CHAPTERS IN ECONOMIC POLICY

Prof. Giovanni PavanelliDept. of Economics and Public Finance

“G. Prato” and ICERe-mail: giovanni.pavanelli@unito.it

Part. I: The scope and limits of economic policy in a

historical perspective

Part II: Economic policy in the short and medium run

Outline of the course:

Part I: The scope and limits of economic policy in a historical perspective

-The theory of economic policy in the classical economic thought;-Monetary policies during the XIX century;-Keynes’ General Theory;-Keynesians vs. monetarists;-The rational expectations critique.

•Part II: Economic policy in the short and medium run

-Monetary and fiscal policies in the open economy;

-Choosing between exchange rate regimes

-The case for a common currency

-Uncertainty and policy; Expectations and policy;

-Topics in fiscal policy

Recommended reading

There is no textbook covering all the material of the course

Part I: students are expected to prepare the material presented in the classroom (slides and additional readings).

Part II: the following book is recommended, O. Blanchard, Macroeconomics, V ed., PearsonPrentice Hall, 2009, chapters: 20, 21, 24, 25, 26.

Economic policy: “general body of principles of governmental action or inaction the agenda or non-agenda of the State in regard to economic activity”

(J. Bentham)

Two conflicting views of the role of the government (XVXVIII centuries):

i) mercantilists

ii) natural law philosophers

• Mercantilism: was by no means a unified and coherent system of thought: the mercantilist literature includes pamphlets written by merchants, entrepreneurs and civil servants with the aim to defend specific interests and policies

• However, mercantilists shared the view that systematic government regulation of economic activity was in the national interest

In particular:

The mercantilists believed that a permanent inflow of gold and silver was in itself a desirable and sustainable goal

As a consequence:- They firstly (XVI century) supported an outright

prohibition of exporting gold and silver (bullionism)

This policy, however, did not work and actually proved to be counterproductive:

The East India Company (EIC) had been accused of exporting bullion to India and therefore to deplete England’s stock of money

In 1621 Thomas Mun, a manager of the EIC, published a famous pamphlet (A Discourse of Trade, 1621) in which he successfully argued that the net effect of the EIC import-export trade was actually positive for England’s “general” (multilateral) balance of trade

Starting from the second half of the XVII century, the mercantilists maintained that a net increase of the stock of gold and silver had to be reached by means of a permanent surplus of the multilateral balance of trade

They therefore defended policies aimed at restricting import and promoting export

- These measures included customs duties on imported manufactured goods, subsidies for the export of manufactured products and restrictions on the export of raw materials (in order to export products with the highest value added)

- Labour-related policies: these included tight emigration rules for skilled workers

- In Europe the most active statesman who promoted mercantilist policies was J.-B. Colbert, minister of finance of Louis XIV

David Hume’s criticism:

The mercantilists’ point of view was subjected to a devastating criticism by the Scottish philosopher David Hume (Political Discourses, 1752)

According to Hume’s analysis (price-specie flow mechanism) an inflow of gold (an addition to the domestic supply of money) caused by NX0, would bring about the domestic price level to rise

ε (appreciation of the real rate of exchange ε = EP/P*) NX worsens

Adam Smith’s criticism:

“It would be too ridiculous to go about seriously to prove that wealth does not consist in money, or in gold and silver; but in what money purchases, and is valuable only for purchasing. Money, no doubt, makes always a part of the national capital; but it has already been shown that it generally makes but a small part, and always the more unprofitable part of it”

(A. Smith, 1776, An Inquiry into the Nature and Causes of the Wealth of Nations, book IV, ch. 1)

Smith’s criticism is, however, unfair

Some mercantilists were aware of the fact that, at least in the short run, money is not neutral.

A few of them (Josiah Child, A New Discourse of Trade, 1693) were even able to identify an “indirect” transmission mechanism linking the stock of money (M) with output (Y)

To simplify, an increase in M would cause a reduction in the nominal interest rate (i), an increase in investment (I) and therefore an increase in demand and output (Y)

Not surprisingly, the mercantilists were considered as forerunners by such an author as J.M. Keynes:

“Mercantilists were emphatic that an unduly high rate of interest was the main obstacle to the growth of wealth; and they were even aware that the rate of interest depended on the liquidity-preference and the quantity of money. […] Several of them made it clear that their preoccupation with increasing the quantity of money was due to their desire to diminish the rate of interest”

(J.M. Keynes, 1936, The General Theory of Employment, Interest and Money, ch. 23 “Notes on Mercantilism”, p. 341)

• More generally, the mercantilists believed that success in international trade had to be guaranted with political power and military strength

• In their view international trade had to be considered a “zero-sum game”

- Mercantilists had a paternalistic attitude: they did not hesitate to propose all sorts of interferences with personal freedom

- According to L. Robbins, a counsellor to the king of Prussia recommended that, in the interest of population:

“It is proper to watch during the fruit season to prevent that the people eat [the fruit] which is not ripe” (Robbins, 1952 pp. 13-14)

Natural law philosophers:

- The foundations of the natural law approach were provided by the ancient Greek philosopher Aristotle (384−322 a.C.) and, during the Middle Age, by St. Thomas Aquinas (1225-1274)

Main points:i) both natural phenomena and social institutions are

based on a natural order, whose laws predate any existing legal system;

ii) the natural order can be discovered and analysed by the reason (but also perceived by the moral sense of the human beings);

iii) every violation of the natural order is bound to bring negative consequences to the society. By following the natural order, on the contrary, economic systems are able to obtain maximum welfare (given the restraint posed by the availability of factors of production and natural resources)

iv) the natural order should form the basis of the laws governing human societies

- After the XVI century the natural law approach was reaffirmed, among others, by:

- Hugo Grotius: (15831645): a jurist. His main work is De jure pacis et bellis, 1625

- Samuel Pufendorf (16321694): professor of law at the Universities of Heidelberg, Lund and Berlin. His main work was De jure naturae et gentium, 1672

-John Locke (16321704): an outstanding political philosopher. Main works: An essay concerning toleration, 1667; An essay concerning human understanding, 1690

Locke was one of the founders of political liberalism: he advocated tolerance in religion, the freedom of the press, extended education

In his view, the main task of the government was to guarantee the natural rights (life, freedom and property)

The natural law approach strongly influenced the 18th century French physiocratic thinkers. Amongst them:

-F. Quesnay (1694-1774), physician of king Louis XV. His main work was Tableau économique (1758; II ed. 1759);

-P.P. Mercier de La Rivière (1720-1795), author of L’Ordre naturel et essential des sociétés politiques)

- The physiocracts strongly opposed Colbert’s mercantilist policies. These policies, they maintained, had impoverished the French agricultural sector

- In their view, only agriculture was able to generate a net product (a surplus of output over input) and therefore had to be considered the cornerstone of economic activity.

- Governments should not interfere with production and commerce. The physiocrats rejected protectionism and campaigned for free trade

- Alleged conversation between Mercier de La Rivière and Catherine the Great, tsarina of Russia (Robbins, 1952):

• C.: “Sir, can you tell me the best way to govern a state?”

• M. “There is only one way, Madame. Be just, that is to say, uphold the constitution and observe the laws”

• C.: “But on what basis should laws be made?”

• M.: “On one basis only, Your Majesty, on the nature of things and of men”

• C.: “Most certainly. But when one wishes to make these laws what rules should be observed?”

• M.: “Madame, to give laws to mankind is God’s prerogative. How can mere man venture on such a task? By what right would he dictate to those whom God has not placed in his hands?”

• C.: “To what then do you reduce the science of government?”

• M.: “To study the laws which God has so manifestly engraven in human society from the time of its creation. To seek to go beyond this would be a great mistake and a disastrous undertaking”

• C.: “Sir, it has been a great pleasure to meet you. I wish you a good day”

• Adam Smith (1723-1790) An Inquiry into the Nature and Causes of the Wealth of Nations, 1776

• Smith was strongly influenced by the natural law philosophers and by the psysiocrats and criticized the “mercantile system”.

• He maintained that the “wealth” of a nation is not determined by its stock of money but by its stock of physical and human capital.

- Government should not interfere with the allocation of the factors of production

“Every individual is constantly exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society, which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is the most advantageous to society” (Smith, 1776, p. 421)

• Furthermore:

- “The statesman, who should attempt to direct private people in what manner they ought to employ their capital, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted not only to no single person, but to no council or senate whatever” (Smith, 1776)

• Provided that free competition holds, market mechanisms are able to ensure an optimal allocation of resources

Basic role assigned to the government by Adam Smith:

- Defence: “the duty of protecting society from the violence and invasion of other independent societies”;

- Justice: “the duty of protecting as far as possible every member of the society from the injustice or oppression of every other member of it”. It included such matters as the enforcement of contracts and security of private property

- Provision of basic infrastructures (“public works” and “public institutions”) “which can never be for the interest of any individual […] to erect or to maintain; because the profit could never repay the expence to any individual or small number of individuales, though it may frequently do much more than repay it to a great society”

• (e.g.: roads, canals, harbours, lighthouses but also, in Smith’s view, education).

• More controversially, Smith supported legal ceilings on interest rates, light duties on import of manufactured goods, banking and currency regulations to promote a stable monetary system

• Smith was not a doctrinaire advocate of laissez-faire: he believed that as a rule competitive market would bring as an outcome general welfare.

• However, government should provide the legal-institutional framework though and within which markets can work

- Smith’s point of view was shared by the English classical economists (D. Ricardo, T.R. Malthus, R. Torrens, N.W. Senior, J.S. Mill):

- The classical economists conceived that the object of economic activity was best attained by a system of spontaneous cooperation, provided that a certain framework of law and order existed and certain necessary governmental services were guaranteed

- In their view, it is the impersonal mechanism of the market which brings about that the interests of the different individuals are harmonized.

- In their writings the classical authors criticized the use of government power in the interest of a small minority to create for themselves privileged conditions

- Price fixing and regulation of industrial processes were considered definitely undesirable. Contrary to Smith they opposed usury laws

Pauperism and Welfare - The classical economists were critical of the Poor

Laws, a system of poor relief which had been introduced in England during the XVI century and which was administered at a local level

- Malthus and Ricardo: favoured the gradual but complete abolition of the Poor laws.

They believed that:

- poor relief encouraged population growth by guaranteeing the means of subsistence;

- as a result of the continued growth of population the whole net rental of the country would in time be absorbed by poor relief;

- poor should be taught self-reliance

• W.N. Senior: advocated a drastic reform of the system which resulted in the 1834 Poor Law

• This was based on:– confining relief to the workhouse;– principle of less eligibility: idea that no one

receiving poor relief should be as well off as somebody working. Standard relief should be below the level of wages