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This version 12 May 1997

Economic rationalism

 

John Quiggin

Professor of Economics

James Cook University

 

 

 

 

Published as: Quiggin, J. (1997), 'Economic rationalism', Crossings, 2(1), 3-12.

 

 

I thank Nancy Wallace for helpful comments and criticism


Economic rationalism

The term 'economic rationalism' has a long history, having been used by the social historians Weber and Tawney to describe the position of those Protestants who advocated the removal of medieval restraints on usury. Like their modern counterparts, the early economic rationalists supported financial deregulation. More generally, 'economic rationalism' was used by Weber and Tawney to refer to the view that commercial activity, particularly borrowing and lending, represents a sphere of activity in which moral considerations, beyond the rule of business probity dictated by enlightened self-interest, have no role to play.

The term 'economic rationalism' first entered the Australian lexicon in the early 1970s, while the Whitlam government held office. The term was used primarily in a positive sense, most commonly in formations such as 'economically rational'. It was applied to the group within the Labor Party, including Whitlam himself, which opposed protective tariffs and agricultural price support schemes. The implication was that the 'economic rationalists' relied on open and unbiased inquiry to determine those policies that would best serve the interests of society while their opponents' approach was based on slogans or on unquestioning adherence to the status quo.

Alastair Watson, then at the University of Melbourne, was one of the first to use the term in print and claims to have invented it. However, given the frequency with which the term 'rational' was used in economic policy discussions at this time, it seems likely that the phrase was 'in the air' and may have arisen independently on a number of separate occasions.

Whatever the origin of the term, it has evolved a great deal since the 1970s. 'Economic rationalism' then referred to policy formulation on the basis of reasoned analysis, as opposed to tradition, emotion and self-interest. With the exception of support for free trade, there was no presumption in favour of particular policy positions. The views of the first generation of economic rationalists were generally in the economic mainstream of the period -- Keynesian in macro terms and supportive of the 'mixed economy' in micro terms. The strongest feature of the economic rationalists of this period was a rejection of the cosy interest group politics of the McEwan era. It was on this basis that Whitlam claimed to lead the first free enterprise government in Australia's history.

During the period of the Fraser and Hawke governments, both the intellectual character and the theoretical and policy content of economic rationalism changed. The critical and sceptical thinking that characterised the first phase of economic rationalism was gradually replaced by a dogmatic, indeed, quasi-religious, faith in market forces and in the supreme importance of 'efficiency' and 'competition'. More and more, economic analysis was based on deductions from supposedly self-evident truths, which were effectively immune from any form of empirical testing.

Thus, economic rationalism now has very little to do with rational debate. There is, however, a philosophical sense in which much current economic thinking may correctly be described as rationalist. The central feature of philosophical rationalism is the use of logical deduction from supposedly self-evident axioms, rather than observation, as the source of knowledge. This type of rationalism is anything but reasonable. It leads to a situation where absurd beliefs can be maintained in the face of overwhelming evidence to the contrary.

Because of this dogmatic approach, and because some of the older generation of 'economic rationalists' still wear that label with pride, it has been suggested that the term 'economic fundamentalism' is a more apt description of the dominant economic policy framework of the 1990s. In this paper, I will use the more common term 'economic rationalism', but on the understanding that the meaning of this term has changed over time, and that many of the older generation of 'economic rationalists' would reject the policies now advanced under that banner.

The theoretical content of economic rationalism

In theoretical terms, the economic rationalists of the early 1970s adhered to the mainstream postwar view. The mainstream view was based on a synthesis between macroeconomic models derived from the work of Keynes and a sophisticated version of neoclassical microeconomics, which began with a simple model of perfect competition, but allowed for many forms of market failure and imperfection, including monopolies and 'external' effects such as pollution. In the mainstream view, government intervention in the economy was justified to correct market failures and to stabilise the level of employment and output.

Within mainstream economics, there was considerable disagreement both about the appropriate choice of macroeconomic policy and about the importance or otherwise of problems of market failure. Traditional Keynesians usually favored a high degree of government intervention in microeconomic as well as macroeconomic policy. At the other extreme, members of the free market 'Chicago school' favored the use of monetary rather than fiscal policy for macroeconomic stabilisation and were generally critical of 'market failure' arguments for government intervention. The views of the Chicago school gained favour within the economics profession in the 1970s, as a result of the failure of Keynesian macroeconomic policies, but tended to lose ground in the 1980s, as it became clear that simple free market models were not consistent with reality.

The economic rationalists of the 1970s refuted widely held views on economic issues that had no basis in mainstream economics. In particular, they were critical of protectionist arguments that took account of the benefits accruing to protected industries but not of the costs borne by other industries, and of arguments for public expenditure that failed to take account of the principle of opportunity cost. In its simplest form, the principle of opportunity cost states that expenditure on one project is at the expense of alternative projects that might have been undertaken instead. Most of the ideas criticised by the economic rationalists favored government intervention. It is not surprising therefore, that, the majority of economic rationalists tended towards the free market end of the spectrum.

By the late 1970s, economic rationalists had largely adopted the microeconomic views of the Chicago school, rejecting ideas of market failure in favour of the belief that the simple neoclassical model of perfect competition was a good description of the economy, or would be in the absence of undesirable government intervention. A variety of arguments were used to show that most market failures were unimportant or self-correcting. At the same time, the public choice theory of politics was used to introduce the idea of 'government failure'. It was argued that, because of the systematic distortion of the policy process by interest groups, the costs of government intervention were greater than the costs of the market imperfections government policies were supposed to remedy.

The central policy emphasis of economic rationalism in the late 1970s was on 'getting prices right', through free market policies such as the elimination of tariffs and subsidies and deregulation of the airline industry and the financial sector. The removal of so-called 'distortions' was justified on the basis that it would improve the welfare of consumers. The simple neoclassical model of perfect competition suggests that such benefits will exist, but that, in general, they will be quite small - a typical estimate is that the removal of all tariffs and subsidies existing in 1970 would yield a long-term benefit equal to 3 per cent of GDP. Thus, it was possible for supporters of existing policies to argue that the costs of unemployment associated with adjustment to tariff reform would outweigh any long-term benefit.

In responding to such criticism, economic rationalists naturally welcomed any argument that suggested that the benefits of free market policies would be large. From the early 1980s onwards, many such arguments were based on a distinction between the 'static' benefits which, according to simple neoclassical microeconomics, will be obtained from eliminating price distortions, and the 'dynamic' gains claimed to be generated by competition.

The dynamic gains hypothesis is the claim that, over time, competitive markets will generate improvements in technical efficiency. The nature of these dynamic gains is not usually described in detail, although statements about dynamic gains are often made in terms that suggest that there is a well developed body of theoretical and empirical analysis supporting the dynamic gains hypothesis. In fact, no such body of work is to be found in the economic literature.

In both simple and sophisticated versions of neoclassical microeconomics, competition is a mechanism for pushing prices down to the market clearing level. It is normally assumed that, since both monopolists and competitive firms want to maximise their profits, both have the same incentive to minimise their costs and seek improvements in technical efficiency. Similarly, if publicly owned firms are directed to maximise profits subject to the achievement of particular service objectives, they will be about as efficient as private firms. Mainstream economic analysis gives no support to the view that competition or private ownership per si will, in general, promote improvements in technical efficiency.

Although the dynamic gains hypothesis is not supported by mainstream economic analysis, it is consistent with views about the benefits of competition that are widely held in the business sector. The rhetoric of groups like the Business Council of Australia contains regular references to the beneficial effects of the 'cold winds' (or, occasionally, the 'hot blast') of competition, which is seen as forcing individuals and firms to 'work harder and work smarter'. As mainstream economists have pointed out in response, working harder for the same pay is just the same as a reduction in wages. It therefore represents a transfer from one group in the community to another and not an improvement in efficiency. The idea that people can be 'forced to work smarter' is superficially appealing, but, on closer examination, turns out to be either meaningless or false. An increase in effort devoted to finding improved ways of doing things is just a particular form of working harder.

The evolution of economic rationalist attitudes towards the public sector followed a similar path. Mainstream economics provides a range of arguments for and against government intervention in particular cases. Consistently arguing against government intervention, economic rationalists came to rely on the view, naturally popular in the business sector, that private enterprise is inherently superior to government action. This view was reinforced in the 1980s by the perceived success of the 'Thatcher revolution' in the United Kingdom, and by the apparent dynamism of private sector entrepreneurs like Bond and Skase.

In the 1970s, economic rationalists had employed mainstream economics to criticise popular arguments in support of government intervention. From the 1980s onwards, however, economic rationalists increasingly relied on popular beliefs about the merits of competition and private enterprise, rather than on mainstream economic analysis.

The divergence between economic rationalism and mainstream economics is increasingly recognised within the economics profession, though not by many economic rationalists. A survey of academic economists undertaken by Michael Harris revealed general agreement concerning the set of policies that constituted the program of 'economic rationalism'. However, while those who identified themselves as opponents of economic rationalism agreed that economic rationalism involved strict opposition to government intervention and a belief in the inherent superiority of private enterprise, economic rationalists disagreed among themselves. Those who might be regarded as 'hardliners' agreed with the characterisation, but others claimed that economic rationalism was nothing more than the application of mainstream economics to policy issues. As has been shown, the latter description was appropriate in the early 1970s, but does not describe the economic rationalists of today.

Economic rationalism and economic policy

Both the terminology used to describe economic rationalist policies and the content of those policies have changed over time. In the 1970s the focus was on deregulation of the private sector and the removal of tariffs and stabilisation schemes for agricultural products, that were seen as distorting price signals. The key idea was that of 'allocative efficiency'. This term is rarely defined precisely by economists, and is quite separate from productive or technical efficiency. Roughly speaking, allocative efficiency is increased if the total value of national output rises, regardless of what happens to the distribution of that output. For example, a policy which took $100 from each of one million families and gave $101 million to Kerry Packer would pass the efficiency test. The central slogan for advocates of allocative efficiency was that of 'getting prices right'.

From 1980 onwards, the 'Thatcher revolution' in the United Kingdom became increasingly influential and attention turned to policies of privatisation, corporatisation and competitive tendering in the public sector. These and similar policies were collectively referred to as 'microeconomic reform'. The term 'microeconomic reform' reflected a conscious rejection of the focus on macroeconomic policy that dominated the economic policy debate from World War II to the mid-1980s. Attempts to restore the effectiveness of macroeconomic policy went on into the early 1980s. However, the lack of success in this area led governments to pay increasing attention to the idea of microeconomic reform.

Microeconomic reform is seen by its advocates as an alternative to macroeconomic policies designed to reduce unemployment and boost growth. Rather than dealing with aggregate quantities like the average level of real wages, the current account deficit and aggregate demand for goods and services, microeconomic reform deals with the productivity of individual sectors of the economy.

Microeconomic reform has continued in the 1990s, but with a steadily increasing focus on the idea of promoting competition.

Since 1993, the term 'Hilmer and related reforms', or sometimes simply 'Hilmer', has been used to describe the present stage of microeconomic reform which focuses primarily on the belief that competition should be the central element of microeconomic policy. The term arises from the report of an Independent Committee of Inquiry into National Competition Policy but the reform program goes well beyond the specific recommendations of Hilmer and his colleagues.

The Committee's Report was issued in 1993, at a time when the community and sections of the government were widely believed to be suffering from 'reform fatigue'. Advocates of microeconomic reform used the Hilmer Report as the basis for a renewed push for public sector reform, centred around the Council of Australian Governments (COAG). By virtue of its reliance on inter-governmental negotiations and remoteness from open political debate, the COAG process permitted further extensions of the microeconomic reform process to be presented as a fait accompli, embodied in the opaque legislation of the National Competition Policy Act.

Popular disenchantment with reform was thereby sidestepped. In the process, the term 'Hilmer reforms' or simply 'Hilmer' has come to be used as shorthand for the entire program of microeconomic reform, particularly as it affects the public sector and government business enterprises. In particular competitive tendering and contracting is playing a central role in the 'Hilmer reforms', even though it was not explicitly discussed in the Hilmer report.

As Hilmer (1995, p. 1) observes:

Competition policy has struck a chord with politicians and the business and wider community far beyond anything I and my colleagues Mark Rayner and Geoff Taperell might have expected when we were asked by the Commonwealth government to carry out an independent inquiry into the subject in late 1992. Competition policy often expressed, albeit incorrectly, as shorthand for 'more competition' is now the central plank of reform in areas as diverse as electricity generation, legal services, health care and ports.

While it is accurate enough to say that competition policy has struck a chord with politicians and with the political leaders of the business community, it is far from clear that the same can be said for the wider community. 'Hilmer' is seen by many as a policy imposed from above without consultation, and competition policy is regarded as a codeword for increased work intensity and reduced job security.

The economic position of economists

The economic rationalists' support for deregulation and free trade made them natural allies of the financial and mining sectors. The models used by economic rationalists, in particular the Industry Commission (now the Productivity Commission), and the way in which the results of these models are reported, have been tweaked and adjusted to the point where they routinely give answers favorable to the finance and mining sectors, even when these answers are apparently contrary to basic economic theory. One result has been a steady flow of economists from public bodies such as the Productivity Commission and the Treasury to highly paid positions in the financial sector to the point where such a progression can reasonably be regarded as a standard career path. At the same time, the increasing importance of economics in the policy debate led to the emergence of well-heeled business lobby groups, many of which were aligned with the financial and mining sectors, pushing economic rationalist views.

Over time, the combination of policy alliances and the availability of attractive career paths has led economic rationalists to feel and express increasing sympathy for the interests of the mining and financial services and an to absorb many of the economic ideas popular in these sectors. Crucial elements of this outlook include a focus on narrowly monetary measures of well-being and an obsession with the balance of payments (and exports in particular) as an index of national economic performance. Neither of these ideas is justified by mainstream economic theory.

The assocation of economic rationalists with the financial and mining sectors is reflected in their attitudes to community services such as health and education, and to the environment. A few consistent libertarians suggest that a purely free market approach to the provision of health and education, and even to environmental protection, is feasible. However, given that state provision of these services is likely to continue, the majority of economic rationalists in Australia have responded by becoming increasingly hostile to the services themselves. Thus, for example, a respectful hearing is given to the tiny minority of scientists who claim that global warming is a myth and to theories implying that higher education is a waste of time and money. This attitude neatly fits in to the naive mercantilism common in the business sector, where community services are seen, not as a central element of our economic well-being, but as a cost burden detracting from 'competitiveness' on export markets.

The outcomes of economic rationalism

The achievements of the economic rationalists have been at best mediocre, at worst disastrous. It may be useful to consider the economic outcomes in three separate areas, namely, microeconomic and macroeconomic performance and income distribution, before turning to the social impacts of economic rationalism.

There are some elements of the microeconomic reform program, such as waterfront reform and egg industry deregulation, for which nearly all economists would agree that the net benefits have been positive. In other instances, for example the laying of duplicate cable telephone systems by Telstra and Optus, nearly all commentators agree that there has been a social loss. For example, the duplication of cable television and telephony implies a social loss of around $4 billion, or 1 per cent of GDP over the three years from the beginning of the rollout in 1995 to the advent of open competition in 1997.

In other areas, such as financial deregulation, the economic rationalists persist in claiming victory even though the evidence of failure abounds. Hardly any of the predicted benefits of deregulation, such as stabilisation of the current account deficit, increased competition in retail banking or reductions in interest rate margins, have materialised. Particularly in the first decade of financial deregulation, the financial sector consumed steadily increasing resources while distorting investment outcomes and putting criminal 'entrepreneurs' in charge of many of Australia's major corporations.

The most important economic failure of the past twenty years has been the rise and persistence of large scale unemployment. Economic rationalism cannot be blamed for the initial rise in unemployment, but it has been a major obstacle to any serious policy response. The macroeconomic misjudgements that led to the 1989-92 recession were due in part to the disturbances in the financial system generated by financial deregulation. In addition, many advocates of economic rationalism argued that the government should not allow short term macroeconomic disturbances to distract it from the 'main game' of microeconomic reform. This set of priorities helped to generate the passive response of the government to rising unemployment from 1989 to 1991, and continues to drive policy today.

Economic rationalism has led to a steady increase in inequality, particularly in market incomes. The replacement of awards by enterprise bargaining will exacerbate this inequality. Under the Hawke-Keating government, the increasing inequality of market incomes was partially offset by tighter targeting and a general improvement in the design of social welfare programs, and by the political mishandling of Keating's proposal for a regressive GST, which was defeated in favour of the moderately progressive 'Option A' package of tax reforms. However, the safety net is steadily unravelling under the Howard government, and it seems unlikely that a GST, including a regressive tax on food, can be staved off forever.

In summary, the microeconomic reforms at the centre of economic rationalist thought have some successes to their credit, but at least as many failures. This mediocre outcome has been achieved at the cost of an ineffectual response to the unemployment crisis and a steady increase in income inequality and social division more generally. The social consequences of economic rationalism include a steady erosion of social cohesion as competition and the naked pursuit of self-interest invade more and more of our social life, with obvious winners and losers.

This negative evaluation of economic rationalism is supported by the experience of countries such as United Kingdom and New Zealand, where reform has been more comprehensive than in Australia. Despite some periods of strong growth, neither country has outperformed the OECD average growth rate since reforms based on privatisation commenced in 1979 and 1984 respectively. The average rate of growth of New Zealand's GDP per capita for the period 1984-95 was close to 1 per cent, considerably below the rates of between 1.5 and 2 per cent achieved in Australia. After two years of good performance in 1994 and 1995, the growth rate of GDP per capita fell back to 1 per cent in 1996 and appears to have stabilised around this level.

Similarly, after all of the cyclical fluctuations are washed out, Britain has little to show for the Thatcher revolution. In 1994, Britain was in 18th place in the OECD league table, just as it had been when Thatcher was elected. After sixteen years of radical economic reform, it had overtaken only New Zealand, the one country where reform was pursued with even greater vigour. This gain was offset by the fact that Italy had jumped ahead of both countries. Statistics of this kind are subject to a wide range of error, and precise rankings are not really meaningful. Nonetheless, despite the opportunities offered by North Sea Oil and European integration, the best that can be said for Thatcher and Major is that Britain's relative decline did not accelerate under their government.

The statistic most commonly cited by defenders of the 'Thatcher miracle' is Britain's relatively low rate of unemployment. But this has not been achieved primarily by creating jobs -- employment is still well below its 1990 peak. The main factor that has pushed unemployment down is withdrawal from the labour force, which contracted in every year of the supposed boom from 1992 through 1995. The unemployment figures say more about the Thatcher-Major government's ruthless treatment of unemployed workers than about the dynamism of the labour market.

The United Kingdom and New Zealand, like the United States, have experienced a massive increase in inequality, and a steady decline in social cohesion. The defeat suffered by the British Conservatives, like the defeat of the Keating government in Australia, reflected a backlash against the social as well as the economic consequences of economic rationalism. Even though the alternative was not particularly promising in either case, more than a decade of accumulated resentment and disillusionment made itself felt at the ballot box.

Concluding comment

Despite their dogmatic certainties, and their dominance of the policy debate for more than a decade, economic rationalists have failed to produce any tangible economic benefits for the Australian people. It is time for a revival of a spirit of objective enquiry and scepticism about established orthodoxies -- for rationality as opposed to rationalism.

 








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