[Note for bibliographic reference: Melberg, Hans O. (1997), Right, Left or
Meaningless (Review of Barro, 1996), http://www.oocities.org/hmelberg/papers/970826.htm]
Right, Left or Meaningless
Barro vs. Krugman, State-intervention, Meaningless quantification
by Hans O. Melberg
Robert J. Barro
Getting it Right: Markets and Choices in a Free Society
The MIT Press, London, 1996
191 pages, ISBN: 0-262-52226-8
Introduction
In the preface to Getting it Right Robert J. Barro writes that "A dominant
theme throughout this book is the importance of institutions that ensure property rights
and free markets. The discussion deals especially with the appropriate range of functions
of government - which areas represent useful public policy and which unnecessary
interference" (xiv). Although he does not provide an answer to exactly how much state
intervention which would be acceptable (as a percentage of GDP, for instance), he argues
that "...most governments have gone much too far in their expenditures, taxation, and
regulations" (xiii).
After reading the book I failed to be convinced by this argument, although I did find
several useful isolated discussions (as well as some less interesting discussions). In
fact, this is one of the key problems with the book: It is a collection of very diverse
and short articles which do not form a coherent overall impression. A convincing answer to
the question of state interference must contain a systematic examination of the pros and
cons - not isolated case studies of mainly the bad effects of intervention.
Given the nature of the book as a collection of a large number of short articles, some
kind of selection is required in this review. First, I shall contrast what Barro says with
Krugman's arguments in his Peddling Prosperity. Second, I want to discuss the issue
of state intervention in more detail. Finally, I shall comment on some of the articles
with which I disagree, as well as some of the (few) lessons I learned from this book.
Barro vs. Krugman
There are no explicit references to Krugman in Barro's book, although there are possibly
some implicit hints (see, for example, p. 84 in which Barro comments on the sour grapes of
those not appointed as Head of the Council of Economic Advisors). What is beyond doubt,
however, is that many of their topics overlap. Prominent among these is evaluation of
supply-side economics, the effect of monetary expansion, and inequality.
Barro defends supply side economics. As he writes: "The much-ridiculed Laffer
curve - the idea that lower tax rates could generate more revenue - worked brilliantly at
upper incomes, even if not for the overall economy" (120). He also writes that the
experiences of Sweden in the 1970s and Peru in the 1980s, demonstrate the empirical truth
of supply side economics (which he compares to the lack of empirical evidence for the
Keynesian multiplier). Krugman, on the other hand, ridicules the supply siders, calling
them "more a cult or a sect than a simple school of thought" (Krugman, p. 92).
Who is right?
The key phrase in Barro's argument is that the Laffer curve "worked
brilliantly at the upper incomes, even if not for the overall economy" (120,
my emphasis). But, this was the key promise of the supply-siders - that the whole economy
would grow faster when you reduced the tax burden. In fact, it was argued that economic
activity would increase so much that it would rise the total amount of tax revenue. In
this they were wrong, as Krugman shows - the economy did not grow that much more after the
tax-cuts. (There is, moreover, the problem of distinguishing between the amount of growth
caused by the tax-cuts as opposed to other factors.)
Barro's evidence in favour of the Laffer curve is that the reported incomes of the top
0.5% in the income distribution increased after the 1986 tax cuts - i.e. either the very
rich worked more, or they tried less hard to avoid tax. I have no problems with accepting
this, and still believe that the supply-side advice was wrong. There is nothing new or
revolutionary about a Laffer curve - and the empirical demonstration of its existence for some
groups. The supply-side claim was that the U.S. as a whole (i.e. not only the top
0.5%) had reached the point when a cut in taxes would increase economic activity so much
that it would led to an increase in tax revenue. This was not true, and to show that it
was true for a small percentage of the population does not make it true for the whole
economy. Thus, Barro's qualification "even if not for the overall economy" is
the key, and not his much elaborated evidence on the top 0.5%.
What is the lesson of this? As long as empirical research show that a cut in the top
marginal tax rates for the rich increase revenue, I would agree with Barro that these
rates should be cut. There is little point in taxing people - or "soaking the
rich" - simply to prevent them from becoming rich (except if you are motivated by
envy, but that is not a feeling that should guide public policy). However, for the U.S.
economy as a whole in 1986 there was little reason to believe that large scale tax-cuts
for most people would reduce the deficit (!), and this was the central argument of
the supply-siders. The result was opposite - a larger deficit - and this indicates that
Krugman's focus is more right than Barro's.
A second point of disagreement between Barro and Krugman, is whether the central bank
should react to an economic downturn with an expansion of the money supply. As Barro
writes "The problem is that this expansion of money growth and inflation would work
to bolster the economy - if it ever works - only if it keeps ahead of expectations"
(54). If anticipated, the expansion "succeeds mainly in creating high and variable
inflation ..." (55). Thus, monetary expansion to reduce the pains of a recession is
not a good idea, according to Barro.
Krugman disagrees. The key argument is that even if expectations are rational, prices
and wages can be inflexible (due to, for instance, efficiency wages, imperfect competition
in the market, informational asymmetries, menu-costs, slightly-less than perfect
rationality. See Krugman p. 206-220).This implies that the economy is not always
self-correcting, at least not very quickly. This, in turn, means that monetary expansion
can have real effects - by increasing demand and by making price adjustments easier. For
example, people are strongly reluctant to cut their nominal wages, but they -
irrationally? - are less worried about real cuts when inflation and nominal increase is
combined. Thus, inflation could make relative wage adjustments easier.
Of course, this does not imply that I believe the economy can grow forever simply by
increasing the money supply and aggregate demand. I believe it is sometimes possible and
desirable to expand the money supply to stimulate demand (when the recession is caused by
insufficient demand). Desirable because we avoid some of the short term pain associated
with the recession (which are real costs, despite their "short term" nature).
Possible because the effects of this expansion will take effect before the economy is out
of the recession by itself. Remember, recessions often last for years, not weeks or
months. Of course, I do not think we should try to use monetary expansion to fine-tune the
economy in the sense that we should expand the money supply when unemployment is 5.4% and
the estimated Natural Rate of Unemployment (NRU) is 5.7%. However, when unemployment is
above 10% and the estimated NRU is 5%, I believe a monetary expansion is acceptable.
Finally, I also accept that recessions are also - but not exclusively - caused by real
factors such as an increase in the oil price. This is why I qualified my support for
monetary expansion with "sometimes". If the recession is caused by real factors,
as opposed to insufficient demand, the optimal reaction is different - although it might
still be the case that inflation can make the adjustment to the new situation easier.
In sum, I believe it is better to follow Krugman's advice, and not Barro's. This is not
because I dismiss rational expectations, but because I believe the correct model of the
economy contains some degree of inflexible prices, and that rational individual actions
can lead to an aggregate shortfall in demand. The failure to distinguish between the two -
expectations and the model of the economy - also represent a weakness in Barro's
discussion (see S. Sheffrin's book Rational Expectations for a good discussion of
this). Admittedly, in a popular book of this sort it is acceptable to simplify (and I an
sure Barro is aware of the distinction), but in this case the simplification generates the
conclusion.
Finally, both Barro and Krugman discuss income distribution. On this issue there seems
to be some degree of consent. They agree that there has been an increase in the spread in
the distribution of income, and that one cause of this is probably technological change.
However, Krugman gives a more cautions and detailed picture of income inequality (see his
chapter 5, pp. 130-150). Also, they disagree to some extent on what should be done about
this increase in inequality. Barro argues "that governments cannot and should not
seek to control" these forces in order to reduce the inequalities (114). Moreover,
Barro wants to introduce a flat rate tax, which in all likelihood would increase the gap
between the rich and the poor. Krugman, on the other hand, clearly states that "I am
a liberal - that is, I believe in a society that taxes the well-off and uses the proceeds
to help the poor and unlucky" (preface, xiv). Hence, he supports the proportional tax
and he wants to "spend more on programs that help poor children, from nutrition and
medical programs for poor mothers up through to aid for distressed school districts
..." (p. 284).
Who is right? Is it possible and/or desirable to use state intervention to reduce
inequalities? As for the possibility, I have little doubt that redistribution is
technically feasible. Some measures, not all, may conflict with efficiency, but this is a
calculated cost which must be measured against the benefits. Is it desirable? To me this
is a question of degrees, and I am unsure about the answer. On the one hand, I agree that
it is possible to go too far, that is, to make a system with bad incentives that erodes
individual responsibility. On the other hand, I do not subscribe to the extreme
libertarian position ("tax is theft"), and I think the state should redistribute
income to some extent. Hence, once again I agree more with Krugman than Barro, but I am
uncertain about the degree to which I want the state to redistribute income.
State Intervention
Barro, as mentioned, thinks "...most governments have gone much too far in their
expenditures, taxation, and regulations" (xiii). Exactly what does this mean? How
much is too much? What does he want to cut?
Without being precise, Barro certainly thinks we have gone too far when the government
absorbs 41% of the Gross Domestic Product as in the UK. The U.S. government absorbs 7%
less, i.e. 34% and this is, according to Barro, closer to the "correct" level,
although it is probably still too much (p. 173).
The figures above sound awfully large? Do the governments really control almost half of
all expenditures in many European countries? No! It is misleading to use the figures
without mentioning that they also include transfer payments. For instance, in many
European countries there is a public pension system. Very often the government does not
have much power over these payments, at least they have no say in how the money is used.
Thus, they do not "control" 41% of the economy in the sense that they decide how
to spend 4 out of 10 pounds.
Still, it is a legitimate political position to believe that the government controls
too much. However, simply saying that the government does too much is easy; Arguing that
Social Security and Medicaid should be cut is less popular. So, what does Barro want to
cut?
Barro does not mention too many concrete expenditures that should be cut - the
elimination of the "National Endowment of the Arts and Humanities" and the
"Corporation for Public Broadcasting" is called "good ideas" (p. 99),
but this only represents $650 million a year - not significant in terms of reducing the
government's share of the total economy. Hence, Barro is vague when it comes to cuts in
spending, especially since he does not discuss Social Security or Medicare in any detail.
He is, however, more concrete when it comes to regulations that should be cut: the
Americans with Disabilities Act, the Clean Air Act, the Civil Rights Act, the Family Leave
Act, and the Endangered Species Act (see, for instance, p. 76). He also wants to introduce
school choice, flat-rate income tax, rules for monetary stability, privatized social
security, and eliminate affirmative-action programs (see preface, xiv).
One may agree or disagree with the proposals above - and one might agree with some and
disagree with others as I do. For instance, after reading Barro I became convinced that
the Endangered Species Act is ripe for serious reform. I also tend to agree with the
elimination of affirmative-action programs and the introduction of school choice. However,
I am less than certain about some of the other proposals, simply because I do not know
enough about the details. For example, I believe the government has a role to play in
regulating pollution, so in principle I would support a Clean Air Act - although I do not
know enough about the detailed provisions of this act to say whether I would support the
current U.S. Clean Air Act.
What is left after these cuts and eliminations? To quote Barro:
I believe that government has some key functions, notably to define and protect
property rights. This heading encompasses national and domestic security and the enactment
and enforcement of a system of laws and contracts. Other important government activities
include ensuring (but not producing) a baseline level of education, providing a minimal
welfare net, and participating in a narrow range of infrastructure investments, such as
highways and airports" (preface, xiii).
As I complained in a previous review (see The pros and cons of state intervention
- a review of Skitovsky's After Communism), this is not too helpful since we
disagree on the definition of a "minimal" welfare net, and the meaning of
"narrow" infrastructure investments. To answer these questions, and to give
better arguments for and against state intervention, I believe we need to start with a
systematic discussion of markets, market failures and government failures. Ultimately,
however, it is also a normative question which cannot be answered by empirical analysis.
But Barro does not engage in this type of systematic positive and normative discussion,
and this is why the book fails to live up to its already stated ambition of determining
"the appropriate range of functions of government - which areas represent useful
public policy and which unnecessary interference" (xiv).
Getting it wrong?
In a number of places I think Barro presents either wrong of meaningless arguments. For
instance, the chapters rating the Presidents (US), Prime Ministers (UK), and the Head of
the Council of Economic Advisers according to a revised misery index, is a useless
exercise. Why? First, to add inflation, interest rates and unemployment (and many other
variables) is to add apples and oranges as if they were the same. Second, neither the
President, nor the Prime Minister, controls the economy. They have to struggle with
different circumstances which make simplistic comparisons based on a misery index
misleading. Third, and finally, Barro introduces a lag on all the variables in order to
avoid giving one President the blame/credit that belongs to the actions of the past
President. However, it is far too simplistic to lag all the different variables with one
year. Barro simply cannot be serious in suggesting that inflation, unemployment, growth
and interest rates have the same lags at all times. Instead, I agree with Friedman who
argued that there were long and variable lags in the economy, and this makes the misery
index meaningless. In sum, Barro pretends to give us a neutral measurement of the success
of politicians, ignoring - what he probably knows - that the assumptions required to make
the misery index meaningful are far from fulfilled.
Another implausible suggestion made by Barro, is that the US position on independence
for the former Soviet republics somehow was influenced by sub-conscious thinking about the
US civil war (p. 27). As he writes:
"If the U.S. government had supported the rights of secession in some other part
of the world, such as the Soviet Union ... [...] ... Americans would then be forced to
reconsider whether the enormous cost of the Civil War in terms of lives and incomes was
worth it." (p. 27)
This is simply implausible. Bush's position on independence for the Soviet Republics,
as reflected in his "chicken" speech in Ukraine, was inspired by cold (but
mistaken) realpolitik: the desire to avoid instability. The memories from the American
Civil War were not important.
A third implausible suggestion, is Barro's argument that "the main inference from
a 95 percent reelection rate [U.S. Congress] is that the political process is working and
that officeholders are conforming to the wishes of their constituents" (p. 159).
While avoiding the other extreme ("The US democracy is a failure"), it is
possible - and more plausible - to suggest that the high reelection rate in part is due to
the ease by which incumbents raise money compared to their challengers. If this is the
case, Barro's inference is exaggerated: the reelection rate partly reflect an unfair
advantage given to the incumbents: more money. This is hardly a sign of a perfect
democratic process.
Fourth, Barro suggests that there is an "iron law of convergence" between the
economies in the world (p. 12). Yet, a few pages later he discusses endogenous growth
theory - some variants of which implies that there is an "iron law of
divergence" (due to spillover effects and economies of scale). Most likely the world
is ruled by mechanisms and forces working both ways. Barro's failure to connect these may
reflect his efforts to simplify (mistakenly in this case; simplifications are acceptable
as long as the complexities can be incorporated without changing the conclusion). More
likely, the failure to make the connection between endogenous growth theory and
convergence/divergence, reveals the book's origins as isolated pieces of short articles.
One could go on to mention additional implausible suggestions made by Barro. I doubt
that the "best aid" the US could give to developing countries is to use all
possible means to collect their debt (p. 37.); The logic behind the argument that
"the experience of the rest of the hemisphere suggests that slavery in the U.S. South
would have been eliminated peacefully in not very many years" (p. 28) is also flawed.
The problem is that freeing of slaves in the rest of the hemisphere was not independent of
the U.S. Civil War - without the Civil War in the US the process of slave liberation on
the other countries might have been different. Lastly, the suggestion that Mr. Blair would
be pushed to the left by Mr. Scargill [a union leader] if he were elected Prime Minister
(as he recently was), reveals a lack of understanding of basic British politics. Mr. Blair
might be pushed to the left, but Arthur Scargill is no longer an important force, and
clause four [promising public ownership of the means of production] of the party's
manifesto is no longer in effect.
In sum, Barro sometimes gets it wrong. Of course, to be fair, Barro also - occasionally
- gets it right. For instance, the idea of indexed bonds seems like a good idea, although
I am a bit sceptical since he does not discuss the arguments against indexed bonds. If
there are no counter-arguments, then why has not the U.S. government introduced these
bonds? Especially since Barro thinks it can save the taxpayers about $30 billion annually.
(When the bond is indexed the investors will not demand an "inflation-risk"
compensation when they buy the bond: It becomes cheaper for the government to borrow
money).
Conclusion
I would not recommend this book. It lacks coherence, it does not answer its main questions
(state intervention), it is sometimes boring and misleading (ranking of presidents and
prime ministers), and it is sometimes outright wrong. One might say that this conclusion
reflect my political prejudices, but this would not be true. I am more a
libertarian/conservative than I am a liberal (US sense), or social democrat. Nor does this
lack of recommendation imply that I think Barro is a bad economist. For instance, his
articles "Are Government Bonds Net Wealth?" (JPE, 1984) and "Rules vs.
Discretion" (1981) are well worth reading. Nevertheless, being famous and having
published good articles, do not imply that all your short and somewhat unsystematic
thoughts deserve to be read or published.
[Note for bibliographic reference: Melberg, Hans O. (1997), Right, Left or
Meaningless (Review of Barro, 1996), http://www.oocities.org/hmelberg/papers/970826.htm]