to help society and make it more efficient is a liberal argument. This is not just liberal theory saying liberal policies will work. It is using public finance theory, a microeconomic and largely conservative view, and applying liberal principles to solve the various forms of market failure as defined by public finance. Liberal principles and ideals do more than solve the problem of fairness; they can also make markets more efficient. Liberalism is more than just a Democratic mindset; it is a set of principles that can be applied to problems across the economic and political spectrum.
The Keynesian Revolution
It was previously shown how liberalism and public finance, a conservative micro economic view of the economy, are compatible. However, liberalism must also be looked at from a macroeconomic perspective. The father of macroeconomics was John Maynard Keynes. Keynesian economics is entirely compatible with liberalism, and although some conservatives claim Keynesian economics is dead, the truth is since World War II the United States and the rest of the Western World has steeped its economic policies in Keynesian theory.
Keynesian economics at its core believes professional economists in government should intervene in an economy during times of recession and depression to increase aggregate demand and return the economy to normal (Planet Money 2, 2011). Keynes felt the central issue was unemployment and the role of government is to keep it as low as possible (Planet Money 2, 2011). Government for Keynes was the only entity that could actually decrease bouts of unemployment, especially during a recession. Due to his belief in government, he was a strong advocate for government funded public works projects, which he believed increased aggregate demand and boosted the overall economy.
His theory is based on the fallacies he saw in classical economic models, which argue markets are always striving toward equilibrium where unemployment would settle at a natural and sustainable level (Planet Money 2, 2011). Keynes agreed that may be plausible, but unemployment never did reach this level, which signaled to him that markets if left alone will not just achieve full employment in the short run (Planet Money 2, 2011). Since unemployment rarely reached suitable levels on its own, Keynes saw government involvement as a prudent decision. Government may not solve economic woes entirely but it can ease those ailing in a depressed economy. And it pushes the economy in the right direction quicker than if left alone.
Keynes laid out his theory in what is known as the General Theory. The General Theory laid out the concept of aggregate demand. Keynes argued a drop in aggregate demand causes recessions and it is only until demand increases that the economy will recover (Wapshott, 2011). In a recession individuals are less likely to consume products due to a lack of confidence in the market. This means there are dollars not being spent so government can be used to account for that lack of spending. Spending by the government, when the private sector is unwilling, increases aggregate demand. In relation to aggregate demand is what Keynes called the multiplier effect. The multiplier effect argues a portion of each dollar spent is actually re-spent elsewhere in the economy (Wapshott, 2011). So when government pumps in one dollar to the economy the net effect is much more than just one dollar. Aggregate demand and the multiplier effect are the foundation of Keynesian economics, and they demonstrate how government spending can accelerate an economic recovery.
Many conservatives view Keynesian economics as socialism or anti- capitalism. The fact is Keynes was a not a socialist, he was just a liberal. He never argued that government should own the means of production, which is the basis for socialism. Nor did he view the free market as disdainful. He believed if the free market was operating efficiently and equitably there is no need for government intervention (Wapshott, 2011). Keynesian economics deals with systemic failures in an economy. It is when the economy as a whole is damaged i.e. high unemployment, that Keynesian economics argues for more government. Further, Keynes argued once employment levels returned to normal and there was adequate demand government should hand the reins back to the free market (Wapshott, 2011).
More conservative economists have issues with the Keynesian theory because they feel government spending will only make matters worse. They allege government spending crowds out the private sector and will lead to high inflation rates. Our current recession makes a great case for why those two arguments simply no not apply. The crowding out argument in layman terms is if government is spending a dollar then that means there is a dollar the private sector cannot spend. So the government is crowding out the private sector. This occurs because government spending supposedly leads to increased interest rates, which makes money more expensive and therefore reduces investment. The problem with this argument is interest rates have stayed historically low throughout the entire recession (Appendix 3). For the crowding out argument to actually apply to an economy the economy must be operating under full employment where resource usage is maximized. That is simply not the situation faced by depressed economies. Government spending does not crowd out the private sector because it is spending dollars not being spent.
The other argument against government spending is that it will lead to high inflation. However, government spending has been increasing since the recession hit yet there has not been soaring inflation (Appendix 4). The reason for this is due to the state of our economy. Currently consumer confidence is down, which means even though money is incredibly cheap (due to low interest rates) investment is still down. So we are in a situation where savings is greater than investment, which means the economic recovery requires more investment. This investment can be done with the government without increasing inflation. Currently there are idle dollars in the economy. Both banks and corporations have dollars just sitting there. Government can borrow that money and spend it without inflation being a problem. No new money is being created so dollar values will not drop. Inflation is only a threat with monetary policy, which is controlled by the Federal Reserve not the government. The government engages in fiscal policy, which is not inflationary and can boost the economy. Milton Friedman, a more conservative economist, agrees inflation is caused by the Fed not the government. So the criticisms of Keynesian economics during a recession, that of crowding out and inflation, are not valid.
Government spending is not as catastrophic as many believe. In many cases government is forced to be the spender of last resort. In a recession aggregate demand is down along with consumer confidence. Buyers are unwilling to purchase goods and the only way to reverse that trend is through spending and investment. Since individuals are hesitant to spend, government must spend as a last resort in order bring the economy back to equilibrium.
This idea of spender of last resort brings out another criticism, which is increasing spending can lead to a crippling national debt. Keynes understood this, which is why he believed in boom times government should decrease spending and work to pay down the debt that was accrued during the recession. That is the basis of Keynesian economics. Government spends during busts and pays it back during booms. The national debt in the short run is not a massive threat to the state of a country. Recessions and depressions are though, so it makes sense to tackle those problems when they ensue and deal with the national debt in the long term. The national debt never has to be totally paid off and a certain amount of debt can actually be good. Worrying about increasing the debt at the expense of recovering from a recession is just bad policy. It is focusing on a long run issue while only acerbating problems in the short run. It leaves the economy as a whole worse off.
Critics of Keynesian economics believe in less government and allowing the free market to work itself out. Conservative economists adhere to theories put forth by Austrian Economists like Fredrich Hayek. Hayek argued government only made economic situations worse because government does not have full information (Wapshott, 2011). Therefore, government at best could only temporarily ease the pain of a recession and just push the day of reckoning to a further point in the future (Wapshott, 2011). Hayek admitted suffering will happen when recessions hit, but the economy will be better off in the long run. Hayekian economics believed allowing the free market to work itself out was superior to government attempts at boosting the economy. This theory allows people to unnecessarily suffer though. Not everyone may agree with Keynesian economics, but it is far more practical. Under the Hayekian model people would starve, die of treatable illnesses, and in many cases be thrown into third world living conditions, all because his theory fears the government, due to its lack of complete information. However, providing food stamps, unemployment benefits, or investing in public works projects to provide people with jobs are all beneficial to people. Contrary to Hayek and conservative economists government can help the economy without causing people to suffer.
Further, those government programs can boost aggregate demand and in turn boost the economy. So Hayek’s fear that government involvement will only delay a recession is not necessarily true. Government can do far more than delay a recession it can actually reverse the trend of a declining economy. It is precisely for this reason our economy is set up with “economic” or “Keynesian” stabilizers (Guitton,2012). These are typically government programs, which automatically kick in once the economy begins to dip into a recession. This is to lessen the fluctuations of the business cycle (Guitton, 2012). When the economy enters a recession, unemployment begins to rise and businesses begin to contract. To offset this people receive things like unemployment benefits and food stamps. In effect, these programs give people money to spend, which boosts aggregate demand and through the multiplier effect boosts the economy as a whole.
Also, there is an opportunity cost to not doing anything about a declining economy. Allowing the free market to work itself during a recession can take a long time, which means the economy is essentially forgoing opportunities to grow in order to stabilize itself. The Keynesian theory recognizes there is an opportunity cost to not doing anything, which why it advocates for government intervention. Okun’s law explains this problem. It argues that for every 1 percent the unemployment rate rises, potential GNP decreases by 3 percent (Okun’s Law, 2012). So when the economy enters a recession and unemployment increases it means we are not capturing future economic growth. The Hayekian model does nothing to combat this loss, while Keynesian’s number one goal is to reduce unemployment. So not only is Keynesian economics more practical, it makes more sense economically speaking because there is less of an opportunity cost lost under the Keynesian model.
In reality our economic system is based on Keynesian principles. And in reality we have not had a president since World War II practice anything but Keynesian economics. Albeit some have been more Keynesian than others, there has not been a true Austrian or Hayekian economist in the White House since World War II. It is interesting conservatives have rhetorically jumped onto the Hayekian bandwagon, but never actually practiced it. President Reagan read Hayek, yet practiced Keynesian principles. During his Presidency Mr. Reagan increased government spending. The federal debt also grew during his tenure (Planet Money 2, 2011). Faced with a recession in his first term, President Reagan grew the economy through expansionary budget deficits. To boost the economy he increased spending, and it worked (Planet Money 2, 2011). The successful recovery came to be known as “Morning in America.” This is a wholly Keynesian principle at which Hayek would be appalled. Further, President George W. Bush also practiced Keynesian economics even though he is considered to be a part of the Hayek camp. He increased military spending, which is increasing government spending (Planet Money 2, 2011). Also, the “Bush tax cuts” unless made permanent are Keynesian in principle. Targeted tax cuts, which is what those taxes are, is a Keynesian idea (Planet Money 2, 2011). Yes, we have had presidents who are not as Keynesian as others, but we have never had a true Hayekian. We have never had a president, since World War II, who truly wanted to limit the size of government in order to expand the economy.
A possible explanation for this is that there is a lack of evidence for smaller government leading to an expanding economy. Yes, the free market operates well during boom times, but during recessions the free market struggles to work efficiently. However, there is evidence that government can help an economy in a recession. The 1930s demonstrates successful real world applications of Keynesian economics. At the beginning of FDR’s presidency he took the advice of Keynes and invested in public works programs (Wapshott, 2011). The result was a steadily improving economy. The good news provoked FDR to lessen government spending. Keynes warned him that the recovery was not complete and now is not the time to rein in spending. Unfortunately, Keynes was correct and in 1938 a year after FDR decreased spending America was back in a recession (Wapshott, 2011). We learned government spending can have a positive effect on an economy and reining in spending too early can be detrimental. This story is entirely too familiar with our current economy. We have seen slow growth and conservatives are now demanding we cut spending. The economy is still fragile and if Keynes were alive today it seems likely he would warn cutting spending now would only lead to a deeper recession.
So not only is liberalism in accordance with conservative microeconomic theory it is the only macroeconomic theory used in this country. The Keynesian theory of using government to help solve economic problems is the basis of liberalism. Liberals view government as a positive factor, and Keynes himself was an optimist about the government. He believed the government when used properly served to the benefit of all people, and failing to use government is irresponsible. Government has the ability to help an economy in ways businesses and individuals are unwilling or unable to do.
The Irrationality of Humans
Within our country’s founding documents is the view that individuals have the capacity to pursue life, liberty and happiness. This is taken by conservatives to mean that government should not stand in the way of individuals’ ability to make decisions. Conservatives argue individuals pursuing life, liberty, and happiness will lead to a more efficient economy. They believe individuals are better equipped to make decisions than the government. Beginning in the twentieth century, first psychologists and now behavioral economists have begun to study the degree to which individuals make rational choices. The overwhelming evidence is that individuals have cognitive limitations and biases when making decisions. So, conservative’s call for government to get out of the way so individuals can make more decisions may be misguided. Many areas such as mortgages, credit card contracts, retirement plans, and investment options are complex and many times require outside expertise. More and more evidence has shown humans tend to act irrationally, and if that is the case then there is solid reasoning for government to aid in decision-making.
Behavioral economics has demonstrated people are not completely rational. Humans make wrong choices and are easily swayed in their decision-making. The significance of this discovery is detrimental to all economic models because those models assume humans are completely rational agents (All Things Considered, 2009). Our economic models “assume that the agents in the economy are as smart as the smartest economists,” this is just not possible (All Things Considered, 2009). If individuals are not making rational decisions then it is impossible for a free market to ever work efficiently and equitably.
Behavioral economists have done multiple experiments to illustrate that humans do not always act completely rational. Daniel Kahneman and his colleague Amos Tversky coined the term the “illusion of validity.” It is the belief that one’s own judgments and decisions are always right. The two found people typically assumed their original ideas or instincts were always correct and they held those convictions even in the face of direct evidence against their beliefs. This is problematic in a free market society. If people are irrational in their decision making process with regards to savings, purchases or investments then a free market cannot be expected to work efficiently. Put simply, markets fail when individuals do not act rationally.
Besides acting under the illusion of validity humans are also affected by what Kahneman and Tversky call “anchoring bias,’ The theory is that subconsciously the numbers we see affect us (All Things Considered, 2009). The example Kahneman and Tversky use is in credit card bills. The minimum payment is often very low, which biases people’s decision on how much of the bill they should pay. Since it is set low it entices people to pay a lesser amount. This could be a contributing factor as to why private debt continually grew leading up to this most current recession. Human’s vulnerability towards numbers causes them to act irrationally. A possible solution to this is setting higher minimum payments. A higher minimum payment would actually lure people to pay a more reasonable amount. Here we see how irrationality can be fixed by a simple regulation. It is possible for government to make people more rational.
Another area in behavioral economics is people’s perception of losing. Behavioral economists have found people feel worse about losing than they feel good about winning (Planet Money 3, 2012). A study was done where people were asked to make a bet on a series of coin flips. If it comes up heads they win $6 and if it comes up tails they owe $1. At this point most people agreed to the wager, but as the amount they owed started to increase more people began to decline the offer. At around $4 dollars most people decided they no longer wanted to take the gamble (Planet Money 3, 2012). The problem with this is that it is irrational to not take that bet. Mathematically a person should take it every time because more than likely over time a person would make money.
What the researchers discovered is people stopped taking the bet due to how individuals perceive losing. Losing the $4 dollars affected people more than winning $6. If people acted totally rational, like economic models assume, then people would continue to take a gamble on the coin flip. A hyper rational person would realize winning the $6 increases utility more than losing $4 decreases utility. However, humans act more on emotions than on rationality.
The study related this to the current housing market. In the current recession the housing market is down partly because of this perception of losing (Planet Money 3, 2012). Normal economic theory would suggest that in a recession prices will go down and the market will work itself out. This requires the seller to undersell the house. This is perceived as losing. So the seller refrains from selling the house, which creates an excess of supply. Since people are not willing to undersell the market continues to stay in a slump. Demand is also down because housing prices are set higher than the market value, so fewer people are willing to buy. The slump in many ways is being caused by irrationality. A rational person would realize the market is down and therefore prices are down and should be willing to sell their house at what the market dictates. People are not acting in accordance with our typical economics models. So it is not surprising the housing market is not recovering, as economists would expect.
If humans are not acting rationally then there is an argument for government involvement in an economy. We know people do not always make rational choices and their decisions may be swayed by unreliable information. Human’s irrationality and our cognitive limitations are partially responsible for market failure. Since people are irrational actors it makes sense for government involvement. Government can help individuals to act more rationally so the markets in which they participate are made more efficient. Government can correct these problems through regulation or taxes or actual government involvement. Now it should be noted this is not socialism. This is not a pitch for government takeover. Rather it is a pitch for government to intervene in markets to make them more efficient or more equitable. If a market is doing that on its own then the government should not intervene. However, it is precisely because some markets are controlled by irrational individuals that they fail.
Now, one counter argument to this theory is that government is made up of people who are also subject to make irrational decisions. Therefore, there is no reason to assume any government decision is any better than a decision made by an individual or business. However, the same argument cuts both ways. The free market is made up of irrational actors who are just as apt to make poor decisions that make situations worse. Hayek feared government involvement because he argued it would only make matters worse, but persons acting in a wholly free market are arguably more dangerous.
Government has made poor decisions; however, it has also done a lot of good as well. The point Kahneman makes is that the government does not have to be this ultra rational decision maker. Government can make economic models hold true by pursuing policies to increase rationality. Government can create laws and policies that act as an incentive for people to act more rational. He uses an example of the London government intervening for the better. In crowded London intersections with a lot of American tourists many Americans were being hit by cars because the traffic goes in the opposite direction. So the government put a sign at those busy intersections saying, “look right” (All Things considered, 2009). The problem was a simple fix but it demonstrates government does not have to be super rational to make a difference and government can actually make people more rational.
This is an example of what is known, in behavioral economics, as “nudge” theory. Nudge theory purports that government can nudge people in the right direction (The Economist, 2012). In England, the government has simplified the language on car taxes to basically say, “pay your tax or lose your car.” This simple “nudge” doubled the amount of people paying their car tax (The Economist, 2012). In Denmark, government put green footprints leading to trashcans and the result was a reduction in litter by 46 percent (The Economist, 2012). And in America, a study was done where people were told the energy consumption of their neighbors. Those who used greater energy actually reduced their output after learning about their more energy efficient neighbors (The Economist, 2012). We begin to see how government can push people in the right direction to be more rational.
The difference between government and individual people is that government is not some homogenous body that makes every decision. Government is made up of people who may not be hyper rational, but can be experts in various fields. Government can hire expert economists to make decisions regarding the economy. Government can hire expert doctors or bankers to solve problems in their respective fields. So government can create policies and regulations based on advice from people who have dedicated their cognitive resources to specific fields.
Our government has shown an ability to do this throughout history. There have been many successful government programs in recent decades. The government has invested in NASA. Government invests in many other areas of research and development. It has given funding to the entities where the most progress can be made. The government has built roads, bridges and buildings based on expert engineers. The government does not have to be hyper rational to have an impact. Government can delegate to those who are hyper rational. The government has the ability to better the economy and the society through a combination of foresight and rationality.
Recently President Obama appointed a new director to the Consumer Financial Protection Bureau (Wagner, 2012). The CFPB’s goal is to help people make better decisions. It is essentially a government agency meant to “nudge” the financial sector in the right direction. One goal of the new agency is to make mortgages easier to read. This will prevent people from agreeing to loans, which they are unable to afford. The government can create policies like this, which pushes people to make more rational decisions. Government has the ability of oversight in a market to direct the market towards a path of rationality. The free market alone cannot do this.
Behavioral economics demonstrates that humans by nature have cognitive limitations, which leads to irrational decision-making. With this understanding, a completely free market where individuals make all the decisions is obviously not ideal. Government can help to remedy the problems caused by irrational individuals. Unlike individuals, government has the power of oversight and regulations. And unlike individuals, government can hire experts in various areas to create policies that make people more rational. So not only does government have a role in the economy economically speaking, government may also be needed due to psychological reasons. So really, government can bring markets closer to their optimum theoretical point, than if markets are left alone.
Success in Europe
The previous chapters have demonstrated, economically speaking, there is a role for government involvement in the economy. They have also shown that humans are not entirely rational, so a completely free market cannot be expected to work efficiently or fairly. Further, government has the ability to increase individual’s rationality, which can make markets more efficient. The story thus far is government can help an economy when markets are unfair or inefficient. Conservatives may concede government can do good things, like in national defense, but that does not mean we should strive for more government involvement. Conservatives still believe less government is better. The fact is though there are many countries that have much more government involvement in their respective economies and they have much better results.
We always hear about the European financial crisis and assume Europe in general is doing poorly right now. Although many European countries are struggling, many of them are doing fine. They are in fact doing better than the United States with substantially more government involvement. European countries like Denmark, Germany, Finland, Norway, Iceland, The Netherlands and United Kingdom all have higher government expenditures as a percentage of GDP than the United States.
|Country||Government Expenditures as Percentage of GDP|
Source: Heritage Foundation (2012)
Now if we look at an area like healthcare all these countries outperform the United States in basic measures like infant mortality and life expectancy.
|Country||Life Expectancy at Birth||Infant Mortality Rate |
Source: Human Development Report (2011)
Further these countries all have government run healthcare and their overall expenditures on healthcare are less than in the United States.
|Country||Public Expenditures on Health Care as a Percentage of GDP||Per Capita spending on Health Care|
Source: Human Development Report (2011); OECD Health Data (2011)
The United States spends way more on health care as a percentage of GDP compared to a lot of European Countries and we also spend more per capita than these other countries. Yet these countries have better results. This tell us when done properly government run healthcare can be more cost effective with better results.
The truth is the United States is falling behind in a lot of areas where other countries are doing much better. The United States’ high school graduation rate is 77.5 percent. Comparatively Germany’s rate is 99.5 percent. Finland (96.8), Norway (91.9), The United Kingdom (88.7), Iceland (85.9) and Denmark (85.4) all have a higher proportion of high school graduates than the United States (Clinton, 2011).
Along with lower graduation rates than many of these countries the students in these other countries outperform American students in math and science. The Program for International Student Assessment (PISA) measures students in these areas among many developed countries. America’s scores are among the lowest of these European countries. America has the lowest among math scores and only beat out Norway and Denmark in science scores.
|Country||Math Score||Science Score|
Source: Bill Clinton Back to Work: Why We Need Smart Government for a Strong Economy (2011)
So our graduation rates our lower and our students are not performing as well in areas that really matter like math and science.
Along with a below average healthcare and education system, America is slacking in environmental standards. The United States emits more carbon dioxide emissions per capita than any of the aforementioned Europeans countries. This greenhouse gas is one of the main drivers of climate change today.
|Country||Co2 emissions per capita in metric tons|
Source: Energy Information Administration (2006)
Another measure of the environment is known as the Happy Planet Index. This index takes into account things like life satisfaction and ecological footprint. Their website says, “it represents the efficiency with which countries convert the earth’s finite resources into well being experienced by their citizens.”
|Country||Happy Planet Index|
Source: Happy Planet Index (2012)
So we see all of these European Countries have a higher Happy Planet Index, and they produce fewer emissions per person. This means they are producing better, more environmentally friendly results with their resources than the United States.
Critics of Europe claim all their government spending has led to a massive debt that is crippling the country. This fallacy is driven because critics address Europe as if it is one homogenous body. The fact is, yes, some of Europe is struggling, and some country’s debt is creating massive problems. Greece, Ireland and Italy are examples of this. However, some countries, like the ones I have been pointing too, are doing quite well without a burgeoning national debt.
|Country||Government debt as a % of GDP|
Source: CIA World FactBook (2012)
We see Denmark, Finland, Norway and the Netherlands all have lower debt as a percentage of GDP. Other countries like United Kingdom and Germany have a higher percentage of debt to GDP but it is not unsustainable. The only country with a possible problem with its national debt is Iceland. However, this is mostly due to the most recent recession. Iceland was the seventh hardest hit country by the recession, but is actually coming out of it quite nicely (Darvas, 2011). Their unemployment rate is at 6 percent, which is 2.1 percent lower than in 2010, and is lower than the United States’ unemployment rate. In fact all of these countries have lower unemployment rates than the United States.
Source: CIA World FactBook (2012)
It has been shown that many European countries are doing better than the United States in various areas, but the most startling area where the United States is failing is in social mobility and income inequality. Social mobility is the ability to move from lower class to upper class, and income inequality is the share of wealth held by the wealthy as compared to the share held by the lower class. If we look at the Gini Coefficient, which measures income inequality, we see America is at the bottom of this list. The Gini coefficient is measured on a 100-point scale where zero represents perfect equality.
Source: Bill Clinton Back to Work: Why We Need Smart Government for a Strong Economy (2011)
This is also important because government essentially redistributes wealth. It takes tax revenue from some area of an economy and directs it to another area of the economy. So it is not surprising the countries with more government involvement have less income disparity. Just to put America’s score in perspective with the rest of the world; the Gini Coefficient of China is 41.5, Cameroon is 44.6, Iran is 44.5, Kenya is 42.5, Mali is 40.1, Nigeria is 43.7, Uganda is 44.3, and Venezuela is 41. These countries are obviously not models for America; it shows how skewed our income disparity is when Iran has more income equality than us.
This is something that needs fixing because economic growth becomes much more difficult when the rich are getting richer and the poor are getting poorer. Poor people cannot purchase as many goods, they do not receive as much education and they are not as productive. All those things lead to a stagnating economy where a small percentage of the population does very well at the expense of middle class growth.
This is exactly what is happening in America though. We see since the 1980s income disparity has exponentially increased. The most recent demonstration of this came from a CBO study from 2011, which showed the top 1 percent of people’s income grew by 278 percent compared to only 18 percent growth in the lowest quintile (Krueger, 2012).
And when we look at annual growth rate of income for families, the prognosis for the lowest quintile is even worse.
Here we see income for families in the upper quintile have seen their income grow by 1.2 percent each year compared to the lower quintile who has seen a drop in real income by .4 percent each year. It is important to note this is not some continual trend in America. This started in the 1980s (coincidentally when income tax rates were being slashed). Prior to the 1980s and after World War II the rich did not see their income increase as rapidly as it is now (also coincidentally when Keynesian Economics was at its peak).
We see the top 1 percent’s and even the top .1 percent’s share of the income earned stayed relatively constant. Then in 1980 the richest in the country began earning a larger percentage of the income. So when there was less income inequality, in the 1950s and 1960s, the middle class prospered. Then when the rich began getting richer in 1980 middle and lower class growth stagnated.
This growing income disparity is having significant effects on our economy and on our country in general. Income disparity makes social mobility more difficult to accomplish.
This graph represents social mobility. It is taken from a study done of all OECD countries. The X-axis has the Gini Coefficient of each country in 1985, and the Y-axis has intergenerational earnings elasticity. This measures how much of an effect a parent’s earnings have on the earnings of their children. A higher numbers means a parent’s earnings have a greater impact on their children’s earnings. Basically saying it is more difficult for poor children to become rich because their parents were poor. The further to the right and the higher up means less social mobility. We see America is among the worst in social mobility in developed countries. In fact only the United Kingdom is even in the same ballpark as America.
This is significant because it represents the American Dream. The dream of growing up with nothing and becoming something is harder to do in America than in most developed countries (Krueger, 2012). What was once America’s greatest characteristic has now been transferred overseas to countries like Denmark, Norway, and Finland. It is not just coincidental that these countries, with greater government involvement, have greater social mobility. Government when used correctly makes markets fairer for everyone and can provide everyone equal opportunities. No longer is that happening in America, and it is in my view that America should learn from the successes of other countries. It is in my view the most efficient and effective way to solve our problems is to embrace smart government and not regard it as evil. And it is in my view that until we rid the idea that all government is bad, many areas of our economy will continue to fall behind.
Solving Today’s Problems
Behavioral economics, public finance and macroeconomic theory all prove there is a role for government in an economy. Government can be used to make markets more efficient, more equitable, and incentivize people to act more rationally. More government in an economy has also shown to be successful as was demonstrated with many European countries that had greater government involvement and better results. Government clearly has a role in the economy and an increase in government should not be feared. Our country faces many major problems and it only makes sense for government to be involved when it can help. There is a strong argument for government to be used in various market places.
One use of government should be in a government mandated retirement system.
The current retirement system is known as Social Security and since its beginning it has provided millions of elderly Americans, widows, disabled people and children financial support. There is a national concern Social Security is a failing system that is draining our economy. However, up until 2010 the Social Security program ran surpluses, which were used to service the national debt or invest in things like national works programs (Grabianowski, 2012). When the recession hit Social Security tax revenues declined, which caused the program to begin running a deficit. Even if nothing is done Social Security will remain solvent up until 2037 at which point the taxes collected will only pay for 78 percent of the benefits (ABC World News, 2011). So although Social Security’s future is not as bleak as some politicians would like us to believe the program does need fixing.
Social Security is one of the most successful government programs. The basis of Social Security is that it collects payroll taxes of 6.2% on all income up to $106,800; employers also contribute 6.2% (Agresti, 2012). Now, when tax revenue exceeds the benefits paid out that surplus of money is put into the Social Security Trust Fund. By law that money can only be lent to the federal government that then uses it pay off debt, or fund other national programs. Recently there was an extension of a payroll tax cut, which is being funded by the Social Security Trust Fund.
Social Security began as simply a retirement plan but has transformed into much more. It is now a safety net for widows or children with deceased parents. It also covers disabled people, and has kept millions of elderly Americans out of poverty. When the recession hit, poverty numbers rose yet the poverty numbers among seniors stayed relatively constant in part due to Social Security (politifact, 2011). Due to its success maintaining a government mandated retirement program is a necessity. And the overwhelming majority of people want to keep Social Security. A recent Harris Poll found that only 12 percent of people want to see Social Security cut (UPI, 2012).
Archconservatives would like to see a private Social Security system. This could mean two different options. One would be completely private where individuals choose how much they want to save and they alone would save for their own retirement. As behavioral economics has demonstrated people will not always choose to save money or save enough money for retirement. Under this system there is no social safety net and this option is really not being purported by any politician.
However, there is a second version of a private Social Security system. This system still mandates a certain portion of income go to Social Security but that portion is invested. The main problem with this is it subjects people’s retirement plans to the fluctuations of the market. There are ways to combat this problem through diversified portfolios and this option is more reasonable than the former. There is merit to this system, but it still has problems. The biggest issue, besides market volatility, is Social Security funds have been used to pay down the debt or pay for other endeavors in the past. In this system money cannot be used to pay down the debt because the funds not being paid to recipients are tied up in investments.
Another possible solution to Social Security is to raise the amount of taxable income. Currently Social Security is funded by taxes on income up to $106,800. Raising that amount would increase tax revenue and make the program solvent for much longer. When Social Security started 90 percent of all income was taxed (Huff Post Politics, 2011). However, in recent decades middle class income has stagnated while the wealthiest Americans have seen soaring growth in their income. The result is that only 83 percent of income is taxed under the current Social Security tax rate (Huff Post Politics, 2011). To correct this flaw the amount of taxable income must be increased to reach that 90 percent threshold.
Democrats favor this fix; however, Republicans believe this will only hurt other sectors of the economy because it increase taxes on the wealthy or as conservatives claim the “job creators.” However, both parties agree Social Security is a program worth saving and increasing the amount of taxable income is one of the simpler more effective ways of making it solvent. Since it is so effective it only makes sense to tax the wealthy more. Some argue that instead of increasing taxable income to increase the tax rate. However, increasing the rate would only make the already flat and regressive tax more regressive, and would place the burden of funding Social Security on the middle and lower class.
Social Security is in need of reform but there are solutions. It is a matter of deciding on an optimal solution. First, the amount of taxable income has to be increased. It must be increased so the Social Security tax is applied to 90 percent of all income. This is estimated to make up for one-third of shortfall in the program (Huff Post Politics, 2011). Further if there were no cap on taxable income, 95 percent of the shortfall would be eliminated (U.S. News, 2010). So striving for a tax that would cover slightly more than 90 percent of income might be more ideal.
Second, a quasi-private system can be used in order to further close the gap in Social Security. In this system only 15 percent of the revenue will be put into private investments (Huff Post Politics, 2011). The money invested is not individual retirement accounts but rather the money in the Social Security Trust Fund. By investing money from the Social Security Trust Fund it no longer makes individual retirement plans susceptible to market fluctuations. Also, since the investments will be made by the government and not individuals, there is a greater chance the investment will have a positive return. Over time a diversified portfolio with safe investments will almost always yield greater returns. With government doing the investments the time frame for those investments to earn income is much greater than just a single person’s life. This leads to an overall increase in revenue, and allows the solvency of Social Security to last beyond the projected 2037 date.
Finally, we can combine these two ideas to make the system be solvent for decades to come. We need to increase the cap on taxes to ensure at least 90 percent of all income is taxed. That must happen. Then we need to start gradually investing a portion of the income into the market, which should over time increase earnings for the program. Finally, we should put in a “tax as needed” policy (U.S. News, 2010). This would be an increase in taxes on an as needed basis. If the Social Security investments are doing well then there is not a need to increase the taxable income. However, if investments are not doing as well, or revenue declines due to a recession then the tax cap can be raised to make up for the losses. So basically a floor will be set that 90 percent of all income is taxed. The government will also invest 15 percent of the trust fund into the private market. Depending on the solvency of the program and earnings from investments government can, if necessary, increase the percentage of income taxed.
A government mandated retirement system like Social Security is incredibly beneficial to society. The success of Social Security is direct evidence in favor of government involvement. Although it has been successful is does need some reforms to keep it solvent. Liberal principles can be used to solve Social Security. Solving Social Security is a matter of mixing efficiency with fairness and mixing government with the private sector. The program does need money that is fact, so it only makes sense to ask those who are earning more income to pay more into the system.
The program can also be reformed to be more efficient. By allowing a portion of the Social Security Trust Fund to be invested into the market there is the ability to increase revenue in ways other than tax increases. Investing in smart productive assets like stocks can greatly increase revenue in the long term. These ideas can make Social Security solvent for the foreseeable future.
Cap and Trade
Due to our increasing dependency on oil and fossil fuels the planet is feeling the devastating effects of pollution. The increase of greenhouse gases in the atmosphere has caused the global temperature to rise and the vast majority of scientists realize a warming earth will be troublesome for many areas of the planet. The vast majority of scientists also agree the most significant greenhouse gas being emitted by the burning of fossil fuels is carbon dioxide. Government should be used to curb the amount of carbon dioxide being spewed into the atmosphere. Government has to be used in this situation because polluting companies have no incentive to reduce pollution. Methods to cut CO2 can be expensive and businesses do not want to increase their costs. However, pollution is a negative externality that imposes costs to society, which the companies are not paying for. So government has to step in to ensure companies are paying for the externalities they produce, which will push companies to reduce pollution.
There are two main ideas for reducing greenhouse gases; first there can be a direct carbon tax. This places a tax on companies proportionate to the amount of carbon they produce. So it is supposed to act as an incentive for companies to reduce their emissions.
The other mainstream option for reducing carbon dioxide is through a cap and trade system. This sets up a market for emissions and President Obama is currently pushing this as solution. Cap and trade works by establishing a cap on total emissions. The government will determine the cap. Then the government will auction off emission permits, which allows a company to produce as much carbon dioxide as it has in permits. Permits will not be issued that push total emissions above the cap, effectively lowering CO2 pollution. Why this works is because companies who either produce less or invest in “greener” technologies will not have to purchase as many permits and the companies who do produce more pollution can buy the permits not in use by the other companies. It still gives incentive to reduce pollution like a direct tax but it is in a market place fashion, which should make it more efficient.
Cap and trade works efficiently because it combines private and public sector solutions to a problem. Further, it actually has been proven to work in the past. In 1990, the Clean Water Act was revisited and added to the Act was a provision about acid rain. A cap and trade program was enacted to reduce sulfur dioxide (SO2) and nitrogen oxide (NOx). The program worked better than expected. The benefit to cost ratio is estimated at 40:1 while saving people $70 billion yearly in public health expenditures (EPA, 2012). A 2002 study showed that SO2 emissions from power plants were 41 percent less than in the 1980’s (EPA, 2012). The same study showed that NOx emissions were 33 percent less than in the 1990’s (EPA, 2012). Along with these results the cost of enforcement of the cap and trade system is only one-fourth of what the EPA expected (EPA, 2012). So, not only has cap and trade worked in the past it also uses market forces to solve the problem.
These are two examples of problems we face today, which can be solved by liberal solutions. Liberalism believes government can be used to solve real world problems. And it can do it efficiently and effectively. Whether that means combining private sector investments and increasing taxes to make Social Security solvent or a government set up marketplace to reduce emissions; government can and should be used to solve the problems we face. Liberals believe government should be used to help society and not regard it as a drain on society or a hindrance to the free market as many conservatives do.
Liberalism is more than just a big government political theory. Liberals believe smart government serves an essential role in multiple sectors of an economy. Government can be used to make markets fairer, and work toward a society where each member has an equal opportunity to succeed. Liberals argue for government intervention because it is possible to have an efficient market that is not producing fair results; government can correct that. Beyond the fairness issue government can also be used to correct market failure. Many times markets do not operate with Pareto efficiency and government alone has the unique ability to make certain markets more efficient. Not only can government be beneficial to individual markets, government can be beneficial to the economy as a whole. Macroecomics is based off of Keynesian economics, which is a liberal economic theory. Keynesianism argues for government intervention to help boost a slumping economy, and every administration since World War II has adhered to this theory. Our economy is centered on Keynesian and in turn liberal principles. Not only is government necessary economically speaking, emerging evidence is showing that government may be necessary due to our cognitive limitations. Behavioral economics is demonstrating that humans are not always rational. This discovery is a devastating blow to economic models that assume humans are completely rational. This means the free market will not necessarily work itself out like free-marketers seem to believe. Government has the ability to push people to become more rational. Governments across the world are using the “nudge” theory and having positive results. Further, other countries, like those in Northern Europe, have greater government involvement with better results. These countries have better health care, better education and greater social mobility. So liberalism does not just want government control of the economy. Liberalism understands government can be a positive factor in the economy and can actually produce economic growth. Government, when used correctly, can lead to a fairer society, more efficient markets, more rational citizens, and an overall higher standard of living.
ABC World News (2011) “CBO Projects Social Security will be Drained by 2037: Do You Think the Next Generation Will See a Solvent Social Security System?” http://abcnews.go.com/US/cbo-projects-social-security-drained-2037-generation-solvent/story?id=12776481#.Ty_6UxzEziAsocial%20ose%20solvency%20at%202037
EPA. “Acid Rain Program Results” (2012) http://www.epa.gov/capandtrade/documents/ctresults.pdf
Agresti, J.D. Cardone, S.F. (2012) “Social Security Facts” Just Facts. http://www.justfacts.com/socialsecurity.asp
Akerlof, G.A. (1970) “The Market for “Lemons”: Quality Uncertainty and the Market Mechanism”. From: Quarterly Journal of Economics, Vol 84, No. 3. http://www.iei.liu.se/nek/730g83/artiklar/1.328833/AkerlofMarketforLemons.pdf
All Things Considered (2009) “Using Psychology to Save You from Yourself” NPR Podcast. http://www.npr.org/templates/story/story.php?storyId=104803094
Backhaus, J. G. (2005) Handbook of Public Finance. Ed. Wagner, Richard. Boston, MA. Springer Science & Business Media inc.
Belli, Paolo. (April, 2012) How Adverse Selection Affects the Health Insurance Market Harvard School of Public Health.
Burman, E.L. Moynihan, D.P. (March 2012) “Tax Reform to Encourage Growth, Reduce the Deficit, Promote Fairness” http://budget.senate.gov/democratic/index.cfm/files/serve?File_id=1206f206-fe66-4156-98c4-dff62a6d337a.
Clinton, Bill (2011) Back to Work: Why We Need Smart Government for a Strong Economy Borzoi Book by Alfred K. Knopf
CIA World FactBook. https://www.cia.gov/library/publications/the-world-factbook/
Darvas, Szolt. (2011) “A Tale of Three Countries: Recovery After Banking Crisis” Bruegel Policy Contribution.
Donovan, Jim. (2008) “Outside Lemon Law? Try Mag Moss Act” Lemon Law Blog: http://www.lemonlaw.com/wordpress/outside-lemon-law-try-the-mag-moss-act/
Energy Information Administration. (2006) “World Per Capita Carbon Dioxide Emissions from the Consumption and Flaring of Fossil Fuels, 1960-2006” www.eia.gov/pub/international/iealf/tableh1cco2.xls
Grabianowksi, Ed “How Social Security Works” How Stuff Works. http://money.howstuffworks.com/personal-finance/financial-planning/social-security.htm
Grosen, H. S. Grayer, T. (2008) Public Finance: Eighth Edition. McGraw-Hill Irwin.
Guitton, Henri. “Economic Stabilizer” Encyclopedia Britannica. http://www.britannica.com/EBchecked/topic/178486/economic-stabilizer
Heritage Foundation. (2012) http://www.heritage.org/index/explore?view=by-variables
Human Development Report (2011) “Sustainability and Equity: A Better Future for All” http://hdr.undp.org/en/media/HDR_2011_EN_Complete.pdf
Huff Post Politics. (2011) “Andy Stern: Invest Social Security Funds in Wall Street” http://www.huffingtonpost.com/2010/06/30/andy-stern-invest-social_n_631228.html?
Keynes, J.M. (1925) “Am I a Liberal” From: an address to the Liberal Summer School. http://www.facebook.com/notes/espacio-agón-blog-de-filosof%C3%ADa-pol%C3%ADtica-ciencias-sociales-y-humanidades/john-maynard-keynes-am-i-a-liberal-1925/10150101931696844
Kennedy, John, F. (1960) “Acceptance of the New York liberal party nomination” http://www.pbs.org/wgbh/americanexperience/features/primary-resources/jfk-nyliberal/
Krueger, Alan. (2012) “The Rise and Consequences of Inequality” http://www.americanprogress.org/events/2012/01/krueger.html
Krugman, Paul. (2012) “People are Human” New York Times Blog. http://krugman.blogs.nytimes.com/2012/02/14/people-are-human/
McGowan, John. (2007) American Liberalism: An Interpretation for our Time. University of North Carolina Press, Google Ebook. http://books.google.com/books?id=8DtzsNVzbjQC&printsec=frontcover&source=gbs_ge_summary_r&cad=0#v=onepage&q&f=false
Netherlands – OECD Better Life Index. http://oecdbetterlifeindex.org/countries/netherlands/
OECD Health Data (2011) Frequently Requested Data http://www.oecd.org/document/16/0,3746,en_2649_37407_2085200_1_1_1_37407,00.html
Okun’s Law. 2012 Investopedia. http://www.investopedia.com/terms/o/okunslaw.asp#axzz1r0lxOr6c
Planet Money Podcast (1) (2011) “Will Economic Growth Destroy the Planet?” NPR. http://www.npr.org/blogs/money/2011/10/25/141701559/the-tuesday-podcast-will-economic-growth-destroy-the-planet
Planet Money Podcast (2) (2011) “Keynes vs. Hayek http://www.npr.org/blogs/money/2011/10/28/141802704/the-friday-podcast-keynes-vs-hayek
Planet Money Podcast (3) (2012) “Housing, Weddings, Space, Bacon” http://www.npr.org/blogs/money/2011/11/22/142668486/the-tuesday-podcast-housing-weddings-space-bacon
Politifact (2011) “Poverty Among Americans 65 and Over is Statistically Unchanged in recent years because of Social Security” From: The Rachel Maddow Show. http://www.politifact.com/truth-o-meter/statements/2011/sep/19/rachel-maddow/rachel-maddow-said-social-security-keeping-older-a/
Rawls, John (1971) A Theory of Justice: Revised Edition. Harvard University Press
Schlesinger, Aruther. (1956) “Liberalism in America: A Note for Europeans” From: The Politics of Hope. (Boston: Riverside Press, 1962) http://www.writing.upenn.edu/~afilreis/50s/schleslib.html
The 10 Biggest Employers in the World. (2012) Business Insider. http://www.businessinsider.com/the-10-biggest-employers-in-the-world-2011-9#us-department-of-defense-32-million-1
The Economist (2012) “Nudge nudge, think think” http://www.economist.com/node/21551032
The Happy Planet Index. http://www.happyplanetindex.org/
UPI (2012) “Poll: Most Don’t Want Social Security Cuts” http://www.upi.com/Top_News/US/2012/03/04/Poll-Most-dont-want-Social-Security-cuts/UPI-76871330900339/
U.S. News, Money. (2010) “12 Ways to Fix Social Security” http://money.usnews.com/money/blogs/planning-to-retire/2010/05/18/12-ways-to-fix-social-security
Wagner, Daniel (2012) “Richard Cordray, Consumer Financial Protection Bureau Director, Touts Enforcement Powers” Huffington Post. http://www.huffingtonpost.com/2012/01/24/richard-cordray-consumer-bureau_n_1228519.html
Wapshott, Nicholas. (2011) Keynes Hayek: The Clash that Defined Modern Economics W.W. Norton & Company, New York & London
 Efficiency in a market assumes a certain distribution of income. Markets then take that distribution and translate individual tastes and preferences into market demand. However, if the initial distribution of income is not fair then while market outcomes might be efficient the resulting distribution of good and services will not be fair.
 Even conservatives understand some government in an economy is necessary. Government is needed to provide safety, create laws for businesses and corporations, enforce contracts and enforce laws in general.
 Income redistribution is still a crucial issue today. A recent CBO study showed that the top 1 percent of the country has seen their income grow by almost 278 percent since 1979 while the lowest quintile of people has only seen their income grow by 18 percent. Even with this growing income disparity conservatives today still are hesitant to do anything to temper this widening income gap (Appendix 1) (Krueger, 2012)
 I go into this in greater detail in chapter 5.
 It is called a Pareto improvement and not Pareto efficient because there are many factors in the market that could make the market Pareto inefficient even after the transaction. It is still a Pareto improvement because the market is closer to Pareto efficiency after the transaction.
 Prices may go up under this system, but that is largely irrelevant in microeconomics. Prices are signals to buyers, and they represent how much a good truly costs. So arguing that the system will increase prices does not hold up in microeconomics because microeconomics argues for prices to actually represent the cost of the good. Not a price that is kept artificially low.
 This would be something like a cap and trade system, which will be addressed in greater detail in chapter 6.
 Recessions are a good time to analyze Keynesian economics because during boom times the differences in economic theories are not that great. Most economic theories, including Keynesianism, are advocates of the free market in prosperous times. Small variations exist, but where theories tend to diverge is during recessions and depressions.
 Keynes argued an optimal economy operates when investment equals savings.
 The Federal Reserve is considered the lender of last resort, which is typically money given to banks to keep them solvent in during crises.
 The Greek Financial crisis illustrates this nicely. Greece, like the rest of world, was hurt by the 2008 financial crisis. Greece was seen as a major contributor to the European Crisis due to its high national debt. The Euro-Zone then imposed harsh austerity measures to try and decrease the debt and boost Greece’s economy – known as expansionary austerity. However, their economy did not get better and the national debt only grew larger.
 Neither do individuals in markets though.
 The law is not an exact science but merely illustrates as the unemployment rate increases potential GNP decreases.
 Considered the founders of behavioral economics.
 Number of deaths per 1000 live births
 Only the Netherlands had a lower Graduation rate of 73% (Netherlands, 2012)
 This number does not include debt held by states, and intra governmental debt. If these were added debt as a percentage of GDP would be over 100 percent.
 Higher numbers represent greater income inequality
 The graph tries to represent social mobility so they take the Gini coefficient of 1985 so they can measure how people who grew up then are doing now.